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Corporate Finance
Venture Capital Exit Routes
Comparing the most popular methods of releasing venture capital

By: Koen Vanhaerents (Brussels) and Helen L. Shroud (London)

Contact Information is provided below

Private equity houses (or venture capitalists) set up funds which are used principally to
invest in equity and equity-related securities of companies in the private sector (investee
companies). Whilst the venture capital market has in the past been to some extent volume
driven, fund managers now tend to make fewer investments, concentrating on quality deals of
higher value. In addition to wanting to maximise returns, they need to demonstrate that
performance has been consistently good so as to be able to attract new money from their
investors for further funds. The pressure to make sure that each investment pays off is
consequently greater.

An inherent part of the investment strategy of a venture capitalist is the timing of the sale
of its interest in the investee company (the exit). Typically, investors look for a return between
three and five years after the original investment. Statistics published by the European Venture
Capital Association indicate that the average actual exit takes place after eight years.

Timing is also of vital concern to the management team. Management will not want the
exit to take place at a time which does not suit the business or their own vested interests.

Another vital aspect of the process is the choice of method of exit. The method
ultimately chosen will impact on the venture capitalist, the investee company and its
management. However, the parties often give insufficient attention to exit planning at the time
the investment is made.

There is no foolproof way of guaranteeing how an exit will happen. The investment
cycle involves too many uncertainties for that. However, parties to the investment can try to put
themselves in the best position to take advantage of opportunities which arise. All parties will
derive advantages from factoring into the original negotiations decisions which will influence the
end of the investment arrangement.

It is therefore important for all parties to address:

• The range of exit methods commonly used.
• How and by whom the decision as to timing will be made.
• Other contractual devices which can influence the ultimate outcome.
• The relative advantages and disadvantages of the principal methods.

Exit Methods
There are two principal types of exit route:
• A trade sale. A trade sale is a sale of the shares or business assets of an investee
company by way of a private sale agreement.
• An initial public offering (IPO). An IPO is the offering of shares to the public, normally
followed by the listing of the shares on a stock exchange.

The general perception is that an IPO will generate a higher price than a trade sale.
However, this is not necessarily the case and there are in fact advantages and disadvantages for
all parties in both trade sales and the IPOs (see boxes “Advantages and disadvantages”). The
capital gains tax consequences for the seller vary from country to country. However, as a
general rule, the sellers’ position is the same on a trade sale as on an IPO.

Other exit options are:

• Recycling - a sale to co-investors or other private equity houses (secondary buy-out).
• A buy-back by the company or management.

As market conditions become more turbulent, the number of IPOs seems to be decreasing. The
expectation is that the number of trade sales and secondary buyouts will increase
correspondingly. Moreover, there is increased competition between venture capitalists as the
level of investment increases but the number of appropriate deals decreases.

Advantages and disadvantages: IPOs

IPO advantages
3 Popular with management. An exit through the stock market seems to be favoured by
management, since it allows them to remain in place and in control. Having a range of
institutional shareholders is often preferable to management rather than one shareholder with
ideas on future direction which are different from their own. Also attractive stock options
plans might be linked to a flotation of the shares.

3 Dual track. Preparations for an IPO often provoke a pre-emptive trade bid which
allows the venture capitalist to follow a dual track approach.

3 Retained shares. Investors may continue to share in the future growth through their
retained shares.

3 Position of underwriters. Normally no warranties on the business have to be given by

the venture capitalists to the underwriters. However, in certain jurisdictions the seller may
have a statutory liability which could go beyond liability as to valid share title. In addition,
the venture capitalist company may have placed one of its own employees or managers as a
director in the target company and he or she may retain liability under the prospectus.

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IPO disadvantages

x Higher costs. There will be additional costs for the selling shareholders and the
company such as the preparation of the prospectus and investment bankers’ fees.

x Market risk. Illiquidity of the markets or an unexpected downturn may result in an

IPO being aborted.

x Image. The message has to be simple. For certain companies, it may prove difficult
to convince the market and the analysts of the real worth of the company.

x Less than full exit. Often an IPO does not provide for a full, clean exit. The venture
capitalists are often required to show confidence in the future growth of the company.
Indeed, sometimes only a partial sale is possible at flotation, often just sufficient to recover
the initial investment, either directly or in the green shoe (or over-allotment option) period
(see below “Preferential flotation rights”). After the IPO, liquidity may be restricted, either
through contractual or regulatory obligations or as a result of the state of the markets.

