better exits - astraea4 better exits e uropean vcs are better at investing than exiting....

B E T T E R E X I T S 1

Written by John Wall and Julian Smith,Price Waterhouse Corporate Finance, for EVCA

BETTER EXITS

Results of a survey of the Venture Capital exit marketand guidance on how Venture Capitalists

can improve exit performance

2 B E T T E R E X I T S

INTRODUCTION

This special paper, written by John Wall and Julian Smith of Price Waterhouse CorporateFinance, was commissioned and edited by the Exits Committee of the European Venture

Capital Association (EVCA). The role of this committee was to stimulate exit opportunities forventure backed companies. With the successful launch of Easdaq, the committee has now ful-filled its role. The Committee requested Price Waterhouse Corporate Finance to carry out a survey of thepractical experience of major European venture capital funds in exiting their investments with aview to establishing what steps can be taken to improve exit performance. 30 venture capitalistswere interviewed representing 14 countries in Europe. This paper presents the findings of thesurvey and gives advice to venture capitalists on how the problems identified in the survey mightbe resolved or reduced in order for them to achieve a significant improvement in exit performanceand therefore investor returns.

THE AUTHORS

John Wall is chairman of the Price WaterhouseCorporate Finance cluster for the North ofEngland and a member of the former EVCAExits Committee. He has extensive experienceof advising on venture backed disposal man-dates as well as acquisitions, buyouts, buyinsand complex fund raising.

Julian Smith is a manager in Price WaterhouseCorporate Finance, London, specialising inbuyout and disposal advice. In 1993/94 hespent 2 years on secondment at MontaguPrivate Equity (now HSBC Private Equity).

MEMBERSHIP OFTHE EXITS COMMITTEE

Chairman: Mr Diederik Heyning,GILDE INVESTMENTFUNDS (NL)

Member s: Mr Daniel Janssens,EC-DG XIII (L)

Mr Philip Vermeulen,GIMV (B)

Mr John Wall,PRICE WATERHOUSE (GB)

Mr Ian Riley,BC PARTNERS (GB)

Mr Pierre Riels,SOFINNOVA SA (F)

Mr Erkki Kariola,START FUND OF KERA (SF)

Mr Waldemar Jantz,TVM (D)

3B E T T E R E X I T S

CONTENTS Page

I EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

II THE INVESTMENT OVERHANG . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

III THE SURVEY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

• Coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6• Exit record . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6• Exit routes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8• The approach to exit - planning or reaction? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11• The sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12• Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

IV HOW TO IMPROVE EXIT PERFORMANCE . . . . . . . . . . . . . . . . . . . . . 17

• Planning exit from the point of entry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17• Focusing management on exit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17• Which exit route? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18• Managing the business for exit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18• How to get value from trade and financial sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

V THE APPOINTMENT OF ADVISERS . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

GLOSSARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23


E uropean VCs are better at investing thanexiting. Consequently there is a significant

overhang of investee companies waiting to exit.

The Price Waterhouse Corporate Financesurvey found that:

• European VCs regard IPOs as the ideal exit,and consequently do not devote enoughattention to trade sales

• Financial buyers are not taken seriously bymost VCs

• Many exits are by buy back, though this isoften not anticipated at the outset of the deal

• Many VCs do not plan for exit from the dateof investment

• Most VCs do not market their investmentswidely enough, and many do not make fulluse of intermediaries to help them, and

• Management are often an obstacle to aprofitable exit.

This paper therefore discusses how exitperformance could be improved by:

• Focusing more attention on alternatives toIPO

• Planning exit from the beginning of theinvestment

• Preparing adequately for trade and financialsales

• Making effective use of the buy back option

• Wider marketing of businesses for sale

• Using intermediaries when needed, and

• Getting the support of management for theVC’s exit intentions.

I EXECUTIVE SUMMARY

5

A comparison of the level of exits with thelevel of new investments for venture

backed companies in Europe indicates thatthere is a significant overhang of investee com-panies waiting to exit. In other words, venturecapitalists (hereafter referred to as VCs) appearto be better at investing than they are atexiting! The current European venture capitalportfolio, totalling ECU 25.1 billion at the end of1995, equates to 8 years of divestment activitywhereas the venture capitalists we interviewedhad a normal target life for their investments ofbetween 3 and 6 years. More importantly, giventhat the majority of large investments (greaterthan ECU 50 million) exit relatively early, theposition must be significantly worse for smallerdeals.

There clearly is a problem in achieving exit with-in an acceptable timescale and for that reasonthis survey was undertaken.

The annual survey of EVCA members indicatesthat by far the largest number of exits takesplace by trade sale. The only exception was in1994, when IPOs had a particularly strong yearand overtook trade sales in terms of value,though not number.

B E T T E R E X I T S

EUROPEAN VENTURE CAPITAL EXITS BY ROUTE

II THE INVESTMENT OVERHANG

6

Coverage

Thirty venture capitalists were interviewedrepresenting venture capital funds in 14

countries throughout Western and CentralEurope. The funds chosen had investmentportfolios of at least ECU 100m and werejudged by EVCA to be a representative sampleof the venture industry in Europe.

The survey covered the following issues:

• The record of VCs in achieving exits

• The significance of price compared to otherfactors in deciding on exit

• The advantages and disadvantages of differ-ent exit routes

• How pro-active are VCs in planning exits?

