Excuse Me, Which Way Is the Exit?

The professional investor always has an eye on the exit while negotiating investment terms. The pros know that good investment opportunities come fully equipped with liquidity opportunities.

Entrepreneurs should learn from what professional investors do. Founders and executives should plan their own exit strategies when they commit their resources, even if they are contributing sweat or ideas rather than cash.

This article looks at the exit alternatives from the entrepreneur's viewpoint. Unless viable exits are examined and agreed upon early, achieving favorable exit terms for founders and executives can be difficult or impossible.

An exit strategy for executives in a widely-traded public company is easy. They just call their broker and authorize the sale of Starbucks, Costco, or Microsoft. Investments in these companies can be turned into cash at anytime within a few days. The privately-held startup, of course, presents different and more difficult challenges. Liquidity of an investment in a private company, if it is possible at all, requires advanced planning. Sometimes this planning must begin years in advance.

A shareholder agreement is the place for the entrepreneur to start in creating a viable exit strategy. The shareholder agreement should be negotiated and executed before stock is issued to the second shareholder. And with each successive round of financing, this agreement is likely to be renegotiated. If the entrepreneur does not pay careful attention to these negotiations, exit flexibility can be reduced, and good alternative exits blocked, if investors with different interests dictate the agreement terms.

To end up with an agreement that provides optimal exits for entrepreneurs and investors, all parties' objectives should be reasonably consistent. If the exit strategy of the investors is contrary to that of the entrepreneurs, or causes financial instability for the company (e.g., sacrifices long-term prospects for short-term objectives), conflicts will likely arise between investors and entrepreneurs, and both parties may become unhappy.

For example, the investor will want a commitment to sustained best efforts by the management team, rather than a quick exit. The entrepreneur who wants to grow the company for the long term to enable an IPO or favorable merger will not want to be surprised by being forced to resign within a few months, even though milestones are being met. Similarly, common shareholders such as entrepreneurs and managers will not want to be forced by investors to sell the company early, and before full value can be realized.

The shareholder agreement should be negotiated before the investment is made and before the parties' positions become set in stone. Early negotiations can achieve a win-win outcome with reasonable fairness to all parties. In addition to the basic buy-sell issues addressed in most businesses, such as triggering events, valuation method and payment schedule, outside investors and entrepreneurs will likely want to address:

• Board membership or visitation rights;

• Voting agreements as to certain kinds of transactions such as sales or mergers;

• Provisions for election of successors for board or key officers to preserve the negotiated balance on the board or in management; and

• Co-sale rights providing for participation on an equal basis upon sale of controlling interest in the company.

The agreement will also address restrictions on transferability, the opposite of liquidity. These restrictions prohibit certain exit strategies that the parties mutually agree may be harmful to the company or its shareholders.

Examples of useful restrictions include allowing transfers for estate planning, but prohibiting those to competitors, political groups with special interests incompatible with those of the company, and perhaps former spouses of key team members. Similarly, owners of the company will want to avoid having to comply with expensive securities law regulations before the company is financially able to do so.

The most common exits, sale of the business to a capable buyer, sale by one shareholder or group of shareholders to another or to an IPO, are likely to appeal to entrepreneurs as well as investors. The shareholder agreement focuses on permitting the preferred exits in restricting those that might be unacceptable to one or more of the parties.

Founders and entrepreneurs should consider execution of employment contracts at the same time the shareholder agreement is negotiated. Such contracts provide protections the investors will want, such as non-competition and non-disclosure, and can also provide assistance to the management team in getting what they expect, such as reasonable severance payments, and participation in the proceeds if the company is sold.

What is the bottom line for the entrepreneur? Plan for the exit when the investor comes aboard. Make sure both entrepreneurs' and investors' exit plans are compatible. Otherwise, understand that less-than-ideal exit opportunities will likely result.