Ongoing risks. A continued shareholding results in continued risks:

x The special rights normally granted to venture capitalists at the outset of their
investment to protect their interests are usually abolished on an IPO. Underwriters and
market authorities tend to dislike the continued existence of special rights for certain
shareholders. The special rights may include board representation with veto, tag-along and
information and inspection rights.

x Continued board representation may result in additional liability, which cannot always
be covered by insurance.

x Potential restrictions on the subsequent ability of the investor to sell the shares may
apply under insider dealing restrictions at the time when the director representing the venture
capitalist is an insider. Quite often, a shareholders’ agreement is entered into with the (other)
controlling shareholders covering matters such as board representation rights, special pre-
emptive rights and transparency issues.

Preparing for exit

The parties may take several precautions at the outset of the investment to prepare the
way for a trade sale or IPO. The investee company and its management should be aware of the
obligations and incentives relating to the ultimate exit which they are likely to be asked to take
on by the venture capitalists. They will need to consider the impact of these on their own
position both for the duration of the investment and on the exit itself.

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 Common devices used in investment agreements in relation to exits include:
• Exit control covenants.
• Management covenants.
• Ratchets.
• Put options.

Exit control covenants. It is fairly standard to see a covenant from management and the
investee company acknowledging that:
• The investor is subscribing for shares to make a return on its investment.
• Management will therefore use reasonable endeavours to arrange a trade sale or flotation
before a certain date.

In practice this type of clause may be difficult to enforce. Ascertaining what is meant by
reasonable endeavours is not a straightforward process. It might be extremely difficult to prove
breach unless management went so far as simply refusing to discuss the issue. Also, if
management is being difficult when a sale is initiated, a prospective purchaser may be put off.
However, an exit covenant will at least help to focus minds on the exit strategy throughout the
life of the investment.

The covenant may be made more effective by including specific arrangements as to how
and by whom the exit will be controlled. The investment documentation may specify:
• Who has the right to force an IPO or trade sale. For example, 15% of the shareholders or
the majority of the shareholders.
• The method of establishing the selling price, for example, through a pricing committee,
the composition of which can be agreed in advance.
• Who is allowed to sell how many shares and when.

Often sophisticated procedures are set up to demand, in particular, an IPO subject to

specific time limits for making the demand and minimum intervals between two demands.
Clauses of this type sometimes provide for the appointment of an investment bank to make an
IPO report covering the IPO value, the timing, the required reorganisation and other related
issues. Sometimes, the request for an IPO has to be accompanied by a commitment by an
investment bank to underwrite the transaction.

A sanction mechanism may have to be provided to make the arrangements work. This
could be achieved through a put option in favour of the investors against any shareholder
refusing to co-operate (see below “Put options”).

Management has vested interests in the exit decisions which will ultimately be taken,
particular in relation to:
• The life cycle of the company. Management may have strong views at any given time on
whether a sale, merger or flotation is the next step for the business.
• Management’s own job security (see boxes “Advantages and disadvantages”).
• Effect of timing on any performance-based ratchet (see below “Ratchets”).

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Advantages and disadvantages: trade sales

Trade sale advantages Trade sale disadvantages

3 Premium. Notwithstanding a widespread x Management opposition. Management often

belief that IPOs provide for good returns, a opposes a trade sale, especially if it has a
trade buyer may also be willing to pay a substantial stake in the company or if existing
premium for reasons such as synergy, market management may not fit into the management
share or market entry. culture of the trade buyer. They will be aware that
a change in the ownership of the company may
3 Simplicity. The procedures involved in a result in them losing their jobs.
trade sale tend to be cheaper than an IPO and
quite often faster and simpler. However, if a x Confidentiality. In most cases the best
tender procedure is used, the process might candidate buyers are often close competitors. The
become complex and take more time. due diligence process might therefore be
comfortable. It could result in the disclosure of
3 One buyer. Only one buyer has to be confidential information which, notwithstanding
convinced of the deal. In an IPO investment good confidentiality agreements, is transferred to
bankers and the public at large have to be the competition.
handled.
x Warranties and indemnities. Purchasers from
3 Full exit. Trade sales will normally venture capitalists should be aware that certain
provide for a clean, full exit. private equity companies apply and enforce a strict
no-warranties policy (see below “Negotiating
warranties”).

Management may therefore wish to negotiate into the investment agreement an element
of control or influence over the decision making process. Similarly, mezzanine and bank lenders
may wish to influence the ultimate choice of exit route. The influence of the latter would depend
on how heavily endebted the investee company is and on its relationship with its banks.

Management covenants. The venture capitalists will not want to discover unexpected
revelations about the investee company when due diligence enquiries are being answered, a
prospectus is being prepared or a data room is being set up for a controlled auction (see box
“Controlled auctions”).

