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The subject of exit is an important one for entrepreneurial ventures, particularly if they are funded by venture capital (O’Conor, 1985; Holmberg, 1991; Petty, Shulman and Bygrave, 1994). Yet relatively little empirical or theoretical work has been done on how entrepreneurs might maximize value at exit. In this paper we turn to the large body of literature and acquisitions to identify what constitutes strategic value for the buyer. Using this construct we define exit readiness as the extent to which the seller is able to create strategic value for the buyer in order to extract the maximum value for the selling shareholders. We then test empirically the hypothesis that value at exit is a function of exit readiness. I this paper, we describe a model of hw internal buyer factors, acquirer factors, acquisition process factors, and alignment and compatibility affect the premium or discount secured at exit on the fair market value. Firm-level strategy factors such as established product-market domain and proven business model are controlled for as they are measured by the fair market price. In this study we focus on factors that influence a sale premium or discount over and above fair market price. We measure these factors using an instrument that ask the entrepreneur to rate their firm at the time the deal was done for each of 32 dimensions by choosing one of five states of exit readiness, from “nothing done” to “fully achieved”. We measure the price premium/discount (the dependent value) as the price achieved expressed as an estimated percentage above or below fair market value. Preliminary data collected from recently exited entrepreneurs in the UK through a snowball methos suggests that serial entrepreneurs achieve higher premiums on average on fair market value and are more “exit ready”. This has implications for entrepreneurs preparing for trade sales.
The effect of exit readiness on exit values of entrepreneurial ventures: a theoretical framework and empirical test. Jonathan Levie, University of Strathclyde
A model of trade sale outcomes is presented, following a review of the literature and analysis of a pilot survey of 21 exited entrepreneurs in the UK. The model suggests that issues related to the venture itself that are under the control of management: governance, due diligence and alignment, may be moderated by issues related to the trade sale process, some of which can be managed. Analysis of the pilot survey data also suggests that repeated experience in trade sales may moderate the effect of seller-related exit management issues on the level of the price premium above fair market value. Further research is proposed.
In this paper we present a model of how exit readiness affects value at exit, and discuss the results of a pilot survey of 21 exited entrepreneurs. The subject of exit is an important one for entrepreneurial ventures, particularly if they are funded by venture capital (O’Conor, 1985; Holmberg, 1991; Hall & Hofer, 1993; Petty, Shulman & Bygrave, 1994). When entrepreneurs exit the ventures they have created, they receive a price for their shares that reflects the buyer’s perceptions of the value of the venture to the buyer. This price is effectively a reward for the value the entrepreneurs have created for the buyer. Exit also facilitates entrepreneurial recycling (Mason and Harrison, forthcoming) in which the accumulated expertise and capital created by an entrepreneur in growing a new venture is released for use in new ventures. The more capital that entrepreneurs accumulate through this process, the more they can do for their own and others’ subsequent new ventures, and the more their wealth creation acts as an incentive for others to engage in new business creation and growth. Yet relatively little empirical or theoretical work has been done on how entrepreneurs might maximise value at exit. (McKaskill, Weaver, & Dickson, 2004). On the other hand, many scholars from different disciplines are researching how buyers can extract value from acquisitions (Reuer, 2005). There is a consensus in this literature that many acquisitions tend to destroy value for shareholders of the acquiring company. The acquirers are seen, in hindsight, as paying an unwarranted premium over fair market value for the company. Given the risky nature of acquisitions on average, we argue that if an entrepreneur knew how to prepare the venture for a successful sale, acquirers would recognise the extra value and he or she could extract an even higher premium at exit. In this paper we turn to the large body of literature on mergers and acquisitions, written from the perspective of the buyer, to identify what constitutes strategic value for the buyer. Using this construct we define exit readiness as the extent to which the seller is able to create strategic value for the buyer in order to extract the maximum value for the selling shareholders. Exit readiness is a multi-faceted construct. Based on the literature and interviews with over 30 business angels, venture capital fund managers, mentors, successful entrepreneurs and incubator managers, one of us (McKaskill) developed a 32 item exit readiness index (published in McKaskill et al., 2004). Building on this work, in this paper we then propose a model of the relationship between exit readiness and the premium over fair market value achieved by an entrepreneur at exit. The results of a pilot survey of 21 exited entrepreneurs from the UK are then discussed. Finally, we set out how we intend to test the model in a full survey.
