When venture capitalists invest in an upstart with lots of potential, they generally have two exit strategies in mind: selling out or going public.
If the timing is right, the rewards can be immense. If the timing is off, an otherwise lucrative opportunity can fizzle.
So how do investors know when to pull the trigger and make a move? As critical as timing is, there are no hard-and-fast rules.
“You kind of know when you know,” said Layton Crouch, a managing director at Encino-based Pacific Venture Group.
Still, experienced venture capitalists have learned a few lessons along the way, especially as Internet startups have come to dominate the landscape. The common thread is that these companies do not exist in isolation, so it’s key to analyze them in the context of their industry and the overall market.
“There is no real magic to it. A lot is dictated by market conditions,” said Tony Hung, a general partner at Torrance-based DynaFund Ventures. “If a company needs capital, they’ll say, ‘Are the public markets available?’ If not, maybe (they’ll consider) being acquired.”
Case-by-Case Decision
Paul Nadel, president of Los Angeles-based East-West Capital Associates, said timing is really a case-by-case decision that comes down to some age-old questions.
“You have to look at the market and the industry the company is in. Is the area hot? Has it been hot? Is it soon to be hot?” Nadel said. “We look at what kind of wave you are riding.”
Sometimes, a startup is taken to a certain level and it becomes apparent it doesn’t have the infrastructure to grow further without a partner, so finding one becomes the next step.
Sell or Go Public
Even in the face of an attractive takeover offer, decision-makers at a company still must evaluate whether it’s better to sell now or take their chances and possibly get a better valuation in the public markets.
Consider eToys, which turned out to be a big score for Dynafund. Even in its earliest stages, the online toy retailer’s potential was apparent.
“Even though we didn’t actively solicit (buyout) offers, they would come. In retrospect, it’s good we didn’t (sell) because we got a good public market valuation,” Hung said. “We felt bullish.”
Indeed, eToys raised $166.4 million in its IPO in May, valuing the company at more than $2 billion at the time. It was a good time to strike, because many e-tailer stocks have since fallen from favor.
Market conditions aside, the company itself also has to be ready. Doug Wolter, a partner at Newport Beach-based Forrest Binkley & Brown, said the factors he considers when deciding between a buyout and an IPO are the company’s ability to ramp up quickly and serve a huge market,paths to profitability and predictable results.
“Clearly, being predictable is key. If you miss the numbers, there’s a lot of punishment,” Wolter said.
Get Elements in Place
It’s also important to have the right chief executive, as well as an infrastructure in place.
“If you don’t have all the elements together you’re going to fail somewhere,” said Thomas Gephart, chairman and managing partner of Irvine-based Ventana Group Ltd. “It’s best to wait and build for the next stage. You can make as much money in a build-to-sell.”
Internal and external factors are both important. Even if the company itself is ready, it still requires a strong market to succeed. A couple of medical technology companies that Gephart’s firm invested in were all set to go public about two years ago, but the market wasn’t there yet, so they ended up selling.
“If you’re not in the right market space, you know you’ll get hammered,” Gephart said.
Let’s say a company has gone public and the industry later falls from favor. The decision to exit in that case comes down to the relative strength of the company in its particular sector.
“If we believe one of our investments is a category killer, we’re more inclined to sit and ride,” Nadel said. “We’re not looking for instant liquidity. We don’t have a history of selling out. We stick with them.” n
Hayes is a staff reporter at the Los Angeles Business Journal.
