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."

Photo via SXC.hu

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.

Photo via SXC.hu

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.

Think About Your Exit Strategy

I know that it feels a bit odd to think about your business as something with an end before you even get it off the ground, but the exit strategy is one of the more frequently overlooked parts of a fledgling business plan.

It's important in that investors who want to see a return, will want you to think about where that money is going to come from. Not to put too fine a point on it - it's unlikely that it will come from direct profits in the timescale or quantity that will satisfy all but the most 'angel' of investors.

In fact, many investors will force your hand, and sell out (or go public) at the drop of a hat, if the going looks good, just to turn around their initial capital investment.

You can preempt all of this by taking a few hours to consider, if you had to, how you would get out. Here are some options:

• Retire - in other words, you leave the business when you've had enough, and either keep an interest so that the income can support you, or just never look back;
• Sell Out Early - find someone willing to take on the company as a going concern, or sell to a competitor;
• Float on the Stock Market (IPO) - this is interesting in that it can raise a lot of money an increase your personal wealth, but you may well find yourself deposed or sidelined as shareholder interest takes priority;
• Wind it up - just cease trading, sell the assets (if there are any), and do something else.

There are other options, but these are the most common. There are also businesses that are created purely with the end goal to sell out to a bigger company, and which don't make any money in the interim.

For these kinds of business, the Exit Strategy is the business plan, and it can be a hard trick to pull off!

By thinking about your exit strategy, you may even show investors that you are also emotionally disconnected from (but passionate about) the business, and are likely to make good decisions. You will also be prepared mentally for the end, and it will help you to formulate a worst-case scenario, if it all goes horribly wrong.

To end on a more positive note - a successful business that is sold to a competitor, or complementary business, will make you rich, and free you up so you can launch the next big thing!

How Much is my Business (Idea) Worth, and How to I Get Out?

Serial entrepreneurs often start up companies thinking about one thing, and one thing only : what is my exit strategy?

Put another way – how are they going to get out of the company when they either get bored, or have realized enough value that it becomes more worthwhile to sell it on (or shut it down and dispose of the assets accrued) than keep it ticking over.

The most clinical approach is to build the exit into the business plan, and use that as a way to see (indeed, test) whether the whole venture is actually viable. If the exit strategy is to sell the whole company on as a going concern for a value of 1 million pounds (Euros, dollars, etc.) in five years time, it becomes relatively easy to work backwards through the numbers to test for feasibility.

Other exit strategies also include going public (selling shares on a stock exchange) or selling the company purely on the basis of its value to a competitor or related business – think of Google’s acquisition of YouTube, or Twitter buying TweetDeck, for example – where the classic measures of revenue, profitability, etc. don’t really apply.

However, these are subject to specialist knowledge, market awareness and probably a healthy dollop of good luck, so to provide an empirical example, we shall assume that the business valuation is designed to provide value to an investor – be it 100% (disposal) or some fraction thereof (to garner investment, or when going public.)

This kind of valuation is usually based on current performance. Examples of companies valued on potential performance (the most famous being PayPal) can also be found, but these are relatively special cases : for those that manage a PayPal, there are many, many, successful serial entrepreneurs who never see that level of IPO success.

On the other hand, many start-up investors will also be looking at potential. However, given that it has to be grounded in the figures that reflect believable performance, the discussions about exit strategies also apply here.

There are many, many approaches to valuing a company:

• Wikipedia : Business Valuation
• How to value a Business on BusinessLink
• ‘How to Value a Young Company’ by Martin Zwilling (Forbes.com)

Some reasonable, simple, valuations use trading figures and investor returns on equity to prepare a business plan that will provide targets that can be realized, and also help in the preparation of documentation for potential investors, from banks to angels.

A common measure is to take three to five times profit, and use that as a nominal value to establish targets for exit or investment. From the other side of the table, so to speak, if an entrepreneur needs 10,000 pounds (dollars, Euros, etc.) investment, for a 20% stake in their company, the investor will be expecting to be able to see at least 50,000 pounds worth of company value, as well as a return of 5-10% (using a better than bank rate) on their investment.

Using these techniques, it should be relatively easy for budding entrepreneurs to appropriately value their business idea, and potential of their start-up company.