IPO as a VC-Funds Type of Exit – Fund Fellow Founders

Fund Fellow Founders IPO as a VC-Funds Type of Exit

Dorota Podedworna-Tarnowska has published research-report on possible exits from the Venture. Full report is available on the ResearchGate.

Summary:

Private equity finance: A limited time investment with a big payout goal. Venture Capital funds aim to grow companies and cash out through an exit - going public, acquisition by a bigger corporation, or sale to another investor. The most profitable exit is often an IPO, but it's a complex and comprehensive process with many factors to consider. This research paper explores the success and profitability of VC firms taking their portfolio companies public, examining both literature and statistical data.

Full report can be found HERE (ResearchGate)

Below you can check the bullet-sum up of the available research. (29 pages)

Private equity investors hold their investments for a limited period of time and then sell the company to a third party investor.
Public offerings are the most successful and profitable exit opportunity for private equity firms, but they are not the preferred divestment type for venture capital firms. The success and profitability of going public by VC funds can be shown through literature and statistical data.

PAGE 2 Introduction

A venture capital fund's key goal is to grow a company to a point where it can be sold at a price that far exceeds the capital invested. However, one-third of portfolio companies fail.
A venture capitalist must liquidate the investment and distribute proceeds to investors within the predefined time of the fund to realize a positive return on the investment.
When a venture-backed company exits the portfolio, the venture capitalist distributes the profits to the fund's investors and eventually leaves the portfolio company's board of directors.

PAGE 3

Public offerings are the most successful and profitable exit opportunity for private equity firms, but not for venture capital firms.
This paper reviews the most popular forms of venture capital exits and focuses on an IPO as a type of exit.
This article is divided into 5 sections beyond the Introduction and Conclusion. It discusses the positive and negative aspects of an exit by IPO.
Section 1 describes venture capital and private equity, Section 2 discusses exit types, Section 3 discusses initial public offerings, Section 4 discusses underpricing, and Section 5 discusses conclusions and future research directions.

PAGE 4 Venture Capital versus Private Equity

Private equity is a form of equity investment into private companies not listed on the stock exchange, characterized by active ownership. Venture capital is a type of private equity focused on start-up companies.
The Polish Private Equity Association describes venture capital as a professional equity co-invested with the entrepreneur to fund an early-stage (seed and start-up) or expansion venture, and expects higher than average returns.
The National Venture Capital Association defines venture capital and private equity as investments in new companies with high growth potential and high risk.
Venture capital is regarded as a subset of private equity, referring to investments made during the launch stages of a business. The connotation differs depending on a region and country, which has a historical background.

PAGE 6

J.R. Ritter found that growth capital-backed IPOs have debt in their capital structure and are backed by a financial sponsor that owns far less than 90% of the equity prior to the IPO.

The Framework and Types of Exits in Theory and Practice

V C investors are active, value-added investors that bring capital, knowledge, skills, and a network to an enterprise. They will exit an investment when the projected marginal value added as a result of the VCs' efforts is less than the projected cost.

PAGE 7

There are three basic types of exits for venture capitalists: going public, being acquired by a larger corporation or a sale to a third-party investor.
In a secondary sale, only the V C's shares are sold to a third party, typically a strategic acquirer; in an IP O, the entire firm is sold to a third party.

PAGE 8

Diversification can be achieved through the sale of company shares to industrial investors, the sale of the quoted equity, the sale of the company on the stock exchange, or the write-down of a portfolio company's value to zero or a symbolic amount. Private equity firms can divest their shares in a company in several ways: by paying back their loans, selling their shares to another private equity firm, or selling their shares to banks, insurance companies, pension funds, endowments, foundations and other asset managers.
If private equity investors cannot predict when a company will be mature enough to go public, they are unlikely to invest.

PAGE 9

An exit may be full or partial: a full exit involves the sale of all the venture capitalists' holdings in the company within one year of the IPO, whereas a partial exit involves the sale of only part of the venture capitalists' holdings.
When exiting an investment, VCs sometimes make a full exit, and sometimes they make a partial exit. The key factor in driving this choice is the degree of information asymmetries between the selling V C and the purchaser(s) of the V C's investment.
Every investee firm is different, and a development plan to achieve a successful exit takes into consideration a number of macroeconomic and microeconomic factors. Some of these factors are outside the sphere of influence of venture capitalists, but there are still many factors under their control.

PAGE 10

Venture capitalists select portfolio companies according to the preferred type of exit, and may demand for specific modes of exit depending on the type of portfolio companies. This allows the venture capitalists to control the exit, and may minimize the temptation toward self-dealing by the entrepreneurs.

PAGE 11

Two types of shares can be sold at an IPO: primary equity (new shares sold to investors) and secondary equity (shares owned by the original investors).
Typically, the V C will sell a small fraction of its shares at the time of the public offering, or make a dividend to the fund's owners.
The IPO process consists of the following stages: forming the IPO team, preparing the company, assembling the team, signing a letter of intent with the underwriters, beginning the quiet period, holding the organizational meeting, preparing a preliminary registration statement, conducting the due diligence process, and selling the shares. The decision to go public is not easy, as the process is very comprehensive and complex. A great deal of planning is required, as well as much attention from the directors.

PAGE 12

The market regulators may impose sanctions on the management and venture shareholders of a business considering a listing, and venture investors may be reluctant to give warranties.
Several advantages and disadvantages of the exit through an IPO could be indicated, including the potential for the highest price, the favoritism of the management, the possibility of offering share participations or stock-option schemes as a complementary and highly effective form of employee incentives, and publicity. A private equity investor can retain a stake in a business and share potential profits, and can provide new financing for future investments or acquisitions.

