1 confidential - for classroom use only harvesting a venture

1Confidential - for classroom use only

Harvesting a Venture


Introduction

What is harvesting?– The sale of all or part of an entrepreneurial venture

– A liquidity event

Key question:– Why harvest an ongoing or promising venture?

Hence, questions for the entrepreneur include:– Do I wish to realize all or only part of my investment?

– Do I wish to continue to be associated with the company after the sale?

– What form of payment do I want from the sale – equity in another company, cash on

deferred terms, a pension, a consultancy retainer?

– Which exit route will give me the greatest return?

– If I decide to go for an IPO, what will it cost and who will help me?

– If I decide to seek a trade sale or sale to a third party, how do I find a buyer?

– How patient am I prepared to be?Jeffrey Timmons and Stephen Spinelli, New Venture Creation, (McGraw-Hill Irwin: 2007).


Harvesting Alternatives

1. Continue with the business

– Maximize free cash flows

– Pass the business on to heirs

2. Sell the business to

– Management

– Employees through an ESOP

– Outsiders (incudes the possibility of a merger)

• Other companies (e.g. competitors, suppliers, or customers)

• Private investors

– The public through an initial public offering (IPO)


Increasing Free Cash Flows

By eliminating long-term investment

Advantages

– founders maintain control and freedom of action

– finding a buyer is time consuming

Disadvantages

– double taxation if free cash is distributed as dividends

– shrinking competitive advantage

– greater risk because return does not come out at one time

Not as exciting as growing the business


Passing on the BusinessOnly 30% of family businesses reach the 2nd generation

Less than two-thirds of those survive through the second generation

And only 13% of family businesses survive through the 3 rd generation

An interesting article:

Passing Your Business to the Next Generation: Is It Best for Your Family?

The next generation may have a grand scheme to turn the traditional printing business into a media empire or a liquor business into an entertainment enterprise. A

few years back the second generation of a well known Chicago area computer leasing and IT Services Firm tried to turn it into an Internet Venture Firm with

disastrous results.

Before you just assume that your torch will be carried by the next generation, make sure that the next generation even wants to run the business. Imagine the loss

in value that would have occurred if the real estate billionaire from the western suburbs had turned his empire over to his son who simply wanted to produce

plays.

Are your heirs even capable of running your business? Have you held on to the reins so tightly that the kids involved in the business have not been able to

develop their decision-making or leadership skills? Do they command company respect because of their personal strength and skills or are they grudgingly

granted respect because they are the child of the owner? If that is the case, the odds are not good for them taking over when you retire.

Another big challenge is trying to balance fairness in employing many children or even grandchildren in a family business with various skill levels, compensation

levels and ownership levels. The jealousy and in fighting can absolutely grind the company’s progress to a halt.

The business owner must make some difficult decisions when he or she decides it is time for them to retire. Why did I create this business? Was it to keep this

business in the family for generations or was it to provide for my family for generations? If the desire and the capability of the children are not evident and

the company is large enough, it may be the right decision to first get outside board members actively involved as step one. Step two would be to hire

professional management to run the business. A second alternative is to sell the company while you are still running it and it can command its highest value.

If you have children that want to remain in the business for the immediate future, incorporate that into the sale agreement with employment contracts.

Another way to think of it is, while I am running the business, the best ROI is to keep the bulk of my net worth invested in this company. If I am no longer

running the company what is the best risk reward profile for my net worth? Would my heirs be better off if the business was sold and the value converted to

financial assets?

Simon Bridge, Ken O’Neill and Stan Cromie, Understanding Enterprise, Entrepreneurship and Small Business, London: MacMillan Press, 1998.

http://www.businessknowhow.com/money/nextgen.htm


Selling a Venture

Therefore the entrepreneur or venture capitalist must

1. find the right time to sell

2. decide on the exit route

3. agree a price with the purchaser

4. have the same harvest vision as all key stakeholders

However, in a private company,

– there may be restrictions on the ability to sell, e.g. the owner-

manager may be required to offer the company to the existing

shareholders (who cannot/will not buy)

– the founder may only be a minority shareholder without the power to

sell the entire venture


Management Buyout

Advantages

– continuity of venture

– incentives on the part of managers to increase value

Disadvantages

– interests of managers and founders are often mis-aligned

– asymmetric information can lead to mistrust

– usually requires significant debt financing

– greater risk if deal is financed by founders


Employee Stock Ownership Plan (ESOP)

