When it comes to raising equity, the most important aspects of any investor’s decision to invest are: 1) How they are going to get their money out? And, 2) What they are going to make when they exit the deal. This can often be a complicated matter to explain and, if neglected when developing your business plan, could end up costing you the financing you need to build your business.
First, an exit strategy is much more than just what your company is going to be worth at some point in the future. Understanding what your investor needs to see is an essential element of your presentation. For example, if you investor looks for a 2 to 3 year exit then don’t show him a 5 year exit plan.
A well-conceived exit strategy for a prospective investor will look at things such as; who the potential suitors are for the business, what kind of professional assistance you will require to properly market the company and achieve the desired valuation, whether an IPO makes sense for your business, among other factors. Showing that you’ve put considerable thought into their exit strategy can give you an advantage when they are deciding on the next investment for their portfolio.
When you plan an exit strategy, the issue of valuation will inevitably come into question. While it is possible that your company with $1,000,000 in revenue and breaking even will reach $500,000,000 in sales with 30% EBITDA by the end of year 5, it is simply not likely. A huge “watch out” for any investor is when an entrepreneur with a vision is wearing rose-tinted glasses. So, play it conservative and make sure that your growth and anticipated enterprise value are somewhere within the realm of possibility.
However, be careful… being too conservative can turn an investor off your deal – nobody wants to see flat line projections with five years of losses ahead! If you honestly think that is where your business is going, do yourself a favour by shutting the doors and getting started planning your next venture – never try to set an unrealistic performance expectation to raise capital. Knowing that you are going to fail and taking the money anyway will kill your reputation in the financing community and possibly even your industry.
When possible, provide a potential investor with examples of other companies in your industry that have achieved the type of success that you are projecting. Depending on the type of investor and stage of growth your company is in, it is not unreasonable for an equity investor to expect a 3 to 10 times return on an equity investment over 3 to 5 years.
If you do manage to attract the interest of an investor who likes the exit strategy you have presented, be sure to protect your ability to enjoy in the success of the business down the road. While a good lawyer with extensive merger and acquisition transaction experience is a necessary resource to protect your interest from a legal perspective, it is important to make sure that you understand the intentions of any term sheet or discussion you have from a business and practical perspective. For example, it is not uncommon for investors, even if in a minority position, to insist that they have significant influence when it comes to business decisions or raising additional capital – this could be through a voting trust arrangement or simply taking a majority of seats on the board of directors.
They may also want to ensure that they get their return of capital and any gains paid out in priority to the other shareholders (i.e. you and you other shareholders). If you are comfortable with the idea of having an investor who is going to be self-serving in this respect, then this may work for you. Many companies would not have the balance sheet strength to sustain such a cash flow hit just to pay off an investor, sometimes leaving the remaining shareholders trying to create additional value in a company that is stripped of its book value and all but insolvent. In short, understand what your potential investor is looking for and make sure that they are not in a position to strip the company of the value you and your team has work so hard for when it is time for their exit.
by Ian W Harvey