PAGE 13

He emphasizes the disadvantages of exit via an IPO as well23, such as high transaction costs, extensive preparation and high standards required, intense execution processes, lockup conditions, illiquid stock markets, need to convince a large number of investors about the quality and future outlook of the business. - Substantial risk attached to the process of withdrawal; - Only for sizeable companies with an attractive projected growth profile; - IPO exits typically require a minimum issue size.

PAGE 14

Venture capitalists believe that IPO activity levels in their home countries are too low, and that higher returns generated by IPOs are critical in providing superior returns to limited partners and growth capital to developing portfolio companies.
The likelihood of going public is affected by the number of financing rounds, the invest-ment duration and reporting requirements of the investee to the venture capitalist. Venture-backed companies in the US yield higher first-day rate of return than the others during their IPOs.

PAGE 15

The decision to pursue an IPO is more dependent on the current stock market conditions, the company's future profitability and opportunities for growth than the decision to exit via a trade sale.
Private equity investors take firms public during market peaks and rely on private financing when public equity market valuations are lower.

PAGE 16

B.S. Black and R.J. Gilson argued that a well-developed stock market is critical to the existence of an active and well-perform ing venture capital market.
Many studies focused on the exit of a VC from the financed firm especially on IPOs, which have known, during these last ten years, cycles with strong agitation.

PAGE 17 Underpricing Venture-Backed Companies and Control after the Exit by an IPO

Firms may time their IPO to take advantage of market buoyancy or to display positive growth opportunities. Underpricing is mostly the result of intentional actions and an IP O strategy element that allows investors to gain positive returns.

PAGE 18

P.M. Lee and S. Wahal find evidence for higher underpricing for venture-backed IPOs. They suggest that venture capitalists incur losses due to underpricing to create a reputation in the market.
Underpricing occurs when the issues are offered to the public at a price which is lower than its intrinsic value. More transparent firms pay lower issuance costs, and firms pay higher costs in all the components if they have to pay more in any one component.
P.A. Gompers argues that young venture capital firms take actions that signal their ability to potential investors, and that these actions lead to companies going public two years younger and more underpriced than companies backed by older venture capital firms.

PAGE 19

Private equity backed IPOs experience a significantly lower level of underpricing than venture capital backed or non-sponsored IPOs, because private equity firms tend to be continuing and lucrative clients of investment banks.
W. Megginson and K.A. Weiss confirm the finding that venture capital-backed initial public offerings are underpriced significantly lower than non-venture initial public offerings, and explain that venture capitalists are able to attract higher quality and more experienced underwriters and auditors than other listings.
Ch. Barry, C. M uscarella, H. Peavy, M. Vetsuypens argue that venture-backed companies have less of a positive return on their first trading day, because the venture capitalist has monitored the quality of the company.

PAGE 20

A. Brav and P.A. Gompers found that venture capital-backed IPOs are more underpriced than other issues, and S.A. Franzke found that the involvement of a reputable venture capitalist leads to a higher underpricing.
In a single country, companies going public on secondary markets are as often venture-backed as companies on the main markets. Some young firms may view the secondary market as a sort of 'public venture market' to finance their growth projects.
Private equity firms do not sell their stock after the lock-up period, but rather distribute shares to their own investors. This causes share prices to drop by 2%.

PAGE 21

The ability to control an exit is crucial to the venture capitalists business model of short-term funding of nascent business opportunities. It also allows fund investors to evaluate the quality of their venture capitalists.

The Comparison of Most Common Types of Exit in the USA, Europe and Poland

At the beginning of its existence, the venture capital industry grew slowly, and the flow of money into the industry was rather limited. The market stagnated at the beginning of the 1970s due to a sharp rise in the capital gains tax.
The venture capital market in the US grew dramatically in the early 1980s, as investment opportunities increased and tax-related issues were introduced. The fundraising and investment environments in the venture capital ecosystem remained strong in 2015, but the exit environment was unable to maintain the pace from 2014.

PAGE 22

In the US, for every dollar invested in venture capital, $6.27 worth of revenue was generated in 2010. However, only one in six companies go public.
In the 1970s, the European venture capital market had over 20 funds and invested £20 m illion. By the end of the decade, the industry had grown to £1300 m illion and had outperformed the US venture industry.

PAGE 23

Depending on the national specificities, some sources of financing dominate others, e.g. corporate venturing and family offices in Switzerland, public companies and corporations in France, banks and corporations in Germany.
In 2015, € 47.6bn was raised by European private equity and venture capital firms, and over 2,500 European companies were exited, representing form er equity investments of € 40.5bn. Four out of ten companies followed a trade sale as their exit route.

PAGE 24

Poland is one of the emerging markets in which there has been growing interest from the worldwide investment community. The private equity sector in Poland started to grow in 1990 and is now one of the world leaders in private equity returns.

PAGE 25

Deal sourcing in Poland has evolved in the last two decades. The competition between V Cs is not as strong as in developed countries, and the crisis has influenced the PE sector, so the market decreased in 2009 and then again in 2013.

PAGE 26

In Poland, venture capital funds exit principally by trade sale.

PAGE 27

Although there are numerous similarities between the US and Europe, there are also important differences, such as the easier replacement of the form er management.

Conclusion

Private equity investors hold their investments for a limited period of time and have several options for cashing out on their investment. The exit strategy must take several trends into account.
In the case of high information asymmetries, buybacks, trade sales, secondary buyouts and IPOs would be preferred as exit types, while write-offs would be kept even shorter.
The most spectacular and visible form of exit for a venture-backed or private equity-backed company is an IPO, but it is not the most common form of exit, as historically it was in the US, especially before 2000.

PAGE 28

Although there are many similarities between the US and Europe, there are also significant differences. Younger firms exhibit fewer differences than older firms.

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