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Exiting
a Venture Capital Investment
Exit
strategies vary considerably according to the
structure of investment, from the lone 'angel'
investor at one extreme to publicly-quoted venture
capital funds of funds at the other, but exit
routes consist of an IPO (initial public offering),
trade sale of shareholdings, merger or acquisition.
IPO
During
the go-go years of the TMT boom in the 1990s,
the initial public offering was the most popular
and visible exit route for most venture capital
investee companies. Investors, whether venture
capital funds or individuals, are 'insiders' during
a flotation and their shareholdings are subject
to disposal limitations for after the IPO. Once
the stock is freely tradable, usually after about
two years, investors can choose whether to liquidate
the investment and roll it over into another investment,
or to hold the shares hoping for further appreciation.
Funds or individuals making the latter choice
in 1999 or 2000 had reason to regret their decision
in many cases due to precipitate falls in high-tech
company valuations, although conditions began
to improve in 2002, and by 2004 some kind of normality
had returned to the high-tech IPO sector. Over
the last twenty-five years, almost 3,000 companies
financed by venture funds have gone public in
the US.
Mergers
and Acquisitions
Mergers
and acquisitions represent the most common type
of successful exit for venture investments. In
the case of a merger or acquisition, the venture
firm or investor will receive stock or cash from
the acquiring company. Less often than with an
IPO, shares acquired in this way may be subject
to 'lock-up' limitations for a period of time.
Valuations
It's
a characteristic of the venture capital investment
sector that investee companies will go through
several rounds of financing as they grow towards
the magic moment of an exit. Each round of financing
requires that the existing and incoming investors
should agree on a valuation of the investee company.
During the glory days of the 1990s bull market,
valuation was not difficult - just think of a
number and double it!
Things
have been very different since, not least because
of the various types of 'umbrella' or 'claw-back'
mechanism typically included in venture capital
shareholders' agreements. There are various ways
in which venture capital investors seek to limit
the risks they are taking, and one of the more
usual is to have a clause limiting the returns
of other shareholders if exit takes place at a
low valuation - thus the venture capital company
may receive back its investment in cash before
the sale proceeds are divided among the shareholders.
It gets paid out twice, therefore. Such clauses
are perceived as unfair by entrepreneurs when
they operate at low valuations - but they are
easy to skip over when you are desperate for funding!
The
volatility of stock markets, the existence of
lock-up agreements, and the protection clauses
in shareholders' agreements taken together mean
that valuing venture capital funds is much more
of an art than a science. This doesn't matter
so much in a closed-end fund with illiquid investments,
where valuation may be irrelevant until the fund
closes, but it matters a lot from a tax perspective
to any investor whose investments are disposed
of during the life of a fund or who is party to
a takeover.
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