When investors put money into startups, they do so hoping to receive a positive return on their investment when the company exits. An exit, or liquidity event, can give investors, as well as founders and employees as applicable, the opportunity to cash out and ideally receive more money than they initially invested.
When you invest in a startup, the money you put in will generally not have a quick return. A startup will likely take years—a commonly cited number is 7 to 10 years—to reach an exit, if it ever does. When you invest in a young startup, you need to do so with patience. When, or if, an exit event does occur, this is the point where existing investors in the startup may be able to liquidate their investment and get that money, plus some, back.
It’s important to remember that investment returns are never guaranteed. Many startups never exit, some exit with terms unfavorable to investors, and some exits do not involve liquidity.
The most common liquidity events for a startup are acquisitions, mergers, and IPOs (initial public offerings). Let’s explore these types of startup exits.
Types of Exits
Acquisitions and mergers involve a startup being purchased by or joining with another company in a private transaction between companies, whereas an IPO involves the startup moving from private to public ownership with the offering of its equity (shares of stock) to the public for purchase.
In an acquisition, the startup is purchased by a larger or better-capitalized company. This type of exit is arguably the most common liquidity event for a startup. Acquisitions may occur for a variety of reasons, including that the startup being acquired is disrupting the market or making large strides in gaining customers, or perhaps its product or service would fit well into the acquiring company’s suite of products or services. Regardless of why a startup is bought, this shift in ownership may present an opportunity for investors to cash out and hopefully receive a return on investment.
In a merger, the startup mergers with a typically similarly sized company that produces complementary product or service offerings. A merger typically gives both companies the chance to strengthen their position in the market by combining their resources into a single business. From the financial perspective of investors, a merger may offer an opportunity to cash out.
The terms of the initial investment, as well as the terms of an acquisition or merger, play a significant role in determining investment outcome. An early investor may walk away with more than their investment, some of their original investment, or even none of their original investment. Alternatively, he or she may receive equity in the new company.
In an initial public offering, or IPO, a private company goes public. Shares of the company’s become listed for purchase and sale on a public stock exchange, and early investors can sell their shares to cash out their investments, albeit often after a prescribed lockup period. A company may choose to go public because the IPO process could offer the company a much wider access to raise capital (since it’s open to the public), as well as possibly gain publicity from the IPO process.
Going public is an expensive and lengthy process, however. The time and money involved can deter companies not prepared for the spend, even in pursuit of additional capital, as well as those who can remain well-capitalized outside the public markets. Furthermore, an early investor cannot be guaranteed a positive income as the markets will ultimately determine at what price equity can be exchanged for cash.
Risk and Reward
When you invest in a startup, you can’t predict when, or even if, the company will reach an exit. Investing in a company carries no guarantee of a return on investment, nor a set timeline for a liquidity event if the company does reach an exit. However, early-stage investors continue to invest in new startups with the hope that at least one of the companies they invest in will be the next big thing.
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.