by Mark Davis

I recently had lunch with Gary Kats, a friend from business school who has gone on to work as a tech banker. As part of our chat, we discussed the current exit environment and how it has affected the four types of exits: M&A, IPO, Secondary and Recapitalization. During the course of that conversation, it occurred to me that it would be worthwhile to outline each type of exit and provide some thoughts about how these fit into the venture capital model.

M&A:

"M&A" refers to "Mergers and Acquisitions".

In an acquisition, one company buys another, taking a controlling stake of its share and the rights to the assets. While these are structured in a number of ways and selecting a structure involves numerous considerations, the key variables boil down to: 1) whether or not the buyer takes on the liabilities of the company being acquired, and; 2) the types of assets being used to purchase the company (e.g., cash or stock).

In a merger, two companies are combined, each being treated more or less as an equal. While combinations called mergers happen all the time, they are rarely actually mergers of equals. Even if the financial structure portrays a picture of two equal companies being combined, one of the two parties typically takes control of the other in one way or another. Most often, control is determined by the board or management structure. The CEO that is selected to lead the combined entity typically keeps all of his lieutenants around, squeezing out the other company's management team.

Most VC exits (especially in recent years) are realized when portfolio companies are acquired by larger, often public, cash-rich companies. These transactions are typically structured such that the buyer assumes the portfolio company's liabilities. Venture investors typically expect this, as they do not want to be responsible for paying off debt after the transaction.

Additionally, VCs have a strong preference for selling portfolio companies for cash, rather than shares of the acquiring company. There is good reason for this preference: the value of the buyer's shares can change over time, reducing the effective purchase price. Furthermore, if a buyer elects to pay with its shares, its management may believe that their company's shares are overvalued.

IPO:

IPO or initial public offering is another of the four types of exits. In an initial public offering, a company first sells a portion of it shares in a public market, such as the NY Stock Exchange or the NASDAQ.

By "going public," a company sells a portion of its stock to investors that are entitled to freely sell their shares over the specified exchange. Through the exchange, they can sell directly or indirectly to virtually any buyer in the world.

It's worth noting that not all of the company's stock is publicly accessible at the IPO. Companies typically sell only a portion of the company to investors through the public exchanges.

What makes IPOs so special is that subsequent public offerings are less risky for the company as they have more information about the stock's pricing once shares are being freely traded and priced by the market. During the IPO, the company's investment bankers are tasked with creating a small marketplace and identifying clearing prices for the initial shares. After those shares are sold, the buyers can transact them freely, yielding prices that reflect the valuation applied by more buyers and sellers, creating a price that is truly reflective of the market's estimate of the company's value.

VCs, entrepreneurs and others often participate in the public offering, meaning that they include their shares in the group that is sold to the market. This enables VCs to exit at least a part of their investment – shares are converted into cash which can be distributed to their limited partners.

VCs generally like exiting through IPOs. While IPOs present investors with some liquidity risk, as insiders are often subjected to lock-up periods during which the investors and entrepreneurs cannot sell their shares on the market immediately after the IPO, IPOs offer VCs several advantages. First, public companies remain going concerns, enabling VCs to take credit for investments that they made (potentially) long into the future. An IPO not only offers a VC a merit badge that can be promoted to entrepreneurs and limited partners, but it also enables the VC to leverage its contacts at the newly public company to help future portfolio companies in many ways (from acquiring customers and partners to initiating acquisitions).