In the context of startups, “exit strategy” is synonymous with “payday strategy.” Once a company has obtained sufficient commercial viability, it can be sold or taken public, resulting in a sizable return on investment for both its founders and investors. According to the international business lawyer and founder of Primum Law Group, Svetlana Kamyshanskaya, startups should plan for this windfall from the beginning.
“I like to use the analogy of driving,” Kamyshanskaya explained. “To drive a car, we have to know where we’re driving. Otherwise, we would just go around the world without a destination. The exit strategy is your company’s destination. Planning it enables startups to develop their business plan and strategy.”
What is the purpose of an exit strategy?
Making the business more appealing to investors and the understanding of the potential company value are the main purposes of planning an exit strategy.
“Startups are rapidly growing companies, and this growth is possible to achieve only if you have financing from angel investors and venture capitalists,” said Kamyshanskaya. “The reason they invest in the company is because they want to see a return on investment in the foreseeable future — for instance, in five to seven years.”
This is also why startups need to plan their exit strategy from the start.
“Even to start raising capital, entrepreneurs have to be able to present their exit strategy,” Kamyshanskaya explained. “If investors don’t see where the company is going, they may be hesitant to invest.”
Since raising capital is so critical to a startup’s success, a good advisor will ask executives what their exit strategy is before approaching possible investors.
“Basically, that question makes founders think about their business model, the market, their potential partners and customers, and their legal structure,” said Kamyshanskaya. “How long do they want to work on this product and potential partnerships, joint ventures, or customer relationships? So, one question brings up a lot of sub-questions we need to address in order to develop the pitch.”
The right advisors start the discussion about the exit strategy at the early stage of startup development
While some advisors are only interested in reaping the profit from completing a one-time service, good advisors want to see their clients’ success and help them to reach their potential. As Kamyshanskaya explained, “In my business, for instance, a lawyer can just form the company and charge money for doing this. On the other hand, a good lawyer starts by asking about the product, market, and exit strategy. The answers to these questions guide thinking about what kind of legal structure to choose, what considerations shall be taken into account and what the timeline looks like. It should be noted that one of the important drivers for the proper corporate planning is a tax liability that could differ depending on the structure.”
“If an advisor doesn’t ask what the exit strategy is, that should ring a warning bell,” she continued. “It shows a lack of experience or professionalism. It can also indicate that the advisor doesn’t intend to build a long-term relationship with the startup.”
“The founders have to be open to discuss their plans and be transparent,” she said. “You really have to think about it in the beginning — even before you form the company — especially if there is foreign capital involved or you have foreign founders as it brings more regulatory and tax complexity.”
The problems of not having an exit strategy
Major problems can develop for businesses that don’t think about the “destination” they are trying to achieve. For instance, companies may take money and raise capital without considering if the cap table that they develop is going to be acceptable for potential buyers in case of the acquisition, or founders can be so focused on developing their product but forget to secure sufficient legal protection for the business’s intellectual property.
“I’ve been through many situations, particularly during merger and acquisition transactions, in which a startup cannot provide documents that are sufficient to prove a company’s ownership of intellectual property and minimal risks of potential litigations on this end,” Kamyshanskaya says. “Since this is a critical piece in most M&A transactions, the executives must try to get developers to sign contracts when it’s time to sell the company, they may have to pay extra. Worse yet, the founders sometimes have a hard time locating the relevant parties. In some circumstances, this can prove to be impossible.”
“If they don’t acquire these rights, they may be forced to sell the company at a discounted price or take responsibility for the risks involved,” Kamyshanskaya explained. “When founders don’t think these things are important at the beginning, it usually costs them more to put things in order later.”
In the end, having an effective exit strategy can make the difference between a big payday and a big disappointment. That’s why founders should plan one from the start.