Friday, April 13, 2012

Exit Strategy: Objective?... Or Lifeboat?

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Article: Exit Strategy: Objective?... or Lifeboat?

Until the mid 1980s, the term "Exit Strategy" was not normally associated with the business planning or capitalization (i.e., fund raising) processes. The term itself derives from the classic (but often unstated) "Greater Fool Theory," wherein if I invest in something, I only do it at the very outset if I am reasonably assured that there is some party waiting in the wings who will buy it at a price greater than my investment cost, thereby generating a capital gain for me.

The notion of an exit, or escape, emerges from the idea that an investor or financial participant will likely not derive any income, cash flow or gain unless and until a specific event occurs where that investor (as well as the brokers, advisers, investment bankers and other intermediaries assisting in the orchestration of the transaction) will be taken out of the investment, either in whole or part, and will recoup the sum invested plus a substantial gain. The point of exit is the focal and pivotal point of the entire transaction from its very inception -- oftentimes, especially among contemporary venture capitalists, the only time that any return will be seen.

Today, the prevalent mind set is on the quick "killing" and not on organic growth by increasing profitability and net cash flow. Investment conversations are dominated by talk of exit strategies, just as junkets to Las Vegas are filled with gamblers hoping to "strike it rich."

There was a time when investments (especially those which were made into direct participation programs where the investee company paid profits or gains out directly to investors, or where income was actually generated during the holding period of the asset) were evaluated based upon such primitive but classic metrics as "How long will it take me until I get paid back all of my cash and start to 'ride for free?'," or "What will my yield to maturity be on this bond?," or "What's my annual dividend yield on this preferred stock?"

The closest that anyone came to talking about an exit strategy, without using that term was, "When this company goes public, what multiple of my investment do you think I might get?" Other than this, the exit was not a target or objective -- the inherent stream of income generated by the asset (i.e., a business) was where the payoff was. Many companies stayed private or family-owned (dynastic) and made generations of people rich. The reason was because these assets and businesses were forecast to actually generate profits.

If an investment is being structured or entered into with an exit as the means of capital recovery, gains and fees generated, it is merely being groomed for disposal. And if that disposal mechanism (i.e., a purchase at an inflated price by a cash rich or high 'per share'-priced colossus of a company) were to fail, the investors would stand to lose money.

Private equity fund managers, venture capitalists and other professional institution-sized investors hypothesize that the exit will be there, and the the cash parachute will open as they jump out of the investment aircraft. If this fails, the amount of the investment may never be recovered, and a loss may result. It becomes a high stakes, high-risk game when the only way to profit from participating in the financing of a company or the purchase of an asset is that the market conditions will be right to favor you when you go to sell it.

Boldly stated, many VCs are not looking at companies, but are looking at disposal mechanisms to generate gains, liquidity and reinvestable funds. This is not actually security...especially given the vagaries of the capital markets and the rapid changes in technology. But then again, if you happen to win, you can win big. In the VC's portfolio, there may be four losers and one winner -- but that single winner is expected to be a windfall, more than offsetting the rest.

Given this information, investing with an eye to the one- to three-year exit is potentially quite risky; an all or nothing at all gambit; whereas,investing in a less glamorous business or asset, but one which yields cash-on-cash [a current return, inclusive of a recoupment of invested capital] seems more practical.

As a Global Futurist, I believe that given the emergence of crowdfunding, the resurgence of entrepreneurship and the increasingly speculative nature of the "Greater Fool Theory," direct investment participations will be on the rise, and the cash which they generate will help to fuel a re-emerging economy. Instead of merely hoping to catch a windfall, these inherently profitable businesses will offer greater security, reinvestable cash, and a restoration of the old-fashioned ethos of wealth-building as this was achieved by some of the world's greatest industrialists before the "Quick Buck" became the standard, and businesses and fortunes were built on a foundation of logic, intelligence and inherent profitability.

An exit is always a desirable safety device - let's agree about that - but why would I want to exit something that was generating real, physical income, and building my actual, realized wealth? I would genuinely rather be enjoying my income while my more "sophisticated colleagues" were waiting for a lifeboat or a turnaround in the Dow Jones Industrial Average or NYSE.

Have an exit strategy, by all means, but future funding sources (particularly crowds, groups, angels and the next generation of debt providers) are going to want to see cash flow, payback, and a sensible plan for generating profits before they are going to want to place their bets on a lifeboat. For smaller businesses and real Human investors, their victory is not a terminal event -- it is in distributable profit, gain or cash flow generated by a well-conceived, well-managed business. Did I hear someone say "Amen"?

From The InfoSphere Business Alerts And Intelligence Blog by Douglas E. Castle.


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