Our interest in this study is on factors that influence a sale premium or discount over and above “fair market” price. In the literature, this portion of the price is known as strategic value (see e.g., Test, Hawley & Cortright, 1987). In this section, we use the existing literature and the results of a pilot survey of 21 exited entrepreneurs (see Method section below) to derive a model of how internal buyer factors, acquirer factors, acquisition process factors, and alignment and compatibility affect the premium or discount secured at exit on the fair market value (see Figure 1). Firm-level strategy factors such as established product-market domain and proven business model are controlled for as they are measured by the fair market price and, to some extent, by the age of the venture. Click here to view Figure 1 McKaskill et al. (2004) originally proposed a simple positive relationship between exit readiness, as measured by a composite index of 32 items covering alignment, governance, due diligence, and strategy, and the price premium at exit. Figure 2 suggests that among the 21 respondents to our pilot survey, the relationship appears to be U-shaped, not linear. This result suggests that there are other, unobserved variables that affect the price premium. In the following subsections, we deconstruct exit readiness into component parts and reconstruct a model of trade sale outcomes. Click here to view Figure 2
Seller Internal Management factors Governance Several authors have argued that the price paid for a venture at exit is a function of certain factors under the control of management that are internal to the venture. Indeed, O’Conor (1985, p52) recommended that entrepreneurs begin to prepare their ventures for sale early in their careers, beginning with financial planning. By running the business in a highly professional manner, entrepreneurs will impress buyers, make it easier for them to value the business, and make it easier for them to integrate the business into their reporting systems (McKaskill, 2004, p89-92;). While this may seem just common sense, founder-managed firms often have a different form of governance from that employed by the professionally-managed firm (Gedajlovic, Lubatkin & Schulze, 2004). The following items of the exit readiness index published in McKaskill (2004) cover this issue of governance: B1: Monthly financial and key performance indicator reporting
exists A second governance issue covers professional partnerships. If a firm has retained professional services firms (accountants, lawyers) that understand its industry and understand the trade sale process, the process is likely to be more successful. In our pilot survey, although there is no significant difference between the mean scores of deals in which professional advisors were and were not the main source of knowledge of trade sales (124 versus 121), those relying on professional advisors as their main source of knowledge had no more than 1 prior exit experience. B12 Industry knowledgeable and respected Lawyers have been
appointed Using the data from the pilot survey, a principal components analysis suggested a 2 factor solution for items B1, B2, B3, B12 and B13, with B12 and B13 loading together, but item B2 loaded poorly with B1 and B2 and a reliability test gave a coefficient alpha of 0.496 for items B1 to B3. Items B1 and B3 however correlated perfectly with each other. Given the small N, these results are taken as suggestive only of what might ensue from a large survey, but useful for the construction of a final questionnaire.
Experienced acquirers typically have a shopping list of issues to be explored during their due diligence stage of the sale process that can increase or decrease the value of the firm above book value. These include compliance, litigation, customer and supplier contracts, intellectual property protection, terms of employment (Brockbank, 1999), and tax issues. Acquirers are often public companies that can access cheaper capital than private companies. Public companies have to conduct their affairs in compliance with stock exchange regulations. If the seller has dealt with these issues and documented them, the value to the acquirer increases. One exited entrepreneur commented: “[there is a] simple correlation between level of preparedness and exit price.” Another noted: “The ease of the acquisition [was] linked to the reporting, documentation policies and procedures at the target company – good documentation and control minimises risk to the acquirer”. These issues are covered by the following items taken from McKaskill (2004): B4: Full compliance with regulatory issues (e.g. Environmental,
Health and Safety) Given the large number of distinct items and the small number of cases in the pilot survey, it is hard to extract meaningful conclusions from attempts to reduce the complexity of the due diligence construct. It was found that item B7 (banking relationships) loaded well with the governance items B1 and B3 and these appear to form a tight latent variable with coefficient alpha of .806. Item B8 (contracts are industry standard) loaded tightly with B12 and B13 giving a coefficient alpha of .767, reflecting the impact of professional advice. Consideration could be given to moving these items to governance. B11 and B17 loaded on one factor, perhaps reflecting post sale planning, and B4 and B16 loaded together, reflecting the completeness of pre-sale preparations. The remaining items did not load together, and reflect individual aspects of the due diligence “shopping list”. As a group, they have a low coefficient alpha (.258), suggesting that the respondents differed in the degree to which they were exit ready on each of these items.
