Financial exit – perspective, players, routes and consequences
The government has become engaged in venture capital initiatives in a number of countries. This is also the case in Sweden. There are various modes of engagement. Common methods include investing directly in companies or indirectly through other funds (known as fund-of-funds or holding funds). One consequence of direct investment is that the government also acquires a share in the ownership of private companies. This ownership is intended to be temporary and the shareholding will subsequently be sold, in a process known as an exit. However, there may be a risk that the government’s interest in the investments themselves obscures the importance of the exit and the planning for the exit process.
There are several ways of achieving an exit. The players involved, i.e. the entrepreneur and the investors, may have different goals and strategies. What happens during and after an exit has repercussions on future investments. In a broader sense, it also has repercussions as regards the regional entrepreneurial ecosystem. There are therefore grounds for the government to pay attention to exits as an interesting policy issue. In this report, we argue for the importance of broadening the approach and viewing venture capital investments from a cyclical perspective. This means that an exit is considerably more than an end point in a linear, sequential process.
Growth Analysis has engaged two international researchers with specialist expertise in the field to conduct an in-depth study into financial exits. The aim has been to illustrate exits from several different perspectives. Their English report is the background material for this summary report in Swedish. We have also supplemented it with an appendix containing Swedish exit data.
The study is part of Growth Analysis’ framework project, What lessons can be learned from the government’s venture capital investments in the European Regional Development Fund?
The main players
An exit can be viewed from either the buyers’ or sellers’ side. In this report, we focus on the latter perspective. This means that the main players are the company’s founder (hereinafter referred to as the entrepreneur), as well as the venture capital player(s) who, seeking a return on their investment through an exit. The investors can in turn be divided up schematically, based on the type of venture capital (VC) in question: formal, private VC (VC funds); informal, private VC (business angels) and government VC (GVC).
The entrepreneur is defined in this context as the founder of the company. In practice, a company is often founded by several people, a team. In the event the company is sold, the entrepreneur obviously has an interest in achieving a good return, although he or she is often also interested in what happens to his or her life’s work following an exit. The entrepreneur may also have other private interests (such as the potential for continued control and influence in the company) that are not related to the company’s financial value.
The VC funds are intended to channel capital from investors to portfolio companies. The investors (“limited partners”) are often pension funds, banks, insurance companies or university foundations, but may also be private individuals. Special managers (“general partners”) are responsible for the fund’s activities and handle direct contacts with the companies. The latter invest capital on the basis of a pre-determined, long-term time horizon, and the fund is liquidated after this period has elapsed. In addition to investment capital, the portfolio companies may also receive support from the VC funds in the form of expertise, industry knowledge and networks of contacts. The reason for investments in the VC funds is clear: high returns.
Business angels are private individuals who often have a background as successful entrepreneurs, with their own experience of starting and running companies. The business angels use this background to support the companies they are investing in with non-financial values (network contacts, strategic support, industry knowledge, etc.). Investments are often made at an earlier stage compared to formal venture capital. Business angels are a heterogeneous group of investors, representing a considerable spread in terms of background, motivation and investment processes. They can invest both as private individuals and through their own companies. The current trend is that the role of the business angels is changing. It is becoming increasingly common for groups of business angels to invest, rather than individual business angels. Business angels’ motives are broader than those of VC funds, and can be divided into three main groups: those that mainly strive to achieve a financial yield, those that want to get a return from participating in an entrepreneurial process, and those that are driven by other, non-financial factors (such as helping to create jobs and aid development in their geographical area).
Government VC can be generally divided into three groups: guarantees, fund-of-funds or direct investments. The latter can take place through co-investments with private players or by means of the government investing on its own. Just as with private investors, government funds look for suitable investment objects, support companies with various non-financial initiatives and strive to achieve successful exits. However, the government has a broader goal structure than private investors, i.e. to promote Sweden’s innovation capacity and contribute to regional growth. This approach is fundamentally market-complementary. A common ambition with government investments, is often to “signal” to private players that there are good opportunities for returns, in segments in which they currently are not active. There is also an interest in what happens to the company after an exit, including what potential spin-offs can occur (such as new business opportunities as well as the spread of technology and knowledge).
Multiple exit routes, preferences and consequences
There are several different ways to proceed in an exit process. The five most common are:
- IPO (initial public offering)
- Acquisition or trade sale (industrial sale – the company is sold to another company)
- Funder or management team buyout of venture capital (the company’s founder or management buys out the external VC player’s shares)
- Secondary sale or secondary buyout (the external VC player’s shares are sold to a strategic buyer or to a new VC player)
- Write off (the VC player writes off the value of the shares, wholly or in part)
The first two routes are the ones that are normally pursued. Industrial sale is the most common approach, as it is simpler and faster compared to an IPO.
The entrepreneur, in his or her capacity as the founder of the company, has a wider range of exit strategies than the other players. In addition to financial motives, other possible reasons include the survival of the company or voluntary closure. If one of the main objectives is to achieve a financial return, an IPO or an acquisition/trade sale are both natural exit routes. If the company’s future management and administration are important aspects for the entrepreneur, exit routes other than the five listed above may also be relevant alternatives. This might be the case when ownership is transferred within the family. It might also be the case when selling to the existing management or other employees at the company, or selling to a selected individual outside the company. In the case of voluntary closure, the business ceases operations and the company is dissolved or becomes dormant.