Venture capitalists will therefore seek to ensure that the target company covenants in the
investment agreement to produce regular management and financial information in line with
strict reporting standards. The covenants will often mirror the reporting requirements the venture
capitalists themselves owe to their own investors. Not only is this good corporate practice in any
event, but the venture capitalists will be in a position to monitor through the life of their
investment just when is the optimum time for an exit.

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 Ratchets. This mechanism allows management to share in the growth of a company by
either an actual or a notional redistribution of their shares and the venture capitalists’ shares on
any exit. The distribution is usually calculated by reference to a target rate of return to the
venture capitalist.

To make the covenant more effective from their point of view, venture capitalists
sometimes construct the ratchet so that it becomes less attractive for management if an exit has
not been achieved within a certain period, whether or not the target rate of return has been met.

Put options. A further alternative is to require management or the investee company (or
both) to buy the venture capitalist’s shares if no exit has been achieved within the defined period.
This is intended to provide for the situation where the market is static or illiquid, but is only
effective if management is financially capable of funding the purchase of the shares or the
investee company is legally able to do so.

There are normally local law requirements on exactly how the investee company can
purchase its own shares. Buybacks are only permitted in most jurisdictions if certain, fairly
stringent, criteria are met (see FirstSource “Share buybacks” EC, 1998, III(2), 15).

This may not in any event be the best route from the venture capitalist’s point of view:
• Fixing a price at the outset (whether absolutely or by means of a formula) may not reflect
the actual value of the company at the time of the buyback.
• There may also be a concern that management may sell on to a third party for an
increased price. This concern could be addressed by some form of clawback or anti-
embarrassment clause which would allow the venture capitalist to claim a proportion of
the increase in value on any subsequent sale. Encapsulating in a contract what is meant
by an increase in value is not, however, straightforward and such clauses may run to
many pages of drafting to ensure all possible disposals have been covered.

SEC registration rights

If exit through an IPO on the US securities markets is envisaged, the venture capitalist may seek appropriate
registration rights in the investment documentation. These will be required not only in respect of US securities,
but also for foreign securities which are offered in the US.

US law requires that securities of companies cannot be sold to the public unless the sale of those securities has
been registered with the US Security and Exchange Commission (SEC) or unless the sale is exempt from
registration. Only the company, rather than individual shareholders, may register with the SEC.

In order to be able to create an obligation on the part of the company to cause the registration of a subsequent
sale, shareholders routinely request that the company in which they are considering making an investment grant
them registration rights.

There are several kinds of registration rights. The two most common are:

• Demand registration rights These allow a shareholder to demand that a company register the sale of its
securities if certain preset thresholds are met.

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• Piggy back registration rights These allow a shareholder to include the registration of a sale of
securities on a registration statement filed by the company for the sale of the company's securities. In
this way the shareholder makes use of the registration process already in progress. This is more cost-
effective for the company and reduces the number of registrations the company may have to make.

In most European countries, registration rights are not required. Usually, if the company is the subject of an
IPO and obtains a listing of its shares, all other shares of the company, at least those of the same class, are also
considered listed or can very easily be listed without the need for a further complex listing procedure.

Planning for trade sales

There are certain issues of forward planning which relate specifically to trade sales,
including:
• Negotiating warranties.
• Piggy back (or tag along) clauses.
• Come along (or drag along) clauses.
• Limiting contingent liabilities.
• Earn outs.
• Non-compete clauses.

Negotiating warranties. When negotiating a trade sale a purchaser will require warranties
as to the state of the business. Warranties and the associated disclosure of information which
limits their scope play a part in allocating risk between the parties and determining the price the
purchaser will pay for the business.

Venture capitalists are likely to argue that they will not give warranty protection to a
purchaser of their shares, other than a warranty that they actually own the shares. This is a
conscious approach which is often adopted despite the fact that it may act as a depressant on the
price. It is sometimes argued that the price discount resulting from this policy is often larger
than the actual amounts which might have to be paid by the venture capitalist sellers if
reasonable warranties and indemnities were given with appropriate disclosure.

The arguments generally put forward by the venture capitalist are that:
• It is difficult for investors who are not involved in the day to day running of the company
to quantify potential exposure under the warranties.
• If the venture capitalist gives warranties on exit, it will be prevented in practical terms
from distributing the proceeds of sale to its investors until the limitation period for claims
has expired.
• Venture capitalists may be seen as deep pockets, especially where management is the
only other shareholder or where management continues to be involved in the business.

It is fairly common for the venture capitalists to try to pre-empt any argument on this
issue by including an acknowledgement by management in the investment agreement that the
venture capitalists would not be required on an exit to give any warranties other than as to title to
shares.

