Whenever a startup decides to conduct an exit, investors may want to understand the impact on their original investment. The method by which a startup conducts an exit, whether through going public, mergers and acquisitions, or secondary buy-out, can have direct impacts on timing, liquidity, and what the investment may look like in the future. Learn more about navigating startup exits and how investors can understand the benefits and limitations of each exit method in this week’s blog.

Navigating Startup Exits

The following are some of the common methods a startup may utilize in order to conduct an exit.

Initial Public Offering (IPO)

An IPO occurs when a private company first sells shares of stock to the public, transitioning from private ownership to public ownership. For the company, an IPO can serve as a way to raise additional capital, pay off debt, and provide liquidity to its investors from its time as a private company. For investors, an IPO means that the illiquid private shares the investor used to hold have transitioned into public securities, which are now subject to new market dynamics and regulatory impacts.

Benefits

For early investors, an IPO traditionally presents liquidity options. When the company’s shares trade in the public markets, these investors can choose to sell nearer-term after lock-up expiration or hold their shares to see how the company performs in the public market, choosing when, or if, to liquidate.

Once early investors are able to sell their shares after an IPO, they may be able to recoup their original investment with profit, just recoup their original investment, or sell the shares at a loss to the original investment. No matter if an investor “makes” or “loses” money after an IPO, publicly traded shares can typically provide some form of liquidity to the investor, unlike the illiquid private market shares the investor previously held.

Limitations

One of the benefits of a portfolio conducting an IPO is the ability for an investor to liquidate their holding and gain access to that capital. However one of the limitations is that liquidity from an IPO may be restricted by a lock-up period, where existing shareholders are prohibited from selling their shares after an IPO. This lock-up period typically lasts between 90-180 days and is designed to mitigate price volatility immediately following the IPO, which could be detrimental to the company’s stock price and long-term place in the public market.

Additionally, it can be difficult to assess the financial history of the newly public company due to the lack of historical financial information. Investors should consider that the speculative nature of assessing a company with limited information can result in a valuation more reliant on investor sentiment than historical performance.

Direct Listing

Direct listings allow companies to go public by selling existing shares instead of offering new ones, achieving the same result of becoming a public company, but the process is typically shorter and less intensive than a traditional IPO. Primarily, a direct listing serves as a liquidity event for early investors and employees rather than serving as a capital-raising event for the company.

Benefits

For investors, one advantage of a portfolio company conducting a direct listing is the absence of a lock-up period, allowing existing shareholders to immediately sell their shares in the public market. This can allow greater volatility for the stock price, however, as it is determined by actual supply and demand on the exchange instead of being set by underwriters in advance like an IPO, it can also provide greater price discovery transparency.

Limitations

Direct listings do have a unique set of limitations for investors. While the absence of a lock-up period can allow immediate liquidity, the no lock-up period and the absence of underwriter support may mean there is no price stabilization mechanism in the early days. As newly public companies are subject to increased volatility as the stock is still finding the equilibrium price between supply and demand, the stock may fluctuate dramatically. This uncertainty can make it difficult for investors to time their liquidation decision, particularly in the early days of trading.

Special Purpose Acquisition Companies (SPAC)

A Special Purpose Acquisition Company (SPAC) is also known as a blank check company. It is formed specifically to raise capital, go public, and then find a private company to acquire with the sole purpose of taking that private company public. Essentially, through the acquisition with an already public SPAC, it allows the private company to make a public debut without undergoing the traditional IPO process.

Benefits

For an investor, a SPAC route can offer a compressed timeline of around 3-6 months once a target company has been identified in comparison to an IPO, which can take months to years, however it does typically take longer than a direct listing which may only take 10-12 weeks. Additionally, the pricing of a SPAC transaction is often transparent, as it is negotiated upfront by both parties, providing a bit more certainty around valuation compared to a traditional IPO or direct listing.

Limitations

SPACs do carry structural risks that investors may want to consider. For example, a SPAC typically has a specified timeframe in which to conduct the transaction from initial identification to final signatures. This could mean that a portfolio company enters into a Business Combination Agreement with a SPAC, but then something may occur that causes the merger to fall through, whether the transaction times out or the necessary funding isn’t able to be secured. In these instances, the agreement would be cancelled and the investor’s portfolio company would remain as a private entity.

Mergers and Acquisitions (M&A)  

Mergers and acquisitions (M&A) represent transactions that combine two businesses. Mergers typically involve companies of comparable scale that decide to combine operations, while acquisitions generally involve a larger entity purchasing a smaller one. M&A can provide a definite exit for investors, often in the form of cash or stock in the new combined entity or the acquiring company.

Benefits

For investors, M&A can also serve as another way to achieve liquidity through an exit event. M&A can also introduce competitive dynamics into the exit process. If multiple companies are interested in pursuing a merger or acquisition, offers for the startup may reflect competitive pricing.

Limitations

However, M&A is not without potential limitations for investors. M&A exits can be subject to execution risk and market dynamics that might impact the outcome for investors. First, the M&A exit may result in the investor receiving cash, shares in the new company, or nothing at all. Any potential returns are dependent on the terms of the deal, any liquidation preference, or other factors. Additionally, deals can be delayed, renegotiated, or blocked by regulators, which can also impact outcomes for investors.

Secondary Buyout

A secondary buyout occurs when a financial sponsor, such as a private equity firm that has held a majority share in a startup, sells that company to another financial sponsor. The transaction allows the selling entity to achieve liquidity and potentially sell the stake at a higher value than the original transaction. However, a secondary buyout could also be conducted at a discount, or a lower value than the original transaction. Secondary buyouts are more common for larger venture capital (VC) or private equity (PE) firms than individual investors.

Final Thoughts

Every exit method that a startup can undergo has a balance of risk, timing, and potential benefits. Across the methods mentioned in this blog, one main benefit emerges: liquidity for investors after they have held illiquid private shares for a significant period of time. Each method has unique benefits, risks, and limitations that investors should be able to understand for when the time comes for a portfolio company to conduct an exit.

Are you ready invest in startups? Sign up for a MicroVentures account to start investing!

Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:

• Understanding Customer Acquisition Cost
• Evaluating a Startup’s Use of Funds
• Technical Due Diligence for Non-Technical Investors
• What to Look for in Investment Updates

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.