Exit options are one of the most important things investors inquire about while deciding to invest in a startup.
Most VC funds invest with a horizon of about 3-5 years, though some are comfortable going up to 7 years. They need to exit their holdings in investee companies because the funds are structured as close-ended i.e. they have a limited tenure, typically 10 years.
Within this period, their stake in investee companies need to be sold, and the proceeds distributed to the investors in the fund, after paying off expenses accrued towards the fund managers.
Investments that are not sold on the maturity of the scheme are distributed among investors in the fund in the ratio of their contribution.
A fund may exit its investment through any of the following routes:
Private sale to a financial investor – The financial investor may be another fund or any other investor who does not have a strategic interest in the industry or company.
There is also a category of investors called ‘strategic financial investors’. Such investors do not have a strategic interest in the industry but are prepared to hold their stake in the company much longer than a typical financial investor.
Rich business groups or individuals are typical strategic financial investors.
For example: In sectors like insurance and telecom, there are limits to foreign investment. Suppose the foreign investment limit in a sector is 26%. The local promoter who will run the business may not have the capital to hold the entire local stake of 100% – 26% = 74%. The local promoter then ties up with a strategic financial investor to hold the remaining local stake for a long period, without participating in the management of the company.
It is normal for the entrepreneur to assure the strategic financial investor a certain rate of return for this holding period.
Private sale to a strategic investor (also called ‘trade sale’) – Strategic investors are those that have a strategic interest in the sector of the company to which the investee company belongs.
For example, an oil refining company that chooses to purchase a chain of petrol pumps. The rationale for the investment being strategic, the investment horizon is extremely long; the investor may never sell the investment, choosing instead, to merge it into its current business.
Most strategic investors are professionals in their own industry, but not financial market professionals.
Sale as part of IPO – Since IPO entails sale to a retail investor who may not be a professional, it is possible to sell the investment at a higher valuation in the IPO. However, IPO’s are time-consuming and costly. Depending on the market conditions and pricing of the issue, IPO’s can also fail.
The benefit of a sale to a financial investor is that it is possible to conclude the transaction quickly. Divestment to a strategic investor can take time.
However, depending on how good the strategic fitment is between two companies, it is possible to recover a higher valuation than in the case of sale to a financial investor.