More Secondary Transactions Take Place In Weak Exit Environments

As I mentioned in my post about secondary transactions, these deals provide liquidity to shareholders in a number of situations.

One of the common reasons an investor might pursue a secondary is the need to provide limited partners (the investors in a venture capital fund) with liquidity at the end of the fund life cycle. This occurs because venture capital funds generally have a defined term and detailed rules about how investors in these funds can liquidate their assets in at the end of that period. In some situations, the need for liquidity can drive VCs to sell their stakes in a company before the company is ready to be acquired or go public.

Market conditions can also affect the need for secondaries. Simply put, in environments where the time to exit for a given investment is longer, more venture investors are likely to pursue secondary transactions.

The 4 Types Of Exits: Secondary

A secondary transaction is one of the four types of exit options available to entrepreneurs and investors.

In a secondary transaction shares are sold by individual shareholders to a third-party buyer. Note that this differs from an investment in the company since the shares are not being sold by the company. In essence this is structured like a side deal whereby one shareholder is able to realize liquidity without changing the number of shares or cash position.

Secondary transactions generally happen most frequently for one of two reasons. First, employees that have been working on a startup for a number of years may want to liquidate a portion of their shares to get some cash out of the venture, before the company is acquired or has an IPO. Secondaries are also frequently leveraged by investors who are either in need of cash to meet other commitments or who need to liquidate their assets because they are at the end of their fund’s life cycle.

Secondary transactions are generally considered less attractive than an acquisition or IPO. One reason for this is simply the fact that these do not represent a company-wide exit, meaning that this type of exit presents a less sexy story in the track record of founders and investors – the fate of the company may not yet be determined at the time of the transaction. Another reason for this comes from the fact that buyers in a secondary transaction generally understand that they are purchasing assets from individuals in somewhat urgent situations, in some cases enabling them to buy the assets at a discount. As a result, secondary transactions are often (albeit not always) done at a discount to what the share price that would be realized in an acquisition or IPO.

It is important to note, however, that these transactions play an important role in the investment community as they give investors a way out of sticky liquidity situations.

VCs Appreciate Geo-Flexibility

A reader recently asked me if VCs preferred entrepreneurs who are willing to relocate their companies.

In my post, The Importance Of Geography, I make the point that VCs do use the location of a company as a selection criteria. VCs that only have capabilities in the US might not invest in a Chinese startup. As a result, a founder’s willingness to move his company into the VC’s target geography can make the difference when the VC is deciding to invest.

There are, however, some other considerations that should influence an entrepreneur’s (and VC’s) willingness to back a company that is moving. First, both investors and entrepreneurs should only be interested in moving the company if it does not disrupt the core business. If a swath of effective employees would have to be replaced, new partnerships forged or new customers acquired, investors might be averse to backing a company that is relocating.

Second, some VCs are hesitant to back entrepreneurs that don’t have deep relationships in the local ecosystem. There’s a rational argument for this – without a local network, finding talent and getting introduced to key contacts can be difficult.

In sum, the decision to back a startup that is changing locations is typically made on a case-by-case basis. When a move into a VC’s target geography is beneficial for the company, however, it is generally looked upon favorably.

Impact Of The Longer Time To Exit For Both M&A And IPO

An important trend is taking place in the venture marketplace – it is taking longer for VCs to exit their investments.

In 1995 (before the Internet boom), the average software acquisition occurred 48 months after a company was launched. Initial public offerings were made at an average of 56 months into a venture. In 2007, M&A happened on month 65 and IPOs on month 67. That’s a significant change – 35% and 20% later, respectively.

What’s unclear to me is whether or not this trend will reverse over time. If the time to exit continues to lengthen it could have a number of consequences. Some of the potential impacts include:

• Longer LP Commitments: Venture funds are designed in such a way that their limited partners are required to commit capital for about 10 years. However, with an average five and a half years to IPO, there are bound to be companies that don’t exit for up to a decade, meaning that LPs may be required to commit their capital for a longer period.