Steps– Bank agrees to lend money for

purchase of stock

– Employer company agrees to

guarantee loan

– ESOP borrows money from lender

– Cash from loan used to buy

owners’ stock

– Stock assigned to ESOP for

benefit of employees

– Firm makes tax-deductible

contributions to ESOP

– ESOP makes payments on loan

Advantages– owners can cash out quickly

– tax advantages to owners, lender,

ESOP

– both principal and interest are

deductible

Disadvantages– employee retirement and

employment in one place

– financial information must be

disclosed to employees

– all employees must be included in

plan

– employees tend to think like

employees and not owners

http://www.nceo.org/library/esops.html


Merger

Advantages

– diversification of risk

– expansion and stabilization of business

– cashing out

Disadvantages

– loss of control and freedom

– negotiations over value and deal structure

– difficult to find the right partner

– can be expensive structure

Requires due diligence from all parties to the deal


Initial Public Offering (IPO)

Advantages– access to capital

– can mean tremendous wealth for founders

Disadvantages– Few ventures qualify

– Need the right size, industry, management

– Markets are unpredictable

– Valuations tend to be lower than acquisition

– Narrow windows of opportunity

– New issues tend to under-perform

– Time-consuming, expensive, arduous process

– Founders now have responsibility to public

– Company comes under SEC rules

– Probable loss of control and freedom


Initial Public Offering Process

Consider going public

Prepare the prospectus

The road show

The pricing meeting

The consequence The market takes over

Market and investment banker are in control

Investment banker gains power

Company has all the power

Choose an underwriter


The Decision to Sell

The decision to sell is mostly related to the price you expect to

receive for your equity – it’s a lifestyle decision:

Hence, the key questions

1. What is the company worth?

2. Will this give me sufficient capital to do what I want to do with

the rest of my life?

– And this is dependent on two factors:

• The size and profitable track record of the company

• The state of the market

– And therefore, you will need a valuation


Valuation

Per Robert Hisrich, there are eight factors that, although they vary

by situation, the entrepreneur should consider when valuing the

venture:

1. The nature and history of the business

2. The outlook for the economy in general and the industry in particular

3. An assessment of tangible and intangible assets in the venture

4. The overall financial condition of the company

5. The future earning capacity of the company

6. The dividend paying capacity of the venture

7. An assessment of all prior investments and valuations

8. The market price of stocks of companies engaged in the same of

similar lines of business Robert D. Hisrich, et. al., Entrepreneurship (McGraw-Hill Irwin: 2005).


Reminder: Valuing a Firm

All valuation is a negotiation and a function of cash, timing and risk

– Analysts usually use more than one approach/method

Valuation approaches

1. discounted cash flow

2. VC model (e.g., investment must return three times its value in three years (100% ROI)

or ten times in five years (58% ROI)

3. First Chicago method

4. comparables and multiples of earnings

5. fair value of assets

6. capitalized earnings

7. cash flow method

8. cost to create method

9. industry rules of thumb

10. Economic Value Added (EVA)

11. real options and decision trees


Exit Strategies for MedTech


Introduction

Eventually, the investors in a company will want to exit the investment as a mechanism for

recouping the capital they have invested in the business. Investors may also seek an exit in

an bit to diversify their business risk. Two common ways to exit an investment are

1. to sell the company to someone else through an acquisition or

2. enter the public markets rough an IPO.

Acquisitions and IPOs are best undertaken when the entrepreneur, his/her management

team, and the board of directors believes that the company’s value has been maximized

(meaning that they lave done all they can with the resources at their disposal) such that

the only way to continue to grow and mature is to be acquired or raise additional money

through an IPO.

However, exit events are often influenced by the external market environment and may not

be available to the company at a desired time. Investors should be willing to provide

capital to sustain the company until the external environment improves. Another

alternative available to companies is to enter into a licensing agreement as a means of

generating revenue and providing a payback to investors.

Stanford casebook


Acquisition

According to Ellen Koskinas, a partner with the VC firm InterWest Partners who specializes in medical devices,

mergers and acquisitions accounted for as many as 80-90 percent of device company exit strategies. The sale

of a company is usually driven by the strategic fit between the assets or technology of the acquiree and the

strategy of the acquirer. Acquisition can be an attractive exit strategy to investors because they receive cash

and tradable stock that can be acted on immediately, while also avoiding much of the volatility and risk that

can be associated with an IPO (see below). It can also provide investors with a reasonable way to exit a

troubled company.

