Which Way to the Exit? The Importance of a Well Structured Exit Strategy in Private Placements
By: Cora Pettipas
How can you tell you are speaking with a skilled broker?” my former mentor, a wealth management executive and brilliant woman, asked with a gleam in her eye. I stated I did not know. “Simple,” she said, “they have an exit strategy for the investments.” She went on to elaborate that choosing investments was the easier part, knowing when to exit the particular stock or portfolio strategy was a lot trickier. This conversation early in my career had a deep impact on me, as evidenced in that I remember it in detail many years later. When speaking about a client’s portfolio, an advisor needs to include a discussion about exit strategies and portfolio growth expectations. Doing so inevitably reduces the emotion of the client in portfolio management decisions.
In the public markets, there is a robust secondary market for most stocks as exchanges are structured to enhance liquidity. Even in the mutual fund world where fees and products are structured to be invested in passively on the retail level, the portfolio manager needs to be cognizant of an exit strategy with the assets. The ‘buy and hold’ mentality on the retail level may be why there is very little overt focus put on exit strategies in the public investment world.
Exit Strategies in the Private Market
In the exempt market, this conversation is even more important, but it happens much earlier in the process. Issuers need to be cognisant of exit strategies when they are building an investment product, as the exempt market has a very limited secondary market and product redeem-ability can also be limited. Also, a properly structured exit strategy will make the private placement more attractive for exempt market dealers (EMDs), and thus get it in the hands of investors, as they sift through the multitude of offerings that come across their desk. If an issuer wants to be placed on an EMD’s shelf, competition is fierce and the issuer needs to have more than a viable business plan.
This is not to say that an issuer should pander to investor fancy. If the sweet spot for investors is a three year timeline, it should not be structured that way unless it makes sense for the business plan. If the timeline would be better suited at six years, then the security issuance should be structured as such. This is all in the under-promise over-deliver mentality, it is better to have a structure that is a little out of favour with the investor early on than have investors panicked down the road when their money is tied up and their advisor is foretelling that they could have their money delayed or even worse, lose their entire investment.
An exit strategy is how the issuer plans liquidation or divestment of the underlying asset. The exit, or sometimes called harvesting strategy, is the third and final stage of the main business stages of a private issuance, after the product in and development stages. The exit phase should be explicit in the business plan as well as the offering memorandum. The exit strategy will either be in stages, or alternatively, where the investors exit all at once. This stage is very important to the dealing representatives, and their clients, as this strategy directs the timeline and potential returns on the investment, which needs to be matched with the client’s know your client (KYC) parameters.
Studies by David Newton (entrepreneur.com) have shown that the majority of all formal business plans by entrepreneurs name ‘going public’ as their exit strategy. Even though the finance world literature focuses on the remote possibility of going public as the most prominent strategy for a growing venture into a ‘legitimate’ business, there are other successful methods of achieving an exit. Other exit strategies for an issuer are the acquisition, the ‘earn out,’ the debt equity exchange, and the merger. The acquisition is when another business takes over the issuer’s venture. The ‘earn out’ is when the issuer is making significant cash flows from operations and buys out the investors. The debt equity exchange is where debt holder investors are offered equity shares in the business and investors become profit participants through dividends. The fourth strategy is the merger, where two companies with significant synergies merge into one and become one business unit. The key for exempt market issuers is to structure the exit as an arm’s length transaction to a third party, to protect investor interests.
Exit strategies are a vital component of a private offering; so important in fact, that popular industry opinion holds that the majority of issues currently facing the industry have to do away with inappropriate or undefined exit strategies. In the past, some issuers were so focused on getting the capital into the company that the execution of the business plan was secondary; let alone planning properly for the exit of the project. Therefore, inappropriate terms and conditions were agreed to (or offered) by the issuer simply to appease the public’s sentiment on appropriate terms for their funds. The result of this planning method are now becoming apparent, as many short term offerings have simply run out of time to execute their initial business plan. This is not to say that the original business plan was flawed, but simply that their timing did not prove accurate.
What Are the EMDs Looking for in an Exit Strategy?