• Increased Liquidity Premium: LPs agree to lock-up capital in a venture fund for up to 10 years due to the expectation that the risk they taking in having the capital tied up (which may mean they miss future investment opportunities) is compensated by higher returns. If the lock-up period increases, LPs will likely demand a higher return (or they’ll invest their money elsewhere such as with hedge funds or leverage buyout firms).


• Lower Valuations: If VCs across the board need to generate higher returns (and they can’t increase their time to exit) they will likely require greater ownership of their portfolio companies, translating into lower valuations of startups and greater dilution of entrepreneurs.

This scenario is a losing situation for everyone and I am optimistic that the market will evolve back to shorter exit times as the M&A and IPO markets enter future legs of their cycles. However, it’s important to continue to watch these dynamics as they could have industry-wide consequences.

IPOs Usually Take Longer To Realize Than M&A

The average company exiting through a public offering is more mature than a company that exits through an acquisition, at least since 2000.

There is good reason for this extra maturation. Public investors are often seeking to buy shares in companies that will continue to operate independently long into the future. In contrast, corporate acquirers may buy companies when they are very young before the company has demonstrated its ability to sustain itself. There are a variety of reasons why a company might be bought without demonstrating financial sustainability; a fledgling company might be acquired for its assets (technology, customer, contracts or management) or it may be acquired as a defensive maneuver – to eliminate the opportunity for the company to become a long-term threat.

It could also be argued that Sarbanes-Oxley legislation, which requires additional internal process documentation and oversight by public companies traded on U.S. exchanges, has delayed public offerings. Companies must ensure they will be compliant with Sarbanes-Oxley regulations, and that they can afford to pay the associated costs, before they can issue public stock for the first time.

From the period of 1996 to 2008, the average company that IPO’d was 8 months older than the average company to be acquired. It’s worth noting that this pattern didn’t hold true during the Internet boom. In the period of 1996 to 1999, the average software company making its initial public offering was five months younger than the average company being acquired (according to Dow Jones Venture One data).

The general trend of IPOs taking longer to realize than acquisition also puts pressure on investors to push for larger exit values. VCs are judged by their investors based upon a number of metrics, one of which is call the Internal Rate of Return (IRR). An IRR is an accurate way of measuring the average annual rate of return on invested capital adjusted for the timing of cash flows. A simple relationship that comes from this math is the fact that longer times to exit reduce the effective annual return. Returning 200% of invested dollars in 1 year implies a higher average annual increase in value than returning 200% of invested dollars in 10 years. As a result, the delay in exit time drives VCs to require higher exit values to adjust for the delay. While in theory the increase in value can be justified by the company’s ability to expand its operations and increase revenues over that period, every exit is ultimately a negotiation and this delay drives VCs to target higher exit values.

The 4 Types Of Exits: IPO

IPO or initial public offering is another of the four types of exits. In an initial public offering, a company first sells a portion of it shares in a public market, such as the NY Stock Exchange or the NASDAQ.

By “going public,” a company sells a portion of its stock to investors that are entitled to freely sell their shares over the specified exchange. Through the exchange, they can sell directly or indirectly to virtually any buyer in the world.

It’s worth noting that not all of the company’s stock is publicly accessible at the IPO. Companies typically sell only a portion of the company to investors through the public exchanges.

What makes IPOs so special is that subsequent public offerings are less risky for the company as they have more information about the stock’s pricing once shares are being freely traded and priced by the market. During the IPO, the company’s investment bankers are tasked with creating a small marketplace and identifying clearing prices for the initial shares. After those shares are sold, the buyers can transact them freely, yielding prices that reflect the valuation applied by more buyers and sellers, creating a price that is truly reflective of the market’s estimate of the company’s value.

