Friday, 13 September 2013

Twitter, PayPal, IPOs, Dragon's Den and Shark Tank - How to Form an Exit Strategy

One of the questions asked on Dragon's Den (and the US variant Shark Tank) is often the deceptively simple "what are your plans for the future", or the slightly more unnerving "what are your goals for the business."
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I don't think I've heard anyone on BBC's Dragon's Den come out and ask "what is your exit strategy?", but I've heard those words uttered on Shark Tank, and seeing some of the deals that they do there, I'm certain that it's often at the forefront of many of the entrepreneur's minds.

Put simply, and exit strategy is often about maximizing the value that a company owner can take out of a company, whilst ultimately losing both control and overall responsibility for it going forward.

In many cases, an IPO is an example of an exit strategy.

Think about it - the entrepreneur builds something up, and then exchanges a large amount of their shareholding (if not almost all of it) in return for a proportion of cash.

It's like going on Shark Tank, and doing a licensing deal with Mr. Wonderful.Sure, you'll get your dollar per sale, but you'll lose any right you had to dictate where the sales are made, and to whom.

That just fits in with some people's idea of an exit strategy.

Value Based on Potential

Kevin O'Leary, if you asked him, would, I strongly suspect, say that he was offering a deal that is based on the potential of the product, and that his offer reflects that perceived value. And, like him or not, he's often one of the clearest-headed and fairest of the Sharks.

What was not fair, on the general techie population, was the valuation of PayPal at the time of their IPO.

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It set a precedent.According to C|Net, the share price made a 54 percent gain overnight following the IPO. They went on to say the following:

"Although PayPal is popular, it isn't yet profitable. In the quarter ended Dec. 31, PayPal lost $18.54 million on sales of $40.4 million, compared with year-ago losses of $41.9 million on revenue of $8.8 million."

This is a classic case of a value of a company being decided upon its potential to make money. One might be tempted to call is "style over substance" were it not for the fact that PayPal's been pretty successful over the years.

(They were eventually acquired by eBay, whose share price now trades in the 50 dollar per share range.)

Value Based on Performance

The other way to value is based on performance. This is what many Dragons and Sharks (and probably regular, non-TV investors) look for. They look at the current ROI (Return on Investment) based on some piercing questions about the balance sheet and profit and loss account, and decide what to offer in terms of equity.

Some fast reverse mathematics enables the viewers to work out what they're thinking.

Most of the time, the entrepreneurs have fallen into the trap of (a) inflating their company value by the value of the investment, and (b) using a multiplier that boosts the ROI to a point that their equity stake offering is way too low.

The point is that most IPOs are based on some proportion of Potential vs. Performance. In the build-up to the Twitter IPO, it's worth bearing that in mind : it's no PayPal, it's not a Facebook, but there is value hidden in there, and with current revenues in the 100 million dollar range, it looks like a good time to float.

How to Formulate Your Exit Strategy

So, even if your exit strategy isn't quite in the IPO league, you still need to decide how to dispose of the business you've worked so hard to build up. You still need to get the timing right.

For example - suppose you have a  business that can be run as a going concern and has a stable customer base that implies that it will run on for at least 5 years. The right value for such a company might be 5 times profits.

However, if the company has potential for growth, untapped customers, or the possibility to be geographically scalable, 5 times profits might begin to look a bit on the lean side.

On the other hand, a fading company in a declining market might be only barely worth the value of it's assets plus current profit, depreciated over 5 years. In such a case, it might have been wiser to sell up earlier, with the customer base still on the up, and realize a higher value albeit based on risk, than the market might otherwise expect.

This last is closely associated with risk. As always, it's a case of buyer beware - it's someone else's risk once you've sold the company - and picking the right moment when the ratio of profit to potential makes it look as attractive as possible.

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