Stakeholder theory suggests that if all the primary stakeholders in a venture are aligned in relation to a goal, that goal is more likely to be successful (Freeman, 1984). This is captured in the following items from McKaskill (2004): A1: Company Directors agree to a trade sale exit Using the data from the pilot test, a principal components analysis suggested that item A5 loaded on to a different factor to A1, A2, A3, and A4. A reliability test suggested a coefficient alpha of .719 for all 5 items loaded together and .805 for items A1 to A4 loaded together. It appears that item A5 may be ambiguous to respondents. Consideration could be given to dropping or rewording A5.
Market creation O’Conor (1985) argued that once the business is in good shape, it is important to identify and target several potential aquirers, understand their motives for acquisition, and then enter into dialogue with them, rather than leave the process to chance. The purpose of this dialogue is to identify what constitutes strategic value to the buyer and then to position the firm so that its strategic value is both maximised and made transparent to multiple potential buyers. The sale process them becomes more of an auction with multiple willing buyers bidding the price beyond fair market value and into strategic value (Test et al., 1987). One exited entrepreneur commented to us: “[I was] planning for sale in advance, circa 2 years; keeping in close contact at board level with main trade players in our sector. Bids [were] solicited from all major trade players… 2 stage bidding process… doing due diligence with 2 parties to minimise risk of price slipping during due diligence.” In the opinion of the entrepreneurs surveyed in the pilot survey, multiple potential buyers bidding up the price was an important or very important factor in 38% of all the 29 deals in which they were involved that obtained a price premium of over 20% more than the fair market price. The following market creation items, taken from McKaskill (2004), were used in the pilot survey: C3: Industry mergers and acquisitions activity is monitored
In the pilot survey, respondents who had ever been involved in a deal that gained a 20% or more discount on fair market price were invited to record the reasons why. Four entrepreneurs answered this section, but only one did so in the way the researchers intended. Accordingly, the value of this data is limited. However it is noteworthy that this serial entrepreneur reported that for each of his 4 deals that attracted a 20% discount, he was under pressure to sell and that the buyers were existing management. This suggests that a market had not been created for the sale.
A serious potential problem for acquirers is asymmetric information, and the resulting risk of moral hazard (Williamson. One way of increasing trust in the transaction is to allow potential acquirers to “try before they buy” by for example cultivating formal trading relationships (Zaheer, McEvily & Perrone, 1998) or membership of an advisory board or a minority equity shareholding or a non-executive directorship or a joint venture (Reuer, 2005). Porrini (2004) found that technology transfer and manufacturing alliances were beneficial to subsequent acquisitions. The following items from McKaskill (2004) covered this issue: C9: Formal trading relationship exists with potential acquirers
If the entrepreneur can identify what might represent strategic value to a potential acquirer, and adapt the venture accordingly, then this increases the strategic value of the firm and the knowledge of the entrepreneur on what constitutes a good deal from the acquirer’s perspective. This strategic value can be created in a variety of ways ( Adams, 2004). In the pilot survey, respondents who had ever achieved more than 20% above the fair market price were asked to rate the importance of a set of seller/acquirer compatibility factors for each of those deals. The following is the percentage of the 29 deals in which a particular factor was rated either important (4) or very important (5) on a 5 point scale from unimportant to very important:
C2: Strategic value/benefits to potential acquirers are clearly
identifiable While data from only 21 respondents was available, which is insufficient to conduct a meaningful factor analysis, a principal components analysis on the 10 items related to trade sale process factors suggested a 3 factor solution with the items loading on the three factors in line with the three constructs of knowledge of acquirers, prior relationships and compatibility. Knowledge of acquirer (6 items) had a coefficient alpha of 0.767. Compatibility (two items) had a coefficient alpha of 0.93. Prior relationship (two items) however had a coefficient alpha of -.359. This is caused by a negative correlation between the two items proposed for this construct. Because these two items load together, but with opposite signs, this suggests that entrepreneurs have either prior trading relationships or directorship/ownership links with acquirers but not both. This was confirmed by viewing the raw data. Because of this, it would be better to amalgamate these two items C9 and C10 in the final survey, and perhaps create other items that capture the concept of prior relationships. In our pilot survey, only three entrepreneurs offered other reasons in addition to those listed from P1 to P12 for achieving a premium of 20% or more above their estimate of fair market value. These were: “part of buyer’s plans for corporate expansion”, “Buyer was US company and wanted to move into Europe. I was one of the few competitors in the UK with full distribution”, and “strategic growth and market dominance”. Arguably, these fit within P1 or P2 or P12. Accordingly, we believe that we have covered the major factors that, according to entrepreneurs themselves, contribute to a price premium at exit.
