Venture Company Exit Options

By Nicole Gravagna, Peter K. Adams

A lot of confusion exists about what constitutes an exit, also called a liquidity event. At the exit, the venture capital investors convert their investment in your company back into cash (hence the use of the word liquidity). The liquidity event can happen in a number of ways (outlined here), but the important thing for investors is that they get to put cash in the bank.

An exit does not mean that you have to leave the company. In fact, in many cases, the exit terms may require that you stay for a minimum of one to three years after the acquisition in order to ensure continuity and value for the buyer.

Some founders spend the rest of their careers with their companies, even though the company is now owned by someone else. Other founders — think of them as serial entrepreneurs — move on to start something else after every exit.

When it comes to exits, you have options. Different companies pursue different liquidity options. Typically, your agreement with your VC specifies what the exit for your company will ideally look like. You don’t want to enter into a relationship thinking that you’ll buy back the shares while the VC, unbeknownst to you, is thinking that you’ll have a huge initial public offering (IPO).

The type of exit you choose early on doesn’t necessarily mean that you are bound to follow that strategy blindly. Your actual exit strategy will be driven by short-term trends in the economy, the markets, and in private corporations.

If it’s a hot time for IPOs, then an IPO may be a good option. If corporations are sitting on piles of cash, then a merger or acquisition may be your best strategy. Ultimately, the exit is up to the acquirer. If they don’t like the terms or the type of exit, the transaction won’t close.

  • Mergers and acquisitions: The most common way for venture-backed companies to exit is through mergers and acquisitions (M&As).

  • IPOs: In some cases, becoming publicly owned and traded on the stock market is better for a company than undergoing a private acquisition. In these cases, the company has an initial public offering (IPO), when it sells stock publicly for the first time.

  • Stock buybacks: In a stock buyback, the company buys stock back from the angel or VC investors. In this exit, the VCs get their money back directly from the company instead of from new investors in an IPO or from another company in an M&A.

  • Options for angels but not VCs: Royalties and revenue shares.

    • Royalties are small amounts of money that are returned to investors regularly. The amount of the royalty is generally based on how well the company is doing at any given time. The frequency of the royalty payment is defined in the term sheet and is set at closing. Royalties are typically earned on licensing of intellectual property (IP) of some kind. They represent ongoing, passive income and can be attractive to some investors.

      Except in unusual circumstances, VCs are not interested in royalty revenues because they typically don’t have the opportunity to scale like other investments. The investors may get their money back, but this exit strategy doesn’t offer the homerun ability that VCs need. Angel investors are more likely to get involved in a revenue share deal.

    • Revenue sharing can be used to buy out investors as the company grows. (It’s similar to increasing payments on a loan over time and then eventually paying off loan and the interest.)

      Although revenue sharing may be attractive to friends and family investors and some angel investors, you’ll never get a VC to enter into this kind of deal.

      However, if you can demonstrate that your company will generate huge amounts of free cash flow such that you can return the investors’ money in a year or two and then keep that cash flowing until a pre-agreed upon cap is reached, this may be an exit worth pursuing with angels.

    Remember: The SEC has certain restrictions on the types of investments that exempt VC funds can make, and one is that the investments typically need to be equity based, so royalties and revenue shares may not be an option for most VCs, even if they wanted to do them.