Exit strategies

Author: | Published: 4 Jan 2001
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This article will concentrate on exit strategies for first-round institutional venture capitalists in Asian high-tech start-ups. Many of the issues will be relevant to other venture capital situations, most typically in the Asian context infrastructure investment, but also for restructuring and management buyouts – which are still uncommon, despite the Asian financial crash in 1997.

Exit strategies for venture capitalists and private equity providers in the Asian markets owe much to the experience gained and techniques employed in European and, particularly, North American markets. In relation to venture capital for high-tech start-ups in the Asian markets, which has only dominated attention over the last two years, the most influential venture capital firms have a Silicon Valley pedigree. This has led to, or at least coincided with, the fact that most of these investments are structured adopting US-style documentation, with Series A convertible preferred stock, demand registration rights agreements and so on. The legal documentation is often more onerous, in terms of the harness it puts on the entrepreneur and investee company to achieve an exit for the venture capitalist, than typically seen before in Asia. However, there is little reluctance and more of an expectation, on behalf of high-tech start-ups, that venture capital will be deployed using Silicon Valley-style legal structures. It serves as brand approval – but can give rise to terms applied to particular investment situations which are surprising, not to say questionable, at least where practicable enforceability is concerned.

After Nasdaq

As with European and US deals, the exit of choice is overwhelmingly an IPO. At the time of writing, the Nasdaq Index is 45% below its level of March 2000. It is difficult to avoid using hindsight to suggest (with apologies to F. Scott Fitzgerald) that many of the Asian high-tech start-ups and their venture capital providers have been drawn together under the blinding influence of an orgiastic neon light, beckoning "Nasdaq IPO" from across the bay. With the dawn of this quarter's financials, the old job is looking more appealing, breakfast is harder to find and the Pacific an imposingly big piece of water to cross.

Although the surf has calmed somewhat, and the prospect of an exit by an IPO on Nasdaq is only a dull twinkle for many start-up companies and their backers, there are plenty of hopefuls waiting in the water (and more entering) in the expectation that the IPO waves will build again to carry them across the Pacific. In the meantime, attention can properly be given to a wider range of exit options.

IPO

The exit option of choice for venture capitalists, founders and investee companies is a stock exchange listing as soon as possible after the company has achieved its particular business targets or listing appeal, and market conditions allow. Apart from the very obvious attractions offered at the top of the last market cycle, which allowed tech investors to count tomorrow's (and the day after's) chickens before today's had hatched, even more ordinary market conditions will generally achieve the highest rate of return as compared with other possible exits – meaning a sale. (In the time span of IPOs for Asian tech stocks, it is perhaps difficult to say what 'ordinary' market conditions are – apart from extraordinarily volatile!)

Apart from the purely financial lure of an IPO, an IPO offers venture capitalists and entrepreneurs the advantage of flexibility. A liquid public market for the company's securities, facilities to raise money or make acquisitions from fresh issues should provide a platform for further growth so the venture capitalist may choose only a partial exit at the time of the IPO. An IPO is also prominent in many Asian entrepreneurs' motivation, as a listing confers the status of visible success. Moreover, a listing can be expected to leave the entrepreneur in control of his company. A sale of the company, or combination of the company with another through a merger, may provide a financial return, but is less likely to leave the entrepreneur in a position of control. A sale is also unlikely to leave room for the venture capitalist to stay at the table.

The focus on a listing is almost mandatory for some tech businesses, because of the competition to attract and retain scarce technology talent through share incentive schemes. Such schemes have real value only if, in a short-time span, there is a public market for the shares – start-ups are not likely to have the cash to buy in staff options.

Employee share incentive schemes may impact on exit strategies for venture capitalists, particularly in terms of timing. Venture capitalists will often encourage companies to provide these schemes and the stock markets appear to expect tech companies seeking an IPO to have them in place (and to accept an increased proportion of the company's stock available under such schemes). Typically, schemes will vest staff options over a period of four years, and there is an expectation that staff and options will expand rapidly following an IPO. This insurance on staff loyalty is, in effect, purchased by dilution of other shareholders' holdings after an IPO. Before an IPO, a share incentive scheme keeps costs down. Post IPO, they may have the effect of flattening the return to shareholders, as a bigger stake is claimed by employees.