We expect serial entrepreneurs to gain valuable experience in preparing their ventures for sale. Indeed, the most experienced serial entrepreneurs in the pilot survey commented on how fundamental the factors we asked them to rate were. One of them wrote; “It [the survey items] consists of the basic things that I would have thought any experienced manager or someone who has been through it once or twice would do as second nature.” The results of the survey support this experienced entrepreneur’s comments. No deal conducted by an entrepreneur with 2 or more previous exit experiences had an exit readiness score below the mean exit readiness score (see figure 3), whereas 53% of the deals conducted by entrepreneurs with only 1 or no prior exit experiences had exit readiness scores below the mean. Click here to view Figure 3 Separate linear regressions on the pilot survey results suggested that exit experience may act as a moderator of the effect of both governance and alignment on price premiums achieved. This suggests that preparing for exit is a set of behaviours that can be learned. The pilot survey did not include the full list of control variables proposed in this paper, and with only 21 cases the value of regression analysis is limited given the danger of over-fitting the data and other methodological issues. If confirmed in a large sample, these results would suggest that serial entrepreneurs may achieve higher premiums on average on fair market value and are more “exit ready”.
O’Conor (1985, p56) asserted “timing is everything in selling a company” This is a common theme in practitioner journal articles on exit (e.g. Anonymous, 2005). One of the exited entrepreneurs in our pilot survey commented: “timing has been the most important factor in all my successful deals whether buying or selling companies. Nearly all the ‘good’ sales, i.e. 20% + above fair market price could not have been achieved at + or – 2 years from date of sale.” Another simply wrote: “timing is all!!!” In 52% of the 29 deals covered in the pilot survey that achieved a premium of 20% or more above the fair market price, the fact that the seller not under any pressure to sell was considered by the entrepreneur to be an important or very important factor in the achievement of the premium. By contrast, the only entrepreneur in the pilot survey to report on the factors causing a greater than 20% discount on the fair market price rated “seller under pressure to sell” as a very important factor in causing the discount in all 4 deals that resulted in a discount. O’Conor (ibid.) recommended selling “when business profits show a strong upward trend… when the management team is complete and experienced… when the business cycle is on the upswing, with potential buyers in the right mood and holding excess capital or credit for acquisitions… when you are convinced that your company’s future will be bright.” Other writers mirror these sentiments (see, e.g. Roberts, 2004). We propose these timing factors are important control variables that affect the price paid. Although they should in theory affect the fair market price at the time of the sale rather than a premium for strategic value, it is possible that entrepreneurs do not take this into account when estimating fair market value. Accordingly, we might ask the entrepreneurs the following to create a 4 item timing factor: T1: At the time of the exit, was the annual trend in profits
strongly downward, downward, flat, upward, or strongly upward?
To provide a more objective control for the cyclicality of M&A activity, the year of the exit should be included in the full survey.
