How Startups Can Build A Successful Exit Strategy

As a legal advisor for startups, one often hears about the challenges that companies face when it comes to investors or stakeholders mapping out their exits. As a startup, the company’s goal is to create a successful business that will eventually lead to a return on investment for its investors. 

One of the most important things a business can do to ensure success is to have a well-thought-out exit strategy. But with so many different types of exits available, how does one know which one is right?

In this article, I’ll provide a brief overview of the different types of exits and offer solutions to common problems faced by startups. First of all, let’s define what is meant by “exit”. 

An exit is essentially the stage of a startup’s journey when the founders and investors receive a return on their investment. This can happen through various means, such as an acquisition, a merger or an IPO. There are several ways that an exit can be executed and every exit strategy has its own advantages and disadvantages. 

The right exit strategy for a company will depend on a variety of factors, including the industry, its business model, and its growth trajectory. Let’s discuss each of these with a brief explanation and possibly an example.

Mergers Or Acquisitions

For technology-based startups, mergers or acquisitions are one of the most common exit strategies. This happens when another company buys a company for a set amount of money. 

This can be a viable option for startups that have developed a strong product or service but don’t have the resources or expertise to bring it to market on their own. Mergers and acquisitions can be a great way to exit because they allow the company to cash in on a company’s worth without any administrative responsibilities. 

IPO

Another popular exit strategy is an IPO (Initial Public Offer). An IPO is when a company goes public, issuing stock to the public for the first time. IPOs are great because they allow the company to cash in on the value of the company, and they also give the company access to capital that it can use to grow its business. 

However, IPOs can also be challenging, especially if the company is not familiar with the public markets and the regulatory requirements associated with going public. 

Private Equity Sales

Finally, private equity sales are another exit strategy that’s becoming increasingly popular. In a private equity sale, a private equity firm buys a company, usually in exchange for a substantial amount of capital. 

Private equity sales are great because they allow the company to cash in on its value, and the private equity firm usually takes on the responsibility of running the business. However, private equity sales can also be challenging, especially if the private equity firm has different goals for the company than its promoters do.

Consider The Legal Perspective

From a legal perspective, exit strategies are essential for startups as they provide the framework for transferring ownership, management, and control of the company. The exit strategy should consider the interests of all stakeholders, including the founders, investors, employees, and customers. 

But let’s not forget that the negotiation of drag-along rights, registration rights, and redemption rights plays an important part in exit planning as they ensure that the interests of all stakeholders are protected. These rights also provide a mechanism for raising capital, realising the value of investments, and providing an exit option in the event that the company does not perform as expected. 

Additionally, startups must carefully consider these rights as part of their exit planning process to ensure a smooth and successful transition.

Let’s understand the meaning of these terms in an easy, uncomplicated way beginning with the ‘drag along’ rights. Drag along rights give a majority shareholder the ability to force the sale of the company if they are able to secure a buyer. 

These rights protect the interests of the majority shareholder by ensuring that they have a say in the sale of the company and that they are not left holding an equity interest in a company that is no longer viable. This right in an exit strategy helps in preventing a small group of stockholders (such as a sentimental founder or a risk-taking investor) from obstructing a transaction favoured by the majority. In a way, these rights promote bias towards liquidity, even if it leads to subpar outcomes, guaranteeing that investors don’t hesitate and end up with no returns.

Next up is ‘registration rights’, these rights give investors the ability to sell their shares in the company through a public offering, subject to certain conditions. This can be an important tool for startups as it allows investors to realise the value of their investment in the company. It also provides a mechanism for the company to raise capital, which can be used to fund growth and expansion. 

Let’s also talk about redemption rights, they are not being actively used in exit planning these days, but redemption rights give investors the ability to require the company to repurchase their shares for a specified price, subject to certain conditions. 

Registration rights can be a crucial tool for venture capital (VC) funds with a set timeline, such as ten or twelve years. This will specifically affect fast-growing companies as they will be obligated to look out for financial redemption even before they are ready because of the liquidity crisis this creates. It is rather rare to find these provisions in a term sheet these days.  

Why Is It Important To Map Out A Path For Exit From The Early Stage Of A Company?

To explain the ‘why’ in simple words, first, having a clear exit strategy can help the company maximise its value when there is an exit. This is because investors are more likely to invest in a company that has a clear plan for exiting. 

Second, having an exit strategy can help one ensure that everyone is on the same page when it comes to the company’s future. This is especially important if the company has multiple stakeholders, as it helps to avoid disagreements and misunderstandings down the road.

Let’s understand the application of exit strategy with a fairly recent but important real-life example of a successful exit is the case of WhatsApp. In 2014, Facebook acquired WhatsApp for $19 Bn, one of the largest acquisitions in technology history. WhatsApp had a clear exit strategy from the beginning, focusing on growth and user engagement. 

This focus helped the company to build a large and loyal user base, which made it an attractive acquisition target for Facebook. The acquisition was a win-win for both companies, as Facebook was able to acquire a popular messaging platform, while WhatsApp was able to exit and cash in on the value of its business.

In conclusion, having a clear exit strategy is essential for all startups. For technology-based startups in particular, there are a lot of innovations and novel ideas surfacing in the market and one needs to have their exit strategy figured out to be able to successfully run their business. 

Understanding the different types of exits, including mergers and acquisitions, IPOs, and private equity sales along with a few important rights that are part of the term sheet is key to ensuring that the company has a successful exit. With a well-planned exit strategy, the company can maximise its value, which is the goal of every entrepreneur ultimately.