• The steps taken by VCs to prepare theirinvestments for exit

• Marketing to trade buyers

• The use of intermediaries or advisers

• The role of management

This was a survey of attitudes, not outcomes,and it covered a heterogeneous industry.Statistics would not be meaningful or represen-tative; the results are therefore reported usingthe words of the interviewees and, whilst theanswers are inevitably subjective, they havebeen edited to give a representative overview ofthe European exit market.

Exit record

The exit experience of venture capitalists variesgreatly from country to country and from one

institution to another; the most significant factorin this variation is the degree of maturity of theventure capital market in each country. Duringthe survey two types of venture capital investorwere clearly distinguishable, although themajority of VCs combine some of the featuresof each type.

The pro-active investor

The pro-active venture capitalist prefers to buya business as a principal and then incentivisemanagement by stock options or otherwise. Hegenerally plans the exit from day one and ismotivated exclusively by cash returns or inter-nal rate of return in determining the exit route.

The passive investor

An alternative approach is to act as a passiveinvestor, generally with a minority stake. Thepassive VC often invests on a longer term basiswith no specific exit route in mind, relying on anannual dividend to provide his return. Very oftenhis only exit route is by means of a redemptionor buy back of his investment by the manage-ment or co-shareholder. He operates in ayounger venture capital market, often with fewother players, and is concerned about the rep-utation of both his institution and the venturecapital ‘industry’ in general and may thereforenot choose to maximise returns if this wouldrequire an exit route, such as a trade sale,which would not be welcomed by manage-ment.

Reasons for failing to exit

70% of the venture capitalists interviewed saidthat they had at some time experienced difficul-ties in exiting their investments. The followingreasons were identified as the causes of theirproblems:


III THE SURVEY

7

• Stock market sentiment• Lack of institutional buyers for IPOs• Lack of trade buyers for a particular invest-

ment• Uncooperative management or co-investors• Due diligence results• Poor performance by the business

Many of these problems could be avoided ortheir effects reduced by proper planning of theexit from an early stage in the life of an invest-ment. For example, the problem of market sen-timent or a lack of institutional buyers of stockcould be dealt with by having a contingencyplan for a trade exit as an alternative. A lack oftrade buyers does not arise overnight, andtherefore a company with a properly plannedexit route would identify such a problem andenable the venture capitalist to search for alter-native buyers outside the sector or market con-cerned or to consider the possibility of financialbuyers.

It is true that management often have a vestedinterest in keeping their jobs and may thereforeobstruct a trade sale. However, the venturecapitalists with a successful exit record havebeen able to motivate and incentivise manage-ment or their co-shareholders to work withthem for common goals.

If new information at the due diligence stagecauses a buyer to withdraw this often indicatesthat the process could have been better man-aged. Such information should certainly notcome as a surprise to the vendor if the businesshas been properly prepared for exit and there-fore there is no reason to surprise the pur-chaser - unless it is a deliberate tactical reason!Generally however, a smooth exit processshould avoid the purchaser being derailed bysurprises which put a successful outcome atrisk.

Poor business performance is perhaps the oneissue which cannot easily be addressed by exit

planning; however, the effects can be min-imised by correct timing of the exit - and thisdoes depend on planning.

Despite widespread problems, many of the“pro-active” VCs claimed a high rate of suc-cess, while most of the “passive” investors didnot.

Exit consideration - Is pricethe only issue?

Most VCs view price, or their IRR, as the over-riding factor determining their approach to exit:

“Price is the only issue”“No other factors - IRR only”

Where other factors were mentioned, it wasoften because of their impact on the IRR;

“Relative certainty of it happening; natureand style of consideration”“Timescale. No warranties”“Liquidity, tax considerations”

In contrast some of the passive VCs have otherfactors to consider, often driven by their ownstatus or ownership:

“We don’t invest only to make money.We are generally the principal banker sothe price on exit is only one part of thediscussion. The final goal is customerloyalty for the branch, as long as wemake money.”

“The future of the company is important;we want it to prosper after our sale.”

“We are the only active VC house. Wewould not like to leave behind a dissatis-fied entrepreneur.”


8

Exit routes

Trade sales and IPOs

The two most common exit routes for VCs aresale to a trade purchaser and IPO. VCs havestrong views on the advantages and disadvan-tages of each.

IPO - The Holy Grail?

Advantages

• Higher price?• Favoured by management• Can be a dual track approach - may pro-

voke a trade bid• Share in future growth of the business

from retained shares

Disadvantages

• Higher cost than other routes• Is it really an exit? The lock up agreement

prevents an initial 100% exit• Continued shareholding carries a risk

that gains may not be realised and VCslose the special rights they have in a pri-vate company

• Many European markets are illiquid• The message has to be simple and

attractive to a large number of investors• Not an option for many small companies

The VC world’s view of IPOs is summed up by:

“You get the best price if the market isstrong - it also flushes out the tradebuyers.”

IPOs are the VC’s “Holy Grail”; they are seen bymany as the ultimate exit, to which all aspire,because of the super returns they have some-times produced and because they allow

management to stay in charge. However, thereality is that many more investments exit bytrade sale.

