Written by Dan DeWolf
One of the underlying tensions within a venture-backed enterprise is that the management and the venture capital firm may have divergent exit goals. For the venture capital firm, the primary goal is a return on its investment. The venture capital firm has a fiduciary duty to its own investors to maximize its returns and the manner in which a venture capital firm achieves this goal is by a liquidity event or an exit from the investment. In contrast, management's goals may include issues beyond monetary rewards. An executive may be seeking to make his or her mark as a "captain of industry" or "leader of men" or perhaps something as mundane as having a steady job. Whatever the motivation of the management team might be, at some point in time, the venture capital firm will be moving towards positioning the company for an exit. How that liquidity event or exit is facilitated and managed is vitally important to realizing full value for the enterprise.
There are basically two main types of exits for a venture-backed enterprise: (i) an initial public offering ("IPO"), and (ii) a sale or merger to or with another company. For most companies, going public through an IPO is the "holy grail" because the valuations are often based on growth and thus may be substantially higher than what would be paid in a sale or merger. That said, most liquidity events are through a sale or merger as the public markets for technology-based companies have been anemic in recent years.
There are a number of advantages to exiting through a public offering. To begin with, it enables the company to raise large amounts of capital at higher valuations. The large amount of capital will enable the company to execute on its business plan and to initiate additional growth strategies. The limitation of capital will no longer be an excuse for not achieving a company's business goals. A second advantage is that it enables a company to continue to access large amounts of capital. Assuming it operates successfully once public, a company will be able to raise large amounts of funds by having additional offerings. A third advantage is that by going public, the company is then able to use its own stock as currency to acquire additional companies. As a public entity, the company can issue its own currency (its stock) in an acquisition. Perhaps the ability to use its own stock as currency is the most intriguing aspect of going public. Finally, by going public, the investors can begin the process of gaining liquidity.
One thing that everyone should be clear about is that the fact a company is public does not mean that you can just simply sell your stock and liquidate your investment position. The underwriter of the public offering will generally require that no insider or major stockholder can sell any stock for 180 days after the date of the IPO. The reason for this is that the underwriter would be unable to raise the capital in the IPO if the insiders and large stockholders were immediately selling and dumping their stock. It does not say much positive about a company if the people involved in the company are sellers rather than buyers. Moreover, there is a myth in America that if a company is public then all the shares are free to be traded. This is simply not true. The venture capital firm that invests in a private company receives unregistered shares. These shares remain unregistered notwithstanding that the company is public. In order to sell the shares, the venture capital firm either needs to sell its shares pursuant to an exemption from registration, such as Rule 144 — which may have applicable volume limitations — or pursuant to a registration statement—which is both timely and costly.
One other advantage to going public is that management will have the ability to control its own destiny. Of course, management will be answerable to the public. But such accountability is nothing compared to selling your company to another company and working for somebody else. It is the exception rather than the rule where the management of the acquired company is still actively involved in the business three years after the acquisition.
As to why a company may choose NOT to go public, there are three main reasons: 1) it is expensive; 2) it is very expensive; and 3) it is unbelievably expensive. The process is costly not only in terms of the initial expense of filing, but with the passage of the Sarbanes Oxley laws ("SOX") it is exceedingly costly to remain in compliance once a company is public. Additionally, beyond the monetary expense in paying lawyers and accountants, it is very costly in terms of time. From the time a company decides to go public until its shares are sold to the public, the process is likely to take close to half a year. During this process, senior management's time will be diverted from managing the business to managing and orchestrating the financing transaction. Often, this may result in management taking its eye off the ball and sales or revenue not growing at the same pace as prior to filing for the offering. It is not surprising that the financial results published by many companies for the quarter after they go public are often disappointing.
One other reason that a company may choose not to go public is a reason that is rarely discussed. That is, once public, a company is subject to quarterly reporting to the public and its stock price will be judged in large part on a quarter by quarter basis. As such, the time frame for building a business or making the investment required for new long-term initiatives is quite limited. Arguably, the limitations imposed by quarter to quarter reporting inhibit the creation of additional value to the enterprise.
While the goal of many companies is to go public, the reality of the situation is that the major liquidity event for most companies is through a sale or merger. Good companies are bought and not sold. That is to say, a successful start-up company will catch the eye of a competitor or larger company and it will make economic sense for the larger company to acquire the smaller start-up venture. For the venture investor, a sale is welcome because it provides a finite way to realize on its investment, without the wait of liquidating its shares over time in the public markets. Further, a sale is not dependent on the ups and downs of the stock market where the whims of the marketplace can cause the public markets to close for months at a time for new IPOs.
The sale of a company is often accomplished through a share for share merger or by a combination of shares and cash. If the consideration is 50% or more consisting of stock, the stock portion can be structured as a tax-free exchange. The big issue for the party being acquired is whether the shares received will be freely tradable. If the acquiring company is a public company, the shares paid to sellers can be registered and made freely tradable as part of the merger. If the shares are not registered pursuant to the merger, then the sellers will either need to get the shares registered or sell pursuant to an exemption such as Rule 145 or Rule 144. In either event, the seller will have to bear the market risk that the value of the shares may decrease before they are freely tradable.
Of course, the other way to sell a company is to sell it the old fashioned way — that is, for cash. It certainly makes the entire sale transaction a lot less complicated and the sellers never have any problems calculating the value of the deal or how to allocate the consideration.