The problems with the IPO exit route include costs, diversion of management time and dependence on unpredictable market conditions. An additional problem for start-ups has always been timing – the need to build up profits and an operating history before listing. In respect of tech companies, this has meant that funding from the Asian capital markets is not available at the most crucial stage of their growth. This is a major obstacle to their formation. The availability of a listing for tech companies on Nasdaq with a more limited track record and for companies of small size, the phenomenal success of many of those companies (forget the rest) and the spectacular returns made by the venture capitalists who nurtured the "stars", has illuminated the path in Asia. In addition, the few early-mover Asian start-ups, who have listed on the tech-dominated Nasdaq, have achieved a massive profile and recognition in their domestic markets, as well as the influence which being cashed-up brings at the lower points of the market cycle.

The first choice of an exit has, therefore, been IPO on Nasdaq. However, issues of adverse market conditions aside, a US listing is unrealistic for most Asian companies, who operate mainly in their domestic market, are not of a large scale and do not have global or US products. Venture capitalists have kept their options open and let their investees' expectations down gently, but the focus for an IPO exit has shifted to Asian domestic exchanges.

Regional bourses

This choice is possible because most Asian countries have, over the last one or two years, put in place second markets, or acted to adopt new entry standards designed to allow the listing of tech start-up companies. The influence of Nasdaq is apparent from the names of such boards: Stock Exchange of Singapore Dealing and Automated Quotations (Sesdaq), Malaysian Exchange of Securities Dealing and Automated Quotations (Mesdaq), and Nasdaq Japan

(a joint venture between Softbank and Nasdaq). The advent of the latter prompted the established markets, Jasdaq and the Tokyo Stock Exchange, to adopt a Second Standard for early stage companies and launch the Mothers market (the Market of High Growth and Emerging Stocks) respectively. The somewhat dormant Korea Securities Dealers Association Automated Quotations (Kosdaq) has revamped itself and provided fertile ground for IPOs. Hong Kong has named its start-up market the Growth Enterprise Market (GEM) (although it brands itself the 'Nasdaq of Greater China'). Taiwan has established its Taiwan Innovative Growing Entrepreneur market (Tiger board). Most recently, a second exchange in Shenzhen, PRC, was announced, targeted at tech companies, which will allow early-stage listings. This second board will adopt Nasdaq-style trading and is expected to be launched in the first quarter of 2001. This has dovetailed with venture capital regulations promulgated in Shenzhen, allowing foreign investors to participate in venture capital companies in the PRC and to invest in high-tech and emerging industries. Most governments in the region have also adopted policies to attract venture capital to their home-grown start-ups, including loosening foreign investment and exchange restrictions, adding tax incentives and co-investment of government-assembled funds.

Particular local issues arise in relation to these boards, relevant to the choice for a target IPO. Common themes are tax, liquidity and volatility. Only Hong Kong's GEM and Singapore's Sesdaq have real pretensions to offer a pan-Asian market, helped in Hong Kong's case by the ready listing of offshore companies incorporated in the Caymans or Bermuda (as well as companies established in Hong Kong, the PRC and other places, subject to waiver), and is likely soon to see US companies listed.

A number of companies and their venture capital backers want to implement dual listings for start-ups on Nasdaq and the local exchanges. An alternative sequential strategy is to list first on the local exchange and then build up, taking advantage of an opportunity to list on Nasdaq when the development of the investee's business and market conditions allow. While the logical starting place in pursuing a listing is the domestic market where a company's business is established and profile highest, some venture capitalists have sought to engineer links with more attractive regional exchanges for the purposes of an IPO, for example, by bolting-on an acquisition in the preferred market.

An innovation which neatly side-steps the problems of seeking an IPO in volatile markets, has been reverse takeovers of existing listed companies. Structuring reverse takeovers is often complex when trying to avoid triggering mandatory bid obligations or being treated as a new listing with an obligation to be approved again for listing by the relevant exchange. It may also mean (at least initially) that the original business, which is probably moribund, is included in the company – to be disposed of or shut down over a period after the reverse takeover is achieved.