In our current exempt market environment, EMDs can cherry pick the very best offerings for their product shelves. What does an EMD look for in an issuer exit strategy? The main points that were highlighted by industry experts: back up plans, low conflict of interest, investor recourse, and explicit, realistic goals of investor compensation. “When we look at a prospective offering that we may consider representing to the marketplace, we first look for a sound business plan and model that ideally offers a number of potential exit strategies. An issuer who contemplates a number of potential strategies is far more likely to be prepared to changing market conditions over the course of the investment term,” explained Rick Unrau, President and CEO of Pinnacle Wealth Brokers, one of the largest EMDs in Canada.
Darvin Zurfluh, founder and Executive Chairman of Pinnacle adds, “At Pinnacle we want a well-defined timeline, with experienced managers that have done the model before. An exit that has no conflict of interest. Many issuers in the past > have offered to buy out the project on exit (or sell it to a related company) but this leaves too many conflicts on the table. We like to see one to two back up plans as we all know that things don’t always go according to plan. Investors should get to vote on any exit that was different than the original plan. If the issuer doesn’t follow through on their exit plan, an EMD would like to have some recourse. This could mean giving up some of their equity or reducing their management fee.” The issuers exit strategy is an important risk attribute and is factored into the due diligence the EMDs use to assess an offering: it includes taxable nature of income and timelines of funds returned to investors.
What are Common Exit Strategies?
In the Canadian exempt market, there are various exit strategies issuers use, especially with the varying business plans and strategies in play. The common strategies used vary depending on the growth stage of the investment, sector and type of offering. “It really depends on the type of investment, whether it is a company that is operational and growth-oriented, a development or business model with a finite life cycle, or an income investment. Operational/growth oriented companies will likely exit by being acquired by a larger company or in fewer cases going public. A development project generally has a term in which the capital is deployed and then returned, or sometimes the project will be purchased by a larger entity. For income oriented investments, we have generally noticed a preference to having a redemption feature in which the fund will return the capital to the investor, either through cash flow, new investment or by selling assets,” adds Kyle Jacober, one of the founders, and Vice president of Sales, at Raintree Financial Solutions, another prominent Canadian EMD.
What are Some Best Practises for an Exit strategy?
An issuer is ultimately looking for investors to provide the funds to establish and grow their business idea. Competition is fierce for investment dollars, so issuers need to be cognizant of what EMDs are looking for in an exit strategy when building their business plan and drafting their OM, to ensure best practises. “Everyone involved must identify that even though a particular date on the calendar may be a great guideline for liquidating, a particular point in the business plan is really the target that everyone aspires to,” explains Curtis Potyondi, President of Prestige Capital Inc., “Therefore, a proper exit plan should look for a business plan that is executable and defining points whereby take-out events can occur. This builds in a common objective for participants while holding management accountable for reaching milestones.”
The exempt market could benefit from best practises for structuring an exit strategy for their business and have it explicitly stated in offering memorandum clauses. However, there is an innate conflict between the exact defined timelines the EMDs and DRs would like to see, and the real world circumstance that market results cannot always be timed and predicted even with the most astute planning. The recommendation from Potyondi is key; to add or integrate business milestones, not just pure timelines into the planning of the exit.
Planning ahead is very important, as is finding a balance of utilizing the proactive strategic planning of the business plan with reactive changes due to economic and external circumstances. To complement this planning, a management that adheres to strong preparation of documentation and reporting standards can be invaluable in a successful exit. “Best practices would dictate that an issuer very clearly define their project lifecycle and multiple exit strategies. It is critical that the issuer not overcommit on timing nor set expectations with subscribers that cannot be met,” suggests Rick Unrau.
In the exempt market, issuers should be cognizant of what the market desires to see in an exit strategy. DRs and EMDs are most privy to that information as they are closest to the investor. Adhering to best practises outlined in this paper, and avoiding policies that bury investor interests are highly recommended to create a product that EMDs want on their shelf, as well as an outcome that will have investors wanting to reinvest in future projects. A great exit plan should be explicit enough to keep management focus on the business and planned exit, but flexible enough to withstand external environmental roadblocks. The structure of the security and the timelines provided should be based on projected business milestones, not just investor preference. The OM should set up a compensation model that limits agency risk as much as possible; with a realistic compensation model that pays the investor first and is set up to also protect them first. This way, investors know the direction of the business and the way to the exit.