One exited entrepreneur noted that “larger companies tend to pay a premium, however, the deal size needs to have a value of several millions”. The turnover of both buyer and acquirer should be included in the full survey as control variables.
One of our respondents noted that “the questions asked do not address all issues relevant to ‘service sector’ companies i.e. property companies, hire companies and distribution companies”. Industry sector should be included in the full survey as control variables.
The maturity of the venture may affect the price. A young venture may be seen as higher risk than a more mature firm, and therefore merit a lower price. This is standard practice in the venture capital community. Thus the age of the venture should be included in the full survey as a control variable. To sum up this section, our emergent model is shown in Figure 1. Exit readiness as originally conceived (McKaskill et al., 2004) appears to be a multi-faceted construct, composed of a complex of sub-constructs including internal management factors of the seller (alignment, governance, due diligence), and acquisition process management factors (market creation, prior relationship, buyer/acquirer compatibility). It may be that the seller-specific factors that are under the control of the seller’s management influence the price directly, while acquisition process factors influence the price indirectly by moderating the effect of seller-specific factors. A further moderator of seller-specific factors may be the exit experience of the entrepreneur. Serial entrepreneurs in the pilot survey tended to score highly on seller-specific factors, because they understood the value of these factors to the acquirer. Finally, there are control factors including timing, seller and acquirer size, and industry sector that affect the price independently of the seller-specific factors.
METHOD For the pilot survey, we used an instrument that asked the entrepreneur to rate their firm at the time the deal was done for a set of 32 items by choosing one of five states of exit readiness, from “nothing done” to “fully achieved”. We measured the price premium/discount (the dependent variable) as the price achieved expressed as an estimated percentage above or below fair market value in the view of the respondent. Thus we have a subjective assessment by the exited entrepreneur of both the independent variable (exit readiness) and the dependent variable (price difference from fair market price). This raises the possibility of method bias, where respondents who consider their firm to have been exit ready would feel that they achieved a premium price, whether or not either was true. A check on method bias would be to have a second opinion on the independent and dependent variables from a subsample of the sales. A professional advisor could provide this service. We encountered some resistance from the pilot survey respondents to providing names of individuals who could do this. However, we believe that we will ultimately be able to assemble a sufficient sub sample of second opinions to test for method bias. Preliminary data was collected from recently exited entrepreneurs in the UK through a snowball method. Originally, our intention was to use commercial lists of mergers and acquisitions. It quickly became apparent that these lists did not contain details of vendors where these were entrepreneurs rather than corporates. We then used personal contacts to locate cashed-out entrepreneurs. Many of these knew other cashed-out entrepreneurs, and so the list of respondents built up. We contacted 55 exited entrepreneurs throughout the UK, and received completed questionnaires from 21, a 38% response rate. All respondents were male. No respondents reported receiving less than fair market price for their venture, while 9 reported receiving the fair market price and 12 reported a price premium on fair market price of from 20% to 200%. 9 respondents had conducted at least two trade sales, and 6 of these had conducted at least 3 trade sales. 15 of the respondents were based in Scotland, and 6 were based in England. We propose to widen our search for exited entrepreneurs in the full survey beyond the UK to continental Europe. This will require an additional control variable, that of jurisdiction.
The results of the pilot survey suggest that there is no simple linear relationship between exit readiness as measured by an index composed of all 32 items identified by McKaskill et al. (2004) as likely to result in a price premium. However, the results of the pilot survey are sufficiently encouraging to support the development of a refined questionnaire that incorporates appropriate control variables and the collection of sufficient responses to conduct a factor analysis on the items that are designed to capture the concepts of alignment, governance, due diligence, knowledge of acquirers, acquirer trust, and compatibility. The refined model (figure 1) will guide the analysis to identify the complex relationship between exit readiness and price achieved at exit. The results of the full study could have implications for entrepreneurs considering exit for the first time, although they may be less relevant to serial entrepreneurs, who appear to benefit from experience. They could also prove a useful guide to professional advisors and to entrepreneurship educators.
ACKNOWLEDGEMENT We are grateful to Erkko Autio for his intellectual contribution to the modelling of the trade sale process outlined in this paper.
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