However, if implemented there are some obvious advantages: the venture capitalist having already acquired public stock can time his exit or exits in accordance with the market. He can also issue listed securities to make further acquisitions of either bolt-on businesses, or merely assemble a portfolio of investee companies. If these mature they can be spun-off. Venture capitalists who have created such locally listed vehicles are well placed to exploit the market conditions – which now favour mergers and acquisitions.

Sale

After outright failure, acquisition or merger is always the most likely outcome for most tech start-ups. This is not news to the venture capitalists but often addressed in documentation only as Plan B. As well as trade sales, increasingly to the leading local players who have cashed-up on their IPOs, there is a surprising amount of recycling, as venture capitalists look to swap or share investments and assemble larger portfolios in search of synergies and scale – and stars.

While family control has been a cornerstone of Asian business culture, even for listed companies, there are certainly signs that, in emulation of their Silicon Valley mentors, Asian tech entrepreneurs are more ready to take a 'build, sell, move on' approach to their pet projects. No doubt this attitude is dictated by the ever-shortening business cycles, as technological innovation and fads create rapid changes in the business landscape. Miss the window, and the opportunity is gone, so it is not possible to wait on stock market conditions. Moreover, many start-ups could never hope to be stand-alone businesses and often require a partner or big brother to foster their development or reach markets for their products. So the exit of choice may be narrowed to, or the strategy from outset may be, a sale.

There are greater tensions between venture capitalists and entrepreneurs in a sale than for an IPO. An IPO offers a mutual exit, even if the venture capitalists will be first in the queue to realize their investment (or at least have that right). The entrepreneur is able to retain control post-IPO, and pick his exits once his lock-up is expired. The entrepreneur is comfortable that the company's shares will increase in value post-IPO and is therefore prepared to wait (although he may want to realize a little something on an IPO).

A venture capitalist may be best served by a sale, where he can deliver control of the company and deliver the entrepreneur. Where the venture capitalist is a minority investor in the original business, the sale of control is secured by drag-along rights of at least sufficient shares to give control.

In an infrastructure situation, drag-along rights are for the purpose of securing the right to sell the whole company, without minorities which gives rise to the most advantageous sale terms. In a tech business, a big part of the value may require ensuring the entrepreneur stays with the business, which means continuing his ownership interest.

Having paid for his interest in a first-round financing, a venture capitalist will want to avoid a value shift in favour of the entrepreneur, which can be created in a situation where the demands are made on the purchaser to secure the entrepreneur's continuing participation and reduce the value the purchaser is prepared to pay to others. It is both difficult in practice and legally dubious to tie individuals to a business, but the venture capitalist can do his best, typically, by ensuring the entrepreneur retains an ownership interest with the company (because he cannot realize it) and by providing that personnel are subject to service contracts with incentives, such as options based on performance and staying put. The venture capitalist would be advised to ensure transparency in respect of the terms negotiated between the entrepreneur and purchaser, by including a disclosure obligation as well as tag-along rights as part of the investment agreement.

Provisions for a unilateral exit on a sale by the venture capitalist are not likely to be appealing to the entrepreneur. He may be prepared to accept, as part of the price of getting in first-round financing, and on the basis of the venture capitalist's blandishment, that he is irreplaceable and his vital role in value creation means the purchaser will need to secure the entrepreneur and come to satisfactory terms with him at the time of any sale. Well, perhaps! A venture capitalist will say that, in any event, he is only a financial investor, and should be able to secure an exit of his choosing: it is for the entrepreneur to make a go of it and stay with the business.

If a sale is contemplated as the likely exit at the outset, there is likely to be more mutuality in the investment terms governing a sale. The agreements may include drag-along and bring-along rights in respect of a sale desired by another party subject to such a sale realizing a certain value and rate of return for the venture capitalist. An alternative approach is to include buy-back rights for the entrepreneur, protected by the proviso that such purchase will ensure the venture capitalist his desired return. In general, however, the venture capitalist will not want his upside so capped.