The disadvantages of IPOs, particularly inContinental Europe, are summed up by thestatement:

“You can only sell 10-20% (of the com-pany’s shares) and then you have to waittwo years - fewer and fewer companiesare going to the market.”

The lock up agreement which requires a VC toretain a significant investment, if not its wholestake, in order to inspire confidence in institu-tional investors, means that an IPO is notalways an exit.

Since the survey was carried out, the Frenchmarket has improved, as the following exam-ples indicate, however public markets areinherently cyclical, and most other countries inEurope have not experienced the sameimprovement.

CASE STUDY - Aigle

Apax Partenaires held an 85% stake in thismanufacturer of outdoor clothing. It wasfloated in October 1994 with a capitalisationof FF450m but due to general sentiment inthe market, only 20% was passed ontonew shareholders, with the vendors retain-ing a majority.

CASE STUDY - Europeenned’Extincteurs

Europeenne d’Extincteurs was a publiclyquoted manufacturer of fire extinguishers,with a capitalisation of around FF400m, inwhich Credit Lyonnais has a 65.1% share-holding. It was being prepared for sale to a


9

strategic purchaser but the public marketstrengthened and CL therefore sold theirentire shareholding in 10% parcels to insti-tutions in June and July 1996.

Where only a small share is sold, a good exitprice may mean nothing if the price in the mar-ket falls before the VC is able to sell the remain-der; some investors therefore prefer the cer-tainty of the trade sale process.

The strongest argument for IPOs is the ideathat the preparation required, particularly inmarketing, often leads to a pre-emptive tradebid, thus enabling the VC to achieve the best ofboth worlds. However, the other side of thiscoin is that proper investigation of the opportu-nities for a trade sale, and proper planning ofthe process, might well have revealed the samepurchaser and saved some of the legal andprofessional costs associated with a flotation.

Trade Sale - the second bestroute?

Advantages

• Buyers may pay a premium for synergy,market share or market entry

• 100% cash exit and therefore certainty,subject to warranties, indemnities,escrows and deferred consideration

• Cheaper than IPO• Faster and simpler than an IPO• Only option for some small companies• Need to convince only one buyer - rather

than the whole market

Disadvantages

• Often opposed by management, wholose their independence

• There are few trade buyers in somecountries

• Most VCs will not give warranties to pur-chasers

The most commonly identified disadvantage oftrade sales, particularly in smaller Europeancountries, was:

“More difficult to do trade sales thanflotations - there are not a lot of obviousbuyers.”

But it was also noticeable that many VCs donot attempt to identify overseas, non-sector orfinancial buyers - thereby somewhat limitingtheir chances of success.

There was a majority view that trade sales arequicker and easier than IPOs, with dissent onlyfrom those who experienced difficulty findingbuyers.

The real debate was on prices achieved:

“(Trade sales are) the best value - thebuyer knows what he is buying and thereis only one buyer to negotiate with.”

However, the negative quotes about trade saleprices need to be seen in the context of thenumber of VCs who do not market their invest-ments fully when they come to sell!

Sales to Financial buyers

The overwhelming majority view on exit by saleto other venture capitalists, or by secondarybuyout, was:

“Not attractive. If I can’t make money,how can they?”

Sales to other venturecapitalists - VCs’ concerns

• Third best option on price (due to pur-chaser’s high IRR requirement)

• Management would have divided loyal-ties during the sale process, and there-fore the buyer would have better infor-mation than the vendor

• The price impact of the buyer’s concernthat the vendor may have managed thebusiness for short term cash gain


10

However, there was some recognition thatcertain situations present opportunities forfinancial buyers:

“We were approached by a venturecapital house and we were surprised tosee anyone had an interest in taking (ourinvestment) on.”

but these sometimes arise from emotional, noteconomic, reasons.

“(A financial sale) would mean we wereless successful than envisaged but youcan get tired of an investment.”

Opportunities for financialpurchasers

• Transition from early to later stages ofdevelopment “provides an independentvaluation when a capital increase isrequired”

• Re-financing at the end of a closed endfund

• Need by the owning VC to realise a gain(for tax or reporting reasons)

• “A way for management to stay in whenan IPO is not an option”

• VCs may attribute a higher value to ahigh cash/low growth business than atrade buyer would

• Enables a business to re-leverage

• Breakdown in relationship between man-agement and investor - “The buyer maybe a better owner for the company”

The low number of sales to financial buyersseems to be more a result of mutual suspicionthan business logic. Given the increasing

number of businesses now being bought fromcorporates by financial buyers, one wouldexpect to see the same trend in venture capitaldisposals. The trend in corporate disposals ispartly driven by VCs’ willingness to acceptlower IRRs than was formerly the case. Giventhe high leverage applied to VC purchases,which reduces the average cost of finance,there is no reason why a VC buyer should notmatch a trade bidder when there are no syner-gies or other special factors to be considered.

One VC said:

“There are some businesses whichshould be in a permanently leveragedstate.”

An example is United Texon which was a £75mMBO from Emhart of the USA in 1987. Flotationin London was planned for 1994 but cancelledin favour of a sale to Apax for £131 million,which included the refinancing of £90 million ofdebt.