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 In practice, therefore, the burden of giving warranties on a trade sale exit often falls on
the management team. Management tends to resent this position as the perception is that the
venture capitalists are receiving the same return as them and that they are not being compensated
for the increased risk.

Whether management at the outset of the investment or a purchaser on exit can persuade
the venture capitalists to give warranties will depend to a large extent on relative negotiating
positions Where they are persuaded, they are still likely to seek financial caps and tightly drawn
limits on duration.

The following options are available as a means of dealing with venture capitalists'
reluctance to give warranties and the buyer's reluctance to accept warranties from management
only:
• An asset deal followed by the liquidation of the target when the contractual limitation
periods have expired. In an asset deal, assets (and related liabilities) are sold by the
shareholders. In this scenario the shareholders may therefore escape having to give
representations and warranties, but have to wait for the liquidation proceeds remaining
after the settlement of the liabilities which were left with the target.

• Putting a fixed amount in escrow as the sole amount available for recovery under the
warranties and indemnities, subject to a fixed period for claims.

• Entering a contribution agreement to try to ensure that management pays first in order to
encourage greater attention by management to potential claims.

Controlled auctions

Investors are constantly having to be creative in finding an exit route which gives them as
much flexibility as possible. The last five years have seen a considerable increase in the number
of controlled auctions. This procedure involves the following steps:

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 The preparation of an information memorandum on the company being offered for sale. The
memorandum is not as detailed as a prospectus on a flotation but its contents are usually the subject of
some verification by lawyers and financial advisers. Confidential information will be disclosed at this
stage. The sellers should consider drawing up a confidentiality letter (see FirstSource "Confidentiality
letters", EC, 1996, 1(3) , 23).

Prospective purchasers lined up by financial advisers are asked to make an

indicative offer for the target on the basis of this document.

Bidders in the higher range are invited to proceed to limited due diligence
in a data room and are asked to confirm their bids and submit their
proposed amendments to the sale documentation which the seller's lawyers
will have prepared.

A preferred purchaser is usually selected on basis of price offer and

proposed contract amendments. However, it is not uncommon to have
further rounds if there is enough interest.

The preferred purchaser is given exclusivity for detailed negotiations.

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The advantages of this process for the sellers
are:
• Maintaining control over the legal
documents and the timing of the
process.
• Keeping confidential documents from
competitors at the early stages, to
avoid "fishing expeditions".
• The ability of the financial advisers to
use the perceived competition to keep
the price up.
The disadvantages are:
• Cost
• Having to put in place substantial
infrastructure with no guarantee of an
ultimate buyer.
• Sometimes the process takes control of
the transaction. Often it is better to
conduct a bidding war with a few
interested parties and then proceed
straight to a regular trade sale.

• Considering insurance cover for liability under warranties and indemnities.

Piggy-back (or tag along) clauses. This type of clause requires management to ensure
that if they receive an offer for their shares, the intending purchaser also acquires the venture
capitalist's shares on the same terms. This is very common where the venture capitalist has only
a minority stake. It may also be coupled with an absolute veto for the venture capitalist on any
share sale by any other shareholder. Thus it will be able to choose whether to refuse to let the
sale proceed or sell along on the same terms.

Come-along (or drag alone) rights. The come-along clause is almost the reverse of the
piggy-back clause. It enables a venture capitalist to ensure it can sell all the shares of the
investee company. If it finds an exit for its shareholding it can require all the other shareholders
to sell their shares on the same terms.

Since this could operate unfairly where a venture capitalist has only a minority
shareholding, it is often used where it has over 50% of the shares or is drafted to apply only
where it an persuade other venture capitalists or other shareholders who together own at least
50%, to sell. The percentage will vary according to the particular deal structure.

Limiting contingent liabilities. The venture capitalists will strive to ensure that the exit
sale agreement does not make them directly liable for any future liabilities of the company and
that no obligations have been inadvertently accepted by the use of the words "jointly and
severally" anywhere in the document.

On an asset sale, whilst the venture capitalist may not have given any warranties to the
purchaser, it may nonetheless find itself as a shareholder in the remaining shell company. The
venture capitalist in this situation may face liabilities which have not been passed on to the
purchaser either because the purchaser would not accept pre-transfer liabilities or because certain
identified actual or contingent liabilities have been retained.

Earn outs. Venture capitalists tend to dislike compensation which is deferred and linked
to future results (earn-outs). Management control of the company will often no longer be in the

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hands of the management backed by the investor as the purchaser usually insists on taking over
the management on completion. Also, extremely difficult issues can arise in the calculation of
an earn-out, especially in relation to tax.