The venture capitalist may be equipped with a number of incentives to apply, where a sale opportunity does not arise within the targeted parameters. For example, a stipulation that if a liquidity event (such as an IPO or sale, within the investment parameters) does not occur within a set timeframe, then the venture capitalist will have a unilateral right of sale over the company, and/ or it will be compensated by increasing its percentage of the company at the expense of the entrepreneur by a transfer of shares or at the expense of the ordinary shareholders by their dilution. If it has a convertible debt instrument, it will be repaid. The practical value of such rights obviously depends on how good or bad the ultimate prospects for the investee company are.

Timing exits

Apart from the choice of exit, an important element in the exit strategy is timing. Timing involves factors such as expected benchmarks which the investee company is to achieve in its business plan, and the expected level of return which the venture capitalist wishes to achieve. Typically, a venture capitalist will have a target investment span for his portfolio against which a decision to invest is made. In high-tech start-ups, the span is much shorter than for traditional business, and for internet content companies can be six months. In other tech companies it may be 18 months to three years.

Obviously the most influential factor on timing is market conditions. A venture capitalist will wish to have the flexibility to exit earlier if an opportunity presents itself. To provide this flexibility, attention to the investment structure at the outset is required.

Structuring an exit

Although the ideal is to provide an alignment between the venture capitalist's and entrepreneur's interests on an exit, ultimately the venture capitalist will want the legal say-so. The venture capitalist will put in place an exit strategy as carefully as he can. This may include at the outset reorganization of the investee's business to create a pre-IPO structure, for example, the creation of an offshore holding into which investment is made, is often required. This may alleviate the need for local consents and approvals for a subsequent listing, local restrictions on transfers and facilitate tax planning. A pre-funding reorganization provides flexibility and speed when a listing or liquidity opportunity presents itself. The venture capitalist will stipulate an array of contractual provisions in the investment agreements designed to give him control over the exit strategy, i.e. the type of exit and timing. This will impose obligations on other shareholders to cooperate, and incentives in the hands of the venture capitalist to apply if they do not. The investment agreements also contain terms which help an exit for the venture capitalist, for example pre-emption rights, drag-along and tag-along rights, call or put options, as well as protections such as veto and priority voting rights. In addition, the venture capitalist may take dividend preference and liquidation preference rights, in case matters do not go as well as originally hoped.

Venture capitalists have usually stipulated in the investment agreements that they will not be required to give representations and warranties in connection with an exit, either to underwriters in relation to an IPO, or to purchasers in relation to a sale. The alternative approach is to take indemnities from the entrepreneurs for any liability which may arise against the venture capitalists in relation to representations and warranties given in connection with the exit or otherwise arising because of the liquidation event. This is rather second best in terms of protection but the indemnity route is probably the most practicable protection available as often venture capitalists in tech companies will have a bigger proportionate stake and have closer involvement in operational matters.

While previously unusual in the Asian context, the round of venture capital investment in high-tech companies has in some cases seen such venture capitalists assuming majority control of the investee. This arises because the leading venture capitalist often bring or arrange for management skills in support of the entrepreneur, technical and market expertise, as well as contacts to reach partners and build strategic relationships. Such a venture capitalist is clearly in the best position to influence an exit.

Choice of exit, the mechanics, and timing are also important, or should be important, to an entrepreneur. However, he is often neither in a position, or of a disposition, to take a conservative view. The demand to bring in capital and faith in the entrepreneur's project often means his focus does not contemplate anything less than the summit of an IPO.

Future

Asian governments have, with few exceptions, sought to stake their country's claims for a leading place in the new economy. Apart from acclimatising their populace to a diet of buzzwords, steps have been taken by the more developed Asian economies to establish regional bourses, aimed at early-stage companies with high-growth potential. This has significantly reduced the regulatory hurdles in Asia to an IPO, in terms of size and track record, for innovative companies who are, par excellence, the target companies for venture capitalists. For the moment, several of these second boards, like the companies they are designed for, are speculative, at an early stage of their development and have yet to prove they can sustain liquidity. Nonetheless, the readier availability of an Asian exit by an IPO through such markets, can be expected to influence the flow of venture capital into Asia. This and other factors, such as favourable policies pursued by some governments to attract international and local venture capital to local tech companies, means that a deeper Asian venture capital market is developing.


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