Entrepreneurship, Second Edition

10.5. Harvesting Investments

When business angels or venture capitalists put money into a business, there has to be a way they can realize their investments at a future date. This is called the exit or harvest for the investor. There are three ways to exit an investment: an initial public offering, an acquisition, and a buyback of the investor's stock by the company itself. We've mentioned that most investors prefer an IPO because it produces the highest valuation in most cases—but not in every case. An acquisition is the second choice. And a buyback is a distant third because in almost every instance it produces a mediocre return.

One of the questions neophyte entrepreneurs seeking external equity financing most often ask is, "Can I buy back the investors' equity?" The answer is, "In principle yes, but in practice it is extremely unlikely." Buybacks are rare because a successful and rapidly growing company needs all the cash it can get just to keep on its growth trajectory. It has no free cash to buy out its external investors. A firm doing a buyback is more likely to be one of the living dead for which an IPO or acquisition is not feasible, but somehow the company arranges a refinancing in which it buys back the stock owned by the original investors. Sometimes a venture capital agreement includes a redemption (buyback) clause that allows the venture capital firm to exit its investment by selling it back to the company at a premium if an IPO or acquisition does not occur within ...