An acquisition occurs outright when the acquiring company takes full and complete ownership of the business.

The primary advantage of this approach is that it can provide a clean, and potentially desired, break for the

founders and current management team, who may be replaced ‘he major disadvantage is that an outright

acquisition typically results in less value (lower price) and an immediate loss of control of business to the

founders and current management team. Another approach to an acquisition is to do an earn-out—staged

milestones culminating in a purchase. The founders and employees usually continue to be involved under the

aegis of the acquiring company to help the acquiring company meet these milestones. The benefits of this

approach are that it often results in greater value while the founders retain some control of the business

through the transition. On the other hand, there may be less certainty regarding the level of value ultimately

realized (as this may depend on how much the acquirer invests in developing and promoting the product), the

payout milestones may not be under the founder’s direct control, and the founders may need to remain with

the company, allowing themselves to be directed by the acquiring organization. Stanford casebook


IPOAn IPO refers to the first sale of a company’s common shares to public (versus private) investors. The

main purpose of an IPO is to raise capital for the company while providing private investors with a

potential exit strategy. While IPOs are effective at raising capital, they also impose heavy regulatory

compliance and reporting requirements on the business. Due to these increased requirements,

specifically the Sarbanes-Oxley Act of 2002, the frequency of IPOs by start-ups has decreased

significantly. The rash of IPOs in the late 1990s also died down after the decade’s economic “bubble

burst,” with many of the medical device companies that went public during this period failing to

deliver on their high valuations. In late 2006, however, IPOs in the medical device industry appeared

again to be on the upswing. According to one article about the medical device industry, “Just three

companies went public in 2002 and none in 2003. Since 2004, however, 23 have gone public: 12 in

2004, seven in 2005, and four this year[2006].”

With acquisitions and IPOs, entrepreneurs need to be cautious not to sell too soon. Entrepreneurs often

act too quickly and, as a result, limit the potential future value of the company. However, there may be

good personal reasons for an entrepreneur to sell early, such as a desire to try other industries or

medical fields or to move back to an early-stage company if the current company has grown too large

for the entrepreneur’s interest. Also, there is always the pure financial motive of wanting to make at

least some return for one’s time and effort rather than continue with some degree of uncertainty and

risk. In reality, however, the right time to sell will be determined by the market. Stanford casebook


LicensingAnother strategy for companies seeking to realize a payback on their investments is to consider entering into a partnership, such as a

licensing agreement. IP, technology development rights, product distribution rights, and brand names can all be licensed as a mechanism for

generating revenue. For example, Angiotech Pharmaceuticals Inc. licensed its paclitaxel-based restenosis solution to Boston Scientific for

use in that company's blockbuster drug eluting stent. While Angiotech continues to develop its own technologies and products, it generates

sizable revenue from sales of the Boston Scientific stent which it can then use to underwrite R&D and fund other areas of its business.

Nektar Therapeutics is another company that has generated significant revenue from licensing its inhaled drug delivery technology while

concurrently developing its own products. While these kinds of deals can consume a sizable number of a company’s resources, they can

allow a business to constrain its fundraising needs (preventing additional dilution).

Licenses typically include:

1. A detailed description of what is being licensed

2. Field of use

3. Terms of license

4. Performance requirements

5. Degree of exclusivity

6. Financial structure (usually including an up-front payment of cash and/or equity, as well as royalties).

Traditionally, large companies have sought to license technology to supplement or replace in-house discovery and development. Such deals

can also help improve performance, accelerate time-to-market, and control costs. Small companies and entrepreneurs have been drawn to

licensing deals due to the increased level of certainty they provide in comparison to acquisitions IPOs. On the other hand, some

innovators have begrudgingly licensed their products to avoid the time and expense required to litigate their patents.

When considering licensing agreements, be sure to analyze the value of what is being given up. Think carefully about whether the agreement

has the potential to cap the future value of the company and be certain to consider how the licensing deal will affect the company’s

independence, business strategy, IP generation, and competitive position in developing new products or forming new business

relationships.

Licensing can also be used as an exit strategy of sorts for an entrepreneur or young company that decides not to develop its technology into

a standalone business. Stanford casebook

1 confidential - for classroom use only harvesting a venture

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