In this case some of the original investing fundswere nearing the ends of their lives. Therefinancing led by a new investor provided anindependent valuation and this facilitated atransfer from one fund to another within thesame house without any risk of favouring onefund over another. By the same token, anongoing participation by the vendor can help toinspire confidence in a financial buyer and itseems that a large number of sales to financialbuyers involve some retained stake.

A few other positive examples came to lightthrough the survey:

“We got a good price on X, a retailer - itwas an unpopular business - an MBOwas the best option and managementwanted to stay in.”

“It allows you to turn over your invest-ments. Our most recent exit was the


11

second MBO for the business (and wehelped finance it) - it gave managementthe majority stake they wanted and crys-tallised a 22% IRR for us (which we couldonly recognise on a disposal).”

Share buy backs

Buy back or redemption by co-investors ormanagement has historically been a commonexit route for passive investors, and for all ven-ture capitalists when other routes fail.

This is often a result of poor performance lead-ing to a lack of interested buyers, or else a con-sequence of the management or majority own-ers of smaller businesses refusing to accept asale to a third party. It is surprising that manyventure capitalists have not felt able to includestandard buy back terms in their investmentagreements, although the survey indicated thatthese are becoming more and more common.The principle objection is that a pre-determinedformula may mean that the exit price is effec-tively capped even if the business is worthmore.

“Buy backs are the second most com-mon exit route. We have no standardclause because this would put an upperlimit on the sale price - managementwant it both ways.”

There is little doubt that a buy back is the leastfavoured exit route, short of insolvency, simplybecause the lack of competition and thebuyer’s strong position result in a poorer saleprice for the exiting investor.

Venture capitalists are realists, however:

“Creates an opportunity when one wouldnot otherwise be available. We alwaysinsist on having some sort of anti-embar-rassment clause where management

intends to stay in. We did a deal earlierthis year for which management receiveda bid two months after buying us out!”

“A buy back gets the investment off ourbooks and out of the statistics. We mayget the opportunity to buy it back againat a lower price.”

“It is more difficult than a trade salebecause they have to find the money.There is a lot of discussion about value.”

“For a bad investment it is the only wayout. In one case management made anoffer and it required a painful negotiatingprocess to get us a 20% return - butthere was no alternative acceptable tomanagement.”

The approach to exit -planning or reaction?

We asked all the interviewees whether theirapproach to exits was pro-active or reactive.The majority regarded themselves as pro-activeand supported this assertion with commentslike these:

“We are pro-active - we decide to get ridof a company and then work on it. Wehave given up planning exit from Day 1because it always turns out to be differ-ent from what we expect. Very often thetechnology and the market develop dif-ferently from expectations.

“Pro-active - we look at the business andsay ‘Good time to sell’, and start theprocess.”

In our view this does not constitute a truly pro-active approach. However, some people aregenuinely pro-active.


12

“We plan before entry. After two years weplan ahead based on performance andmarket windows, although we are not‘market timers’.”

“We always discuss exit openly with thefounder when we make the investment.Sometimes the operating plans take intoaccount what is required for exit.”

But at the other end of the scale:

“Reactive - the co-shareholders or direc-tors approach us. A lot of clients wouldnot come to us if we planned exits inadvance.”

“Our companies are always for sale -price dependent.”

In general it seems that the commonestapproach is to regularly review the portfolio,keep an eye open for potential buyers, andidentify opportunities as they arise. In our viewthere is scope for improving exit performanceby better planning of the exit process for eachinvestment from Day 1.

The Sale

Preparation for Sale

The venture capitalists who focus on IPOs weregenerally agreed on what preparation is neces-sary, in terms of presentation, to achieve a suc-cessful exit.

“Professional product brochures. Threeyears ago we started sending financialsto the press. Annual reports are consis-tent and accessible.”

Other issues included the quality of manage-ment, consistent company performance,reporting systems and legal structure.

Whilst it was noted that these things were alsouseful for a trade sale, and this is shown by thepopularity of a “twin track” approach, the gen-eral view was:

“With a trade sale you have what youhave - but hopefully you have done theright things.”

... which implies that it is only at the point of exitthat the VC starts to think about the preparationhe should already have done!

Given the short timescale, often less than ayear, which VCs allow for planning trade exits, itis not surprising that less attention is devoted topreparation than is the case for IPOs.Nevertheless, it is self-evident that more effortdevoted to preparing businesses would assistthe sale process.

Perhaps contrary to public perception, themajority of venture capitalists were opposed tothe idea of managing the business strategicallywith a view to maximising exit opportunities andproceeds. They generally believe that it iswrong to jeopardise the long term prospects ofa business for short term gain, either because abuyer might realise what had happened andadjust the price accordingly, or because theyare genuinely concerned for their reputation.

“We wouldn’t manage for the sake ofexit.”

“We just try to make the business as pre-sentable and successful as possible.”

“We don’t normally adjust strategy - butexit is always in the back of the mind, egwhen an investment decision has to bemade we ask to what extent it will addvalue. We may not embark on major newinvestment because we may not recoverfull value.”


13

A small minority of venture capitalists are pre-pared to determine strategy according to exitrequirements. Most commonly this involvesmaking acquisitions in order to be the right sizefor flotation. For example:

“We have strategy discussions, and wemay say (about a proposal): ‘This mightbe attractive in profit terms but will notmake the company big enough for anIPO’.”

“The public market tends to reward agrowth story.”

