1. Exits are ultimately how private equity firms realize returns on their investments. These are ways for a private equity firm to exit an investment?
Exits can occur due to
#1) an IPO (Initial Public Offering) on a stock exchange,
#2) Buy Back of Stock shares (this increases earnings per share and increases control). #3) Being Acquired, and #4) Shutdown (the “going concern problem” reaches its conclusion).
So many factors create a complex calculus of factors: the condition of public markets, the industry segment health, and the various metric conditions inside the private firm dictate the form of the exit. An IPO, merger or acquisition are the common gates of exit for most private equity firms. An IPO versus acquisition is perhaps the clearest split test to be examined by a management team and its board of directors.
2. What are some of the key considerations in determining whether to take a company public?
Evaluating the reception of the investor market is a key process. Understanding that acquisition is a more probable exit; a company needs to be realistic about the success of an IPO process. Due Diligence by an investment bank in addition to potential buyers will reveal a likely stock price range with estimated demand for shares. In 2008 for instance, only 12 private equity backed companies exited via an IPO process on Wall Street (this was a two-decade low). From 1995 to 2005 only 3.5 % of firms exited via an IPO.
VC investors will choose an exit that maximizes gain; while founders tend to prefer the private benefits of operating a public company. When venture investors had board control with the right to remove the founder, the probability of an acquisition increased by 30%. The probability of a write-off fell by 30%. This would suggest that VC involvement created operational improvement in the private firm. In most cases, the value of the business is the value of the operation; it is not in the inventory or other hard balance sheet assets.
3. What are some of the characteristics of a private company that may increase the likelihood of an IPO?
In cases where the founder had more control, the venture investor was less experienced than average, or the investor shares were in common versus convertible preferred stock; IPO exits were 12% more probable. If the company is a significant player in its market, has high-growth rates occurring, and needs to use nondebt funding for further investment.
If the quality and stability of the revenue streams can be established, then the likelihood of going public increases according to Bayar & Chemmanur in their working paper called “IPO’s or Acquisitions? A Theory of the Choice of Exit Strategy by Entrepreneurs and Venture Capitalists.” There is a qualitative difference between revenue from a local mom and pop customer and a Fortune 500 customer. These granular differences can appear as exhaustive due diligence is performed by a potential acquirer. Therefore, the true value of a company can be measured more accurately and if the revenue quality is above average; then revenue quality can increase the probability of the private firm going public.
Also, if the firm is in a highly-concentrated industry, this also increases the chances of a IPO exit versus an acquisition. This is because anti-trust issues legally might prevent a merger. A hot IPO market will most certainly enhance the probabilities of a IPO exit. If the firm is larger than industry average, then this increases the probability in favor of IPO.