PS#054: Exit Analysis – Public Offerings & Downside Protection (Part 3)
Alright, in the last two issues of Preferred Shares, we teed up the different types of exits and went deeper on the Change of Control category.
Today, I’d like to talk a little bit about the other two categories, the extreme upsides (i.e., selling after an IPO or in a direct listing) and the extreme downsides (i.e., a liquidation).
Without further ado, let’s get started.
Public offerings.
If a company is capable of going public (either through an IPO or direct listing), that is the preferred path for most investors. More often than not, a company on this kind of trajectory can be highly lucrative for its investors (depending on when they made the investment).
Over the past few years, public offerings have been a bit volatile. The dynamics of the market allowed a lot of companies to become publicly traded that maybe should have remained private. To put it simply, the bar for going public had dropped significantly. However, as the market has turned, the bar for public offerings has risen back to its (more) normal heights.
The requirements for going public really depends on the company and industry. As with most VC exits, it often takes a significant amount of time before a company has achieved a level that justifies a public offering.
So, how do we think about this potential when we’re making the investment and performing our exit analysis? It really comes down to one concept…
Do we think this company can be a category leader?
If we believe that the startup in question has that kind of potential, then this is an exit scenario that we need to be exploring.
Now, it shouldn’t be the only option we explore. The chances of a public offering are slim, so we want to be thinking through the other alternatives and downside scenarios alongside this path.
Liquidation & downside protection.
On the other hand, we have the downside scenarios or liquidation events.
As we’ve discussed in the past, building a successful venture capital fund is hard.
There is a lot of risk when it comes to investing in startups and most of the companies don’t make it. As an investor, being able to recoup your invested capital can be critical to meeting the fund’s overall returns. It becomes a lot harder to return 3-5x when a significant amount of your portfolio returns nothing.
This is why it’s so important to not just think through the upside scenarios, but also the downside scenarios. And, this is where downside protection comes into play.
There are two ways that investors can think about downside protection:
Structure
Asset value
For today’s newsletter, we’re going to focus on the second one.
The first one is about making sure that you’ve properly structured your investment to protect your capital. If you’d like to learn more about this, take a look at some of my previous posts (PS#023, PS#024, PS#025, #PS026, and PS#027) or my course How to be a VC Associate.
For the second way (asset value), we are thinking through the value the startup has in the event that the company fails and is unable to keep going. This looks at several components (and potentially a combination of them), including…
team or talent,
brand value/presence,
IP, patents, or technology,
industry partnerships/relationships,
revenue streams or customer base, etc.
Essentially, if a startup fails, are there pieces of the business that are still worth something (even if it’s less than the startup’s valuation). If the investors can get some or all of their invested capital back as part of that liquidation process, it can go a long way in protecting their portfolio.
Finding the underlying evidence.
Now that we’ve got a good handle on the potential exit options, it’s time to gather the information that allows us to evaluate them..
In the next issue, I’m going to outline how I gather the information I need to perform this exit analysis. While some of it may be readily available online, a lot of the best information comes from building relationships in the ecosystem.
If done well, I think this step can be a critical component of building your brand and separating yourself as an aspiring investor.