In preparing for a trade sale, other factors comeinto play as size is less significant:

“Be clear about the strategy - chooseone which might make the businessattractive to a competitor.”

“We had a choice of a non-exclusiveexport licence or an exclusive one.Management tried to make it non-exclu-sive but we prevented this because itmight have put off a trade buyer.”

“We are a small country; the cost ofbuilding overseas markets is high so wefocus on one or two to show the poten-tial to a trade buyer. This is partly aimedat exit but is also the right thing for thecompany.”

Marketing the business to trade buyers

Practice varies between those VCs who markettheir exits widely, and those who rely on theircontacts in the industry.

“The market is inactive so we have to beactive. We consider who would be thebest buyer in the world and approachtwo or three.”

“The worst thing is to get into a onehorse race.”

“All things being equal, yes we marketwidely. Sometimes values can be erodedby wide marketing so we might just talkto one or two. Depends how much of thebusiness is proprietary and the impactthis has on value.”

“We are on the board so we know whothe competitors are - who would fitstrategically.”

“Yes - we or the board know them. Butmore and more we are using profession-al intermediaries.”

“We know most of the companies (whowould be interested). We have notlooked overseas because we have nothad time.”

“We know who will buy. We don’t lookoutside our own country. In our sort ofbusiness it is traditional to sell to aregional or national buyer. We know thatUK financial buyers are interested but it isimportant that the deal is accepted bythe other owners and staff, who are oftennationalistic and afraid of foreign buyers.”

The majority of venture capitalists took the viewthat buyers would generally be found from with-in their investment’s own sector and country.This clearly excludes any strategic purchaserwho might pay a premium to establish himselfin a new market, and possibly puts a cap onthe price which can be achieved. Most venturecapitalists seem to be put off marketing by theresources required and the risk of breakingconfidentiality. Many preferred advisers to bepaid by the acquiror.

It was surprising to discover that many venturecapitalists appear to be “satisficers” rather than“maximisers.”


14

“Sometimes we don’t market widely if wecan achieve our hurdle IRR for the partic-ular investment - but in one case wewent around the world to do thatbecause we knew exactly which biotechcompanies had a good fit.”

Case study: Non-sector buyer - Elddis Caravans

Elddis Caravans was the UK market leaderin the manufacture of touring caravans. Itwas a management buyout backed byNorthern Venture Managers and PriceWaterhouse advised on the sale. Weanalysed the UK, European and NorthAmerican markets for caravans and foundthat they were mainly supplied by domesticmanufacturers. We saw an opportunity tosell the business either in ContinentalEurope or in North America and targeted allthe main producers, making presentationsin France, Germany, Canada, New York andCalifornia. The obvious buyer wasFleetwood, a billion dollar turnover manu-facturer of recreational vehicles based inCalifornia, who had European expansionplans. Thor in New York and Firan inMontreal, were in similar positions.

In addition to a strategic search with Elddisfor buyers in the caravan business wesearched for contacts through the PriceWaterhouse Corporate Finance network.Our London office identified a companycalled Constantine, who were previously inshipping-related activities and then proper-ty development and had substantial cashon their balance sheet but lacked a coretrade. They had no existing interest in cara-van manufacturing but were interested inany transport-related companies. It wasConstantine who bought the business at apremium price.

The use of intermediaries to adviseon exit

Venture capitalists seem to be divided in theirviews on advisers. We observed five differentapproaches:

5 approaches to usingintermediaries

• “We always use an external adviser.”

• “We use intermediaries 25% of the time -if you have an interesting asset it sellsitself.”

• “We have our own in-house M&A section- not sure they are specialist but they saythey can do it and it is difficult to gooutside unless other investors request itor we have to market internationally.”

• “We talk to some of the larger M&Ahouses - they act for the buyer.”

• “We do the work ourselves. We are think-ing of using intermediaries more andmore, especially for companies whichhave been in the portfolio too long.”

Regardless of individual approach it seems thatthere is an increasing tendency to use advisers.

“More and more they earn their fees.”

“Advisers focus on one job while we areoften taken out of the process byanother crisis.”

Where external advisers are used, they may beinvestment banks, M&A specialists, thecorporate finance departments of the majoraccounting firms.


15

Venture capitalists look for a number of differentstrengths when selecting advisers.

Factors to consider whenappointing advisers

• Contacts - in the sector- in other sectors- across Europe- worldwide

• Ability to market discreetly• Industry sector knowledge and deal

experience• Independence• Resources• Ability of individuals• Enthusiasm and commitment to the job• Nature and size of investment

Many people appoint advisers they know andtrust; others prefer a beauty parade as a meansto make the adviser work hard.

The role of the adviser may vary from a simplesearch for acquirors to including the prepara-tion of an information memorandum and lead-ing or hand-holding in the negotiations.

Occasionally the adviser will be invited in at anearly stage to advise on strategy.

When asked how advisers add value to the exitprocess, venture capitalists mentioned a num-ber of areas:

How do advisers add value?

“Confidentiality - they judge who to trust.”“Open up connections we do not have.”“Buyers people didn’t think about.”“Resources and manpower.”“Geographical coverage eg Asia and NorthAmerica.”

“Good quality information memorandum;acquirors are busy - they will read it quicklyand form a view.”“It is useful in negotiations to have a party inbetween that you can shout at - you can’tyell at the purchaser.” “They have the time to get a better price.”

