PS#055: Exit Analysis – Research & Relationships (Part 4)
Over the past three issues, we’ve broken down the types of exits and how to think about them in more detail.
Today, we’re going to discuss how to gather the fundamental information we will need to think through the different scenarios. And, as with most things in this industry, it will require two things…
Detailed research
Building relationships
For each category, we’ll discuss what to research and what relationships to build that will provide all the information you need for your exit analysis.
Option to Sell.
We’ll start with the Option to Sell category.
As I mentioned in the last issue of Preferred Shares, we’ve had some volatility in the public markets over the past few years. If you’ve studied the history of the public markets, you’ll recognize that the cycling from bull to bear market is quite common. Even more so, you’ll see just how hard it can be to predict the future state of the market.
Since we are making investments on a long-term scale, it becomes near impossible to predict what type of market we will have at the time of exit. To counter this unknown, we should take a long-term, conservative view of the market.
We can do this by taking the following process…
Identify similar companies/transactions.
Collect historical details on public offering & performance.
Analyze offerings over different periods to build a range of outcomes.
Let’s walk through this in more detail.
(1) Identify similar companies/transactions.
First, we want to identify similar companies or transactions.
This may be done by comparing the startup to other companies/transactions in the industry, those with similar offerings, or even companies that have similar business models. There are several ways to do this (which I’ll cover in a future issue), but the general idea is to find similar public offerings that can be used as precedent in the future.
(2) Collect historical details on public offering & performance.
Next, we need to collect the relevant information on these offerings historically.
To find the best information, we will often need to get access to a paid database (e.g., Pitchbook, CapIQ, Factset, etc.). Some of this information can be found online, but you’ll find much more detail in one of these databases.
We’ll want to collect the pertinent information to our analysis, including financial performance, valuation of the company, relevant multiples (i.e., revenue multiples, EBITDA multiples, etc.), etc. This will allow us to compare this situation with our projections for the startup in question.
For the relevant companies, we should collect information across 3 different time periods…
At the time of the public offering
Historical performance since the offering
Current information on the company’s performance
We can collect the information listed above across these time periods to develop a fulsome view of how the public markets value comparable companies and transactions.
(3) Analyze offerings over different periods to build a range of outcomes.
OK, this part is very important, follow closely…
We need to look at the public offerings over a long time frame. Venture investments could take 10+ years to reach an exit opportunity (depending on when you’ve invested).
We just don’t know when that opportunity will present itself.
With that being said, we should look at relevant public offerings over the past 10-20 years. In particular, we want to get a sense of how these companies have fared in the best and (even more importantly) worst times.
As an investor, we are obsessively focused on whether a startup can meet our desired return thresholds. The word “thresholds'' is very important. We want to see that even in a difficult market environment the startup can still achieve our desired returns. If that’s the case, anything more than this threshold is gravy.
This is often where investors can hurt themselves. They take a “too rosy” view of the startup’s exit potential and underwrite a valuation that just doesn’t make sense.
Before we move on to Change of Control, let’s quickly touch on the selling in the secondary market. This process will require speaking to investors who buy shares in the private secondary markets. They will often value the startup using the typical valuation methods (depending on the stage) with some sort of liquidity discount.
Change of Control.
For the Change of Control path, we will use the same research/analysis process outlined above (except we’ll look at M&A transactions vs. public offerings/companies). The main difference will be how we collect the information.
Alongside collecting detailed research from the databases listed above, we are going to leverage our network relationships to gather information not readily available publicly or even in these paid databases. In my Preferred Shares issue on networking, I emphasized building relationships all the way through the capital stack, including bankers and potential acquirers.
This is where those relationships will start to pay dividends.
If we have built strong relationships here, we can get information on how these bankers or acquirers would value a startup or evidence of how they’ve valued companies like this historically.
I will often research and speak with the following to collect more detailed information…
Boutique bankers
Strategic acquirers
Private equity firms
Let’s discuss what each of them can provide in more detail…
Boutique Bankers
While you can speak with bulge bracket bankers as well, I often find that boutique bankers, focused on specific spaces, have the best information. I will typically call a few of the bankers in the relevant space and ask…
How are companies currently (and historically) valued?
What financial metrics are most important?
Who are the active buyers?
They will usually have detailed information to share for all of these questions. After all, it’s their job to know these answers.
Strategic Acquirers
Between my own research and the bankers, I’ll have a good sense of who the strategic acquirers are in the space. I should have information on (1) their historical acquisitions and tendencies, as well as (2) their approach to the space.
The latter piece will need to be understood through conversations with the strategic corporate development team (and/or equivalent).
Private Equity Firms
Similar to the strategic acquirers, between my own research and bankers, I’ll have a good sense for which PE firms like to buy companies in this space.
Again, it’s all about the relationships. If you have strong relationships with these firms, they will give you clear indications on (1) the type of companies they are looking for, (2) what type of financial performance they expect, and (3) how they will value said companies.
Liquidation.
The final scenario requires some creativity.
We can use a lot of the information we collected above in the Change of Control category to drive our thought process. Essentially, we are trying to understand what the company could sell for in a fire sale (or downside scenario).
Do we think we could recover our invested capital? Yes or no? If not, how much could we recover in a downside scenario?
It’s not a simple question to answer, but the thought exercise alone will be very valuable as you think through all eventualities as an investor.
It’s an ongoing process.
Before we close today’s issue, I just want to emphasize that this is an ongoing process.
This is a lot of information. Most of it isn’t available in any one place and requires building trusted relationships with the parties identified. It takes time.
Give yourself time by starting this process when building out your investment thesis. As you find specific startups and opportunities, you can be more specific, but even a general understanding of the exit landscape can be hugely beneficial.
Now that we’ve got a good handle on the potential exit options, it’s time to put it all together.
Next week, I’ll give you some bonus tips and tricks for how I’ve used this analysis to build my personal brand as an investor and support my portfolio companies.