It is important to note that the players involved may have different preferences as regards their exit. If the entrepreneur’s focus is on the private values that an exit could lead to (being able to retain aspects of ownership and control), they are likely to prefer an IPO over an industrial sale, where the entrepreneur’s connection to the company generally ends. If the VC investor prioritises rapid payment for its shareholding, an industrial sale would be more attractive than an IPO, since the latter usually entails lock-up periods that delay the potential to sell shares. What happens to the company after an exit – for example in relation to operations, jobs or potential relocation – may be of interest above all to GVC. It may also be of interest to some groups of business angels, but hardly to private VC funds.
Difference in preferences means that the various exit routes available will be perceived as more or less attractive by the respective players. During the exit process, there are consequently incentives for the players to continually work towards the exit route that they consider to be most attractive.
From a linear to a cyclical and exit-oriented approach
Conventionally, the investment process in a venture capital context has been described as a linear flow with incremental phases: from deal flow (the flow of investment proposals) through various forms of selection and assessment processes, negotiations, contract writing and the actual investment, to post-investment activities such as monitoring and mentoring activities and the final destination – an exit.
From a cyclical perspective, an exit is far from a final destination. It is rather a phenomenon that creates the conditions for new investments. Indirectly, it also has repercussions as regards regional growth and development. Such an approach also draws attention to activities that involve the reuse of financial capital as well as real and human capital in various ways. Tangible examples of this include serial entrepreneurship, active and liquid investors and – more generally – the opportunity to use the experiences gained in new development and growth contexts. What happens after an exit is consequently a policy aspect that needs to be considered.
With an exit-oriented approach, an exit is not something that is highlighted and completed at a single time. Instead, there is focus on the exit throughout the investment process. In principle, consideration is continually given to how an exit can be facilitated through all the various phases – before, during and after the actual investment.
The choice of exit route and the way an exit takes place can affect the future of the company and the players involved. If it takes place through an IPO, it is likely that the company will remain independent and have its head office and management team in the same place. At least part of the money from the IPO tends to be reinvested in the company to facilitate growth.
In most cases, an exit takes place via an industrial sale, which means that the future of the company being sold is determined by the strategy of the new owners. Are they investing in the company in the existing location to achieve future expansion, or do they intend to move some or all of the business to new locations within or beyond the country’s borders? The few empirical studies that have been carried out indicate both positive and negative impacts on the acquired companies.
An exit also has consequences for the players involved (entrepreneurs and investors). An exit with a positive return provides investors with financial liquidity and the motivation to make new investments. Regardless of the financial outcome of the actual sale, entrepreneurs and other individuals in senior positions have accumulated experience from building up the company as well as from the investment and exit process. This knowledge can be reused when starting up new companies or in other business promotion activities. It goes without saying that such an effect is reinforced by positive exit processes, which strengthen the financial opportunities for future investments. Successful investments also send out a valuable signal to other investors, facilitating future venture capital financing.
An exit can also have indirect effects. Empirical studies indicate that the regional entrepreneurial ecosystem can also be affected. Examples of this include increased business creation, business opportunities for local and regional suppliers, the spreading of knowledge and new job and career opportunities for skilled workers.
The government should employ a more exit-oriented investment approach
The number of implemented investments or the investment amounts that produce a market return are not a sufficient measure of success for public venture capital investments. How an exit takes place and what happens after the exit also constitute a relevant policy issue. Successful exits are both a tool for, and a measure of, the opportunities for future development and growth. We therefore maintain that public venture capital initiatives ought to adopt a more exit-oriented investment method. Prior to making an investment, GVC should evaluate post-exit scenarios based on the choice of exit strategy. In addition, attention needs to be paid to the preferences and strategies of the other players involved, as this may determine which exit routes are possible. GVC should also explore the possibility of reinforcing the positive effects of an exit. One method might be to investigate the potential for increasing the likelihood of “entrepreneurial recycling”, i.e. where knowledge, experience and capital from exits are reused in a way that promotes the regional entrepreneurial ecosystem.
Government investments should be market-complementary
GVC must have a market-complementary role, i.e. it must avoid crowding out private capital. It is generally perceived that the market underperforms when it comes to early-phase investments. There may be a need for greater risk-taking and for employing longer lead times. There may also be additional GVC initiatives in other areas. It is here that the public capital should be focused, not on maximum yield.
 In the international literature, the abbreviation GVC is generally used to denote Government Venture Capital.
 For example, the government could commit to covering a proportion of any losses that might be incurred by private VC players.
 In principle, this group is less interested in what profits the company can generate and more interested in the additional benefits that a purchase might bring them in the form of contributions from technology, products, services and other underlying assets.
 Reasons for this might include a career change or retirement, for example. Closure might be deemed an interesting option if the company is capital-intensive, with most of the value in tradable assets.
 Agreements that shareholders may enter into prior to an IPO, whereby they lock (may not sell) a proportion of their shareholding for a specified period, e.g. six months from the first day of trading in the portfolio company’s shares.
 An exit might e.g. result in the company relocating abroad, within the country or continuing in the same location. The purchaser, the government and regional stakeholders may value these alternatives in different ways.
Financial exit – perspective, players, routes and consequences
Serial number: PM 2018:19
Reference number: 2017/027