The role of management

The exit decision often revolves around man-agement. Even if they do not have voting con-trol, their role puts them in a strong position.

“Anyone who says management isn’tcritical to a float is crazy; and they canmuck up a trade sale pretty badly.”

“You cannot sell if management doesn’twant to.”

Many of the pro-active investors make detailedarrangements with management from day oneregarding decisions on exit, and some will onlyinvest if the management team shares their exitgoal.

By contrast, life for others is more difficult.

“They (management) try to resist exit asmuch as possible.”

“We never get them to agree at the pointof entry. Their goal is to expand - not tosell.”


16

Conclusion

The survey confirmed that the majority ofEuropean venture capitalists have difficulty inexiting some of their investments.

Clearly, there are cases when these difficultiesare due to factors beyond the VC’s control, but the survey revealed that there are manyaspects of the exit process where VCs haveinfluence and can take steps to improve exitperformance.

Areas for improvement

• Use of alternatives to IPO• Planning exit from Day 1• Adequate preparation for trade and

financial sales• Proper use of the buy back option• Effective marketing• Use of intermediaries when needed• Getting the support of management

These issues, and the action VCs can take, areconsidered in Part IV.


17

Planning exit from the point ofentry

E xits need to be planned. Even those VCswho take a long term view need to

consider what will happen when the business isno longer performing as originally expected,when they get tired of management, or whentheir funds are no longer needed for the devel-opment of the business.

Before making an investment the VC shouldconsider, as part of their due diligence process:

• What will be the exit route?• Who will buy the business?• Is the business strategy the right one to bring

about the desired exit?• Is the structure of the business appropriate

for a straightforward exit? (if not this shouldbe addressed in the business plan)

• Is management keen to exit?- If not, can they be incentivised?- If not, how can the VC’s interests be pro-

tected?

Focusing management on exit

If management are not keen to consider exitunder any circumstances, it may not be in theVC’s interests to do the deal.

One approach might be to ask them toconsider:

• What would happen to the business in theevent of retirement/death/illness?

• Whether it might at some point be in theinterests of the business to involve a tradepartner

• Whether they are ever likely to want achange of investor or to buy back the VC’sshare (using surplus cash)

Whatever the plans it is in management’s inter-ests to create a high quality business whichgives them the option of selling it at some futurepoint. They should therefore consider the exitoptions now. Often it may be found that thissubject is best dealt with through manage-ment’s financial or legal advisers to avoid theVC worrying management by giving the impres-sion of being too focused on exit. This may alsobe the best approach at the point when the VCwants to achieve an exit.

If management are agreed that exit is the aim,they can be incentivised by means of shares,share options and bonuses to ensure that theirgoals coincide with those of the investor.Incentivisation will not work unless the manage-ment are agreed on the principle of exit. Theeffectiveness of incentivisation by equity stakecan sometimes be increased by using a ratchet,although it is important that the ratchet is basedon targets meaningful to the investor. Forexample, it would not be appropriate to agree aprofit-based ratchet if the VC was most con-cerned about the final purchase price or IRR.IRR-ratchets are complicated but may ensurethat management and VC have the same inter-ests. It should be stated however that deals areoften best kept simple especially as no ratchetmechanism can cater for all circumstances.

The survey results indicated that more andmore venture capitalists were including buyback clauses as standard in their investmentagreements. This gives them the ability to forcean exit if the business does not perform toexpectations. Some VCs still believe that theirclients will not accept this, and there was aconcern that any price-based formula acts as acap on value.

Structuring the investment as a combination offixed term loan (or preference shares) and


IV HOW TO IMPROVE EXIT PERFORMANCE

18

equity shares - the traditional UK approach -can avoid or reduce this problem, subject tolocal tax and legal constraints, by providing forrepayment of the majority of the VC’s invest-ment after a few years, without requiring thesale of equity shares. This combination alsomeans that the VC has an incentive not to forcerepayment unless this is in the interests of thebusiness because the value of his equity shareswould be reduced.

Which exit route?

The VC needs to know which exit route he isaiming for at the point of investment. This is nothowever, an irreversible decision. Some of themost successful exit performers seem to bethose who aim for an IPO and use this as ameans to encourage pre-emptive trade bids.

The message from the survey, and from actualexit performance, is that trade sales shouldoften be regarded as equal or preferable toIPOs, but that they require the same degree ofplanning.

In the current market financial bidders shouldbe taken seriously. They are often prepared togo through a bidding and shortlisting process inthe same way as a trade bidder, though theyrequire more time to get to know the industry.

CASE STUDY: Betonson

Betonson is a Dutch manufacturer of pre-fabricated concrete products includingpiles, water mains, floors and concrete ele-ments for bridges and viaducts, which wasowned by a syndicate of eight venture cap-italists. Price Waterhouse CorporateFinance advised the syndicate and thecompany on the disposal in February 1996.

Initially, the likely bidders were expected tobe a number of international building


materials producers not yet present oractive in the Netherlands; however, some ofthe bidders turned out to be those withestablished Dutch operations. The eventualpurchaser was Van Nieuwpoort Beheer BV,a major supplier of aggregates, who wishedto avoid the loss of a key customer if a newowner were to switch purchases to theirown group suppliers.