If the compensation is linked to objective factors, deferred compensation tends to be

more acceptable. Factors could include:
• The fact that no previously undisclosed liabilities surface within the limitation period.
• The outcome of an application for a vital licence or patent.
• The outcome of the renegotiation of certain contracts.

Non-compete clauses. In a trade sale, the buyer tends to ask the venture capitalists for a
non-compete clause. The purpose is to restrict them from re-investing into the same sector,
making use of inside knowledge acquired through the target. A venture capitalist will think
carefully before agreeing to this as it will not wish to restrict future investment potential of its
funds or the activities of its managers.

It may instead ask the purchaser to rely on an obligation that it will not poach employees
or customers of the business.

It is sensible also to consider alternatives, such as the use of a Chinese wall which
requires the venture capitalist to ensure that information resulting from one investment is not
used to structure an investment in a similar business area. Contractual documentation may also
include a prohibition on particular investment managers being involved in the structuring or
management of a competing investment.

Planning for IPOs

Often the investment agreement will not determine on which market the IPO will take
place as a number of complex and unpredictable issues will influence that decision. The
emergence of different markets for growth companies, such as AIM, EASDAQ and EURO.NM,
is a relatively recent development (see FirstSource "EASDAQ" EC, 1996, (I(2), 22).

From the issuer' s point of view, the decision will depend to some extent on a
comparison of the rules in each market on:

• Thresholds for admission.

• Costs of maintaining the listing.
• Publication of financial information.
• Dual listings on other markets.
• Multi-jurisdictional IPOs.

The devices which may be used, preferably at the time the investment deal is structured,
to make the company more suitable for an IPO. The investment agreement may contain an
obligation to convert the company from one company form into another or an obligation to set up
a holding company of which the shares can be floated. Also, arrangements can be made in order

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to ensure compliance with corporate governance rules, such as the appointment of independent
directors, an audit committee and a remuneration committee.

Preferential floating rights. Venture capitalists are able from time to time to obtain preferential
flotation rights which allow them to exit before the other shareholders. Preferential rights may
apply at the time of the IPO or in the over-allotment option (or "green shoe"). The over-
allotment option is an option granted to the underwriters to obtain from the company or the
selling shareholders additional shares up to, for example, 39 days after the IPO. The option is
also used by the underwriters to stabilise the price of the shares in the period just after the IPO.

Allocating costs. It is usually appropriate to make arrangements to determine who will pay the
costs related to the IPO. Quite often the company is obliged to cover them, although from time
to time the selling shareholders pick up certain costs. The costs concerned include:

• The fees, commissions and discounts for the investment banks.

• Legal fees of the counsel to the issuer.
• Legal fees of the counsel to the selling shareholders.
• Listing and quotation fees.
• Printing expenses.
• Accounting fees.
• Roadshows.

Minority protection. Investors aiming at an IPO exit are likely to be anxious to make sure that
the minority protection granted to certain minority shareholders automatically lapses on an IPO.
They will want to know that an IPO cannot be blocked by a minority.

Such investors will want the investment agreement to provide for the lapse of:

• Any special minority veto or pre-emption rights at board or shareholder level.

• All other transfer restrictions and preferences as far as dividends or liquidation rights are
concerned. This is often achieved by converting preferred stock into common stock at
IPO. This technique is easier to implement in common law, rather than civil law,
jurisdictions.

Minority shareholders may wish to resist these moves and protect any residual rights they have
for the long term (see FirstSource "Minority squeeze outs" EC, 1998, III(3), 29; EC, 1998 III(4),
29; EC, 1998, III(7)., 53)).

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About the Authors:

Koen Vanhaerents, Partner

Office: Brussels
Practice Group: Venture Capital & Private Equity
Education: University of Leuven (B.A., 1985; Lic. in Law, 1986);
University of California at Berkeley (1987)

Contact: koen.vanhaerents@bakernet.com

Helen L. Stroud, Partner

Office: London
Practice Group: Corporate
Education: University of Manchester (1980);
College of Law at Chester (1981)
Contact: helen.stroud@bakernet.com

Regional Contacts:
We welcome you to learn more about our venture capital and private equity capabilities, wherever your business
takes you. For further information, please contact:

Global North America

Bruce Zivian (Chicago office) Marc Paul (Washington DC office)
1-312-861-8940 1-202-452-7034

Asia Pacific Europe/Middle East

Kien Keong Wong (Singapore office) Marwan Al-Turki (London office)
65-434-2688 44-20-7919-1823

*This article is based on presentations given by the authors at a seminar hosted by the firm's European Venture
Capital Group in Paris in October 1998.

**This article is provided for informational purposes only and should not be deemed as legal advice or a legal
opinion.

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