Steps to Growth Capital Self-Study GuideStep 3

3.9 Exit Strategies and Exit Values

Your growth plan, and your investment proposal, must address how investors will get their investment out and how much their investment will be worth when they do. Because if investors can't recover their investments and profit, then your promising valuation is just numbers on paper.

The mechanism the investors will use to get their money out is called the "exit strategy". And the amount you expect they will be able to recover is the "exit value".

The way the exit value is calculated depends on the exit strategy used. There are five basic strategies available, and the calculation of estimated exit value is different for each:

• initial public offering
  
• sale of all the shares of your company
  
• sale of the investor's shares to a third party
  
• buyback of the investor's shares by your company
  
• debt repayment

Here we'll discuss the value calculations used for each type of strategy. (For more on exit strategies themselves, see " What's On the Table" in Step 8: Negotiate the Deal.)

As you've seen, estimates of the value of the investment at exit time are based on discounted cash flow projections, the discounted residual value of the company. In practice there are many more factors that must be taken into account, such as which values to use for earning (e.g. before or after interest, tax, depreciation and amortization). The way that value is determined must match the exit strategy.

Initial Public Offering (IPO)

If the exit strategy is to take your company public, then you will need to know how to calculate the residual value of the company at the time of the offering.

• Choose a multiple based on IPOs and public trading of similar companies. As we saw, the value is determined by multiplying after-tax cash flow by a multiple of the cash flow that is similar to the multiples for comparable companies. If companies like yours are being bought and sold, or if their shares are trading at a value 10 times their cash flow, then you would use 10 as your multiple. (You can figure out the multiples for publicly traded companies by dividing the stock price by their earnings per share.)
  
• Adjust the multiple subjectively to account for your unique situation. But there are no companies exactly like yours, so this "market determined" multiple should be adjusted to reflect the perceived difference between public companies. The exit multiple should be based on current IPO and public market multiples for comparable companies.
  
• Use the after-tax earnings and the earnings before interest, income taxes, depreciation and amortization (EBITDA) in your calculations.

Sale of All the Shares of Your Company

If your exit strategy calls for the sale of all the shares of the company, and the planned exit date is close to the date used to calculate the company's residual value, you can use the residual value as a the exit value. But if the exit date isn't close to the residual value date, a separate calculation must be made. The exit value can then be determined by applying the multiples or capitalization rates used in the residual value calculation to the estimated maintainable discretionary after-tax cash flow at the exit date.

A word of caution: The estimated exit value associated with the sale of your company may depend on the existence of a viable purchaser.

Sale of the Investor's Shares to a Third Party

In most cases, the exit value is subject to the sale of the investor's shares to a third party and that may be lower than the investor's prorated portion of the total value. That is, if the investor has 40% of the shares and the company is valued at $1 million, the investor will usually get less than $400,000 for his or her share of the company. Why? There are two reasons. First, the new shareholder will want to pay less because he or she will not have control over operations (assuming less than 50% of the shares are bought). Second, minority shares in privately held company can be difficult to sell (i.e. they aren't very "liquid").

Buyback of the Investor's Shares by Your Company

In this exit strategy the exit value would be similar to the value determined for a sale of all the shares of your company, as described above. But it may be appropriate to reduce the purchase price to reflect the fact that your company will have to finance the transaction. The value of your company will be reduced because the financing capacity you use to acquire the investor's shares won't be available to invest in future growth. The amount of the reduction will depend on the cost of the investor's shares and the extent to which your company will require capital to finance future growth at the exit date.

Debt Repayment

What happens if the investor has invested through subordinated debt as well as the purchase of shares? In this case, the funds the investor receives upon exit will have two parts: debt repayment and equity value. The principal of the debt will be repaid at the exit date and participation in the equity value will follow whatever terms were originally negotiated. The equity value portion should be determined in accordance with the appropriate exit strategy, as described above.

<< Previous | Next >>