In the end skillful negotiations with all par-ties resulted in Van Nieuwpoort offering aprice significantly in excess of initial expec-tations, clearly as a defensive move.Management welcomed the acquisition byVan Nieuwpoort because it preserved theirbusiness and avoided integration intoanother manufacturer.

Managing the business for exit

Many VCs are opposed to managing a busi-ness solely with a view to maximising thechances of and proceeds from exit; they preferbusiness decisions to be made in the long terminterests of the business itself, although it isacknowledged that, at the margin, they mightfor example not make a large capital investmentif they were about to sell their stake.

Despite these concerns there are manyaspects of strategy and day to day manage-ment where the thought of exit may lead todecisions which are in the interests of the busi-ness - decision-making may for example bequicker and more focused if management isworking towards a set timescale.

Some of the issues which management andinvestors should address during the life of theirinvestment are set out in the table below. Thisapproach should lead to a more straightforwardexit process and an increased number ofunsolicited offers.

19B E T T E R E X I T S

Exit checklist - things for management to consider to enhancethe business and make exit easier

Strategy - Have one!- Try to achieve a consistent growth record- Reflect exit plans in the timing and choice of strategy options- Ensure that new opportunities are being created as old ones are realised -

to ensure that growth continues - Remember that competitors may be the likely purchasers - they will pay

more for a business which can be merged to provide profit improvements.If they do not buy, their interest will increase the price

PR/Marketing - All achievements should be reported in trade and financial press- Results and new orders should always be announced- Remember that advertising and marketing does not just sell the product -

it may help sell the business

Financial - Accounts should look professional and be well presented from the first year

Statements - They should be informative, and reflect the strategy of the business - theyare not just a legal requirement

- Ensure they are consistent from year to year

Reporting systems - Management of the business and exit are both facilitated by reliable, time-ly and relevant management information

- These requirements should be addressed from Day 1

Legal structure - Keep it simple. If it is not, simplify it while there is time- Avoid minority stakes which do not have a strategic purpose - or try to

eliminate them prior to exit. One single shareholder can hold up the wholeprocess

Management - Ensure the team is balanced, experienced and of a high calibre- Do not allow gaps to develop- Plan for succession- Ensure they can individually demonstrate a successful record at exit

20

How to get value from tradeand financial sales

The disadvantages of trade sales raised by VCswere:

• Lack of trade buyers• Lower price than an IPO• Requirement for warranties

It is worthwhile addressing these issuesbecause trade sales can be quicker and easierthan IPOs, they may attract a premium, and theonly alternative may be a low-value buy backoffer.

The importance of adequate planning andpreparation has already been mentioned.Combined with a proper marketing campaignand good publicity from day 1, this shouldenable a lack of buyers and therefore the lowprice expectancy to be overcome. This lack ofbuyers is often perceived rather than real - butit is necessary to look outside the sector andcountry of the investment and an intermediarymay be needed to do this. It is surprising howoften a marketing campaign produces buyerswho were not on the original list of interestedparties. Price can often be increased by ensur-ing adequate information is available and byproviding warranties to cover areas of uncer-tainty. Preparation of an information memoran-dum is a worthwhile discipline as it exposesweaknesses in the business before they arediscovered in due diligence, thereby avoidingaborted deals.

Practice on warranties varies immensely fromone country and VC to another. Some VCshave a fixed policy of never giving warrantieswhile others are more flexible.

Those that take the narrow approach need torecognise that they will sometimes lose value asa result because the price will be discounted.When they sell by IPO, they often have nochoice but to retain shares in order to support

the price; they should regard warranties in asimilar light, except that in the latter case theyare in control and have received the cash.

Conversely, it should be recognised that war-ranties are intended to deal with a situationwhere the vendor is reasonably certain of thefacts (eg title, audited figures) and wishes toreassure the purchaser - he therefore does notexpect to have to pay a significant claim and,by giving a warranty, realises full value for hisinvestment. If this is not the case then it mightbe preferable to deal with the risk by an adjust-ment to price which might avoid the vendor suf-fering the entire cost. Warranties should alwaysbe limited in time and value with a minimumthreshold to avoid small claims.

An alternative to providing warranties isdeferred consideration. This can be structuredto provide participation in any future upside,similar to an ongoing shareholding, in contrastto warranties which are generally given inrespect of issues at the date of sale. The dis-advantage of deferred consideration is that thevendor has no control over the outcome.

An indemnity should be avoided unless itrelates to a matter for which the vendor acceptsliability, but where the amount is unquantified,such as historic tax liabilities, and it is thereforenecessary to avoid complicating the sale.Nevertheless, if there is a low risk of paymentbeing required, it will often be appropriate toinsist that the vendor takes the risk as this willnot have a significant impact on value.

If the purchaser has concerns about the ven-dor’s good faith or financial position, then anescrow deposit may be an effective means ofadding credibility to the warranty. However, if itis expected that a large part of it will be utilised,then it might well have been worthwhile tomake a corresponding, but smaller reduction inprice.


21

Do I need one?

The survey identified an increasing trendtowards the appointment of advisers to

act for the company or VC investor on disposal.