VCs, entrepreneurs and others often participate in the public offering, meaning that they include their shares in the group that is sold to the market. This enables VCs to exit at least a part of their investment – shares are converted into cash which can be distributed to their limited partners.

VCs generally like exiting through IPOs. While IPOs present investors with some liquidity risk, as insiders are often subjected to lock-up periods during which the investors and entrepreneurs cannot sell their shares on the market immediately after the IPO, IPOs offer VCs several advantages. First, public companies remain going concerns, enabling VCs to take credit for investments that they made (potentially) long into the future. An IPO not only offers a VC a merit badge that can be promoted to entrepreneurs and limited partners, but it also enables the VC to leverage its contacts at the newly public company to help future portfolio companies in many ways (from acquiring customers and partners to initiating acquisitions).

Acceleration Triggers

While the events that trigger the acceleration of vesting can vary by contract, there are a few common structures.

The first is called single trigger acceleration. In single trigger acceleration, the vesting is accelerated when a change of control (AKA acquisition) occurs. Investors, however, might find giving key managers single trigger acceleration disconcerting. What happens if the acquirer requires the key personnel to stick around through the post-acquisition transition? If these key managers get their payouts on the day the transaction occurs, they may not have an incentive to help out after the acquisition, a risk that can scare of likely acquirers.

As a result, managers that are likely to be key to the transition of the company after its acquisition are typically offered double trigger acceleration. This structure requires two events to take place in order for acceleration to be triggered. First, a change of control must take place. Second, the manager must either work for the acquirer for a pre-determined period or be dismissed by the acquirer. These managers still get their payout, but have an incentive to support the acquirer after the acquisition.

Double trigger acceleration is an important requirement as it can prevent the expectation of selfish behavior from derailing acquisitions.

The Intern's Picks: December 23rd

• Laid-Off, But Not Laying Down: Part One
• Washington Is Killing Silicon Valley 
• What does your business actually do?
• Elevation Partners Pours $100 Million More Into Palm. How’s That Nova Running?
• Introducing GamesBeat 2009, a conference about the future of the video game business
  

Compliments of Alex Horn and Jeff Hui 

Acceleration

In my post, Founder’s Equity Will Vest After Investment, I describe the mechanism by which founders earn back their equity over time. Vesting, earning equity over time, also affects the stock options of key managers and employees.

While vesting provides key people with an incentive to stay with the company over time, it can leave some concerned that they won’t get their fair share if the company is sold quickly. For example, if a founder owns 20% of the company and his stake is set to vest over four years (5% per year), he might wonder how much he will be paid if the company is sold after the first year. Will he be paid out as if he owns 5% or 20% (the total amount of equity allocated to him, not all of which had vested)?

The saving grace for individuals exposed to a vesting program is acceleration. An acceleration clause accelerates vesting of stock in pre-defined situations. One commonly pre-defined situation is a change of control, a legal way of describing an acquisition.

If the founder in the scenario above had an acceleration clause that was triggered by this acquisition, he would own 20% (or another number determined by his acceleration clause) at the time of sale.

Earn-Outs: Distributing Risk

When acquirers and the shareholders of a company come to an impasse on valuation based upon assumptions about future performance, the pricing gap is sometimes bridged through an earn-out. In an earn-out, the buyer agrees to pay the current shareholders additional compensation as pre-determined future operating metrics are achieved.

For example, if shareholders expect sales to increase next year and the acquirer doesn’t, the acquirer might agree to pay more for the company in the future if sales do in fact increase. Doing so enables the acquirer to protect itself from paying too much for the target in the event that sales don’t increase – the seller takes on the performance risk.

While structures vary greatly, in the plain vanilla version the target is purchased for a base price with the possibility of an additional earn-out. Earn-outs need to be well defined to ensure that both parties know when the payouts are triggered.

Sellers typically try to avoid earn-outs because it requires them to assume the performance risk. However, earn-outs are not uncommon as they are a useful mechanism for allocating risk.