An adviser or intermediary may not be needed ifthe vendor receives a world-beating unsolicitedoffer, and the vendor has the resources andexperience to maximise the value of the offer. Itis often the case however that the value of anunsolicited offer from a keen bidder can beincreased by introducing competition through aformal sale process.

The VC who is deciding whether to appoint anadviser for a particular sale, should ask thefollowing questions:

• Do I have the time and resources to do thejob in-house without being distracted bymore urgent tasks?

• Do I and the management know of allpotential buyers, including overseas andnon-sector?

• Is it acceptable for the initial approach tobuyers to be open, thereby revealing whichbusiness is for sale (since they can find outwhich businesses I own)?

• Do I have an objective view of the value ofthe business?

• Will management/partners accept my adviceas independent and impartial?

If the answer to one or more of these questionsis ‘No,’ then the appointment of an advisershould be considered. Section III sets out ven-ture capitalists’ views of what is required of anadviser, and how to appoint them.

How do I pay them?

The effectiveness of an adviser is influenced bytheir fee structure. It is normal practice to pay apercentage of the consideration as a way ofincentivising the adviser to achieve a sale andmaximise the price. This approach is increas-ingly being modified to increase its impact.

A fixed element to the fee can help to ensurethat the adviser devotes sufficient time toupfront tasks such as the preparation of aninformation memorandum. Without this, thetime investment by the adviser may be veryhigh in relation to the incremental considerationwhich a high quality memorandum mightachieve. The retainer may therefore be in allparties’ interests; however, there is an alterna-tive view that the adviser will not work so hardif their pay does not depend entirely on results.Any retainer should be deductible from, ratherthan in addition to, the final success fee toensure that the variable fee is high enough as apercentage of proceeds to provide sufficientincentive.

It is more and more common to pay a higherpercentage success fee on a margin of pro-ceeds over a certain level as a super-incentiveto ‘go the extra mile.’ Since the vendor wouldnot otherwise receive these proceeds, a highmarginal percentage is easily affordable. Thethreshold may be set based on the values esti-mated by advisers when competing for themandate. It was traditional to use the ‘Lehmanscale’ (see Glossary) of decreasing percent-ages but this is less common now becausewith a small marginal benefit to the adviser fromany increment in the sale price, it is clearly lesseffective as an incentive.


V THE APPOINTMENT OF ADVISERS

22

How to keep it confidential

One of the chief concerns expressed aboutM&A advisers was the risk of informationleaking.

In practice, leaks arise more often due to gos-sip in an industry (regardless of confidentialityagreements) than from the adviser who will beacutely conscious of the need for secrecy.

Maintaining confidentiality depends on havingthe right attitude. The VC should emphasise itsimportance at the beginning of the process,

use a codename in all correspondence, and ifnecessary request that the M&A adviser limitsknowledge to those of his staff actually workingon the job. Naturally confidentiality lettersshould be used but these are difficult to enforceand rely on the cooperation of the other party.Commercially sensitive information should notbe released, even with a confidentiality letter,where it would damage the business if the dealis aborted.


23

Buy back The re-purchase by management or the majority investor of theVC’s stake in a business

Deferred consideration A portion of the purchase price which is payable at some futuredate, often subject to certain conditions

Escrow account A deposit held by lawyers as security for warranties

Exit The sale of an investment

Financial purchaser A venture capitalist or similar investor who purchases a business asprincipal. For the purpose of this paper the term includes a sec-ondary management buyout

Indemnity Agreement by the vendor to reimburse certain future outgoingsrelating to the business

IRR Internal Rate of Return - that discount rate which, when applied toa series of cashflows, produces a net present value of nil. Used byVCs to measure performance

IPO Initial Public Offer

Lehman Scale Scale of disposal advisers’ fees based on transaction size,as follows:

Sale proceeds Incremental percentage fee

Up to £1 million 5%£1 to 2 million 4%£2 to 3 million 3%£3 to 4 million 2%Above £4 million 1%

Ratchet A mechanism, usually contained in a shareholder agreement, whichtransfers shares from an investor to the management if the busi-ness achieves certain targets

Trade sale The sale of a business to an industrial purchaser

Warranty A guarantee by a vendor of certain facts relating to a businessbeing sold, actionable by the purchaser in the event of breach


GLOSSARY


With offices in 16 European countries and inter-nationally, Price Waterhouse CorporateFinance assists, advises and supports itsclients in the development of their businesses.Our services include:

• Acquisitions and disposals• Finance raising and refinancing• Management buyouts and buyins• Strategic advice• Joint ventures and strategic alliances• Valuations• Stock Exchange circulars• Recommended offers• Bid support• Project finance• Sponsoring flotations

In addition, Price Waterhouse TransactionSupport Group, an independent, pan-European team within the firm, working full timeon investigatory work, provides a completerange of transaction-based services includingdue diligence and structuring, forensic analysisfor bids, IPO reporting and advice on improvingunderperforming businesses.

Contacts:

John WallPartner89 Sandyford RoadNewcastle upon Tyne NE99 9PL

Tel: 00 44 191 232 8493

John HarleyHead of M&A and Listings, EuropeNo 1 London BridgeLondon SE1 9QL

Tel: 00 44 171 939 4615

ABOUT PRICE WATERHOUSE CORPORATE FINANCE

better exits - astraea4 better exits e uropean vcs are better at investing than exiting....

Documents