Hi, everyone. This lecture is on entrepreneurial exits, and let me start with defining with what an entrepreneurial exit is. An entrepreneurial exit is some liquidity event for the stakeholders of an entrepreneurial company. And these stakeholders are, for example, the founders, the investors of the company. And an exit event is some form of buyout of those shares that are held formerly by those investors or those founders. And it's important because up until that event of an entrepreneurial exit or liquidity event, there's a great deal of illiquidity in the shares of the company. And so when I speak about liquidity or exits, I'm talking very much about thinks like buyout of shares, mergers and acquisitions, initial public offerings. And of course the alternative to all this is to remain in the status quo, that is private ownership of the original shares by the founders and by the investors of the company. And why is this an important lecture or topic worthy of our time? It's because shareholders ideally would assemble a portfolio in their assets, some that are liquid, some that are less liquid, with different profiles of returns and time horizons. And so this becomes an important event for shareholders because it offers some liquidity. And beyond just the cashing out of shares, the form of exit that the entrepreneur can choose could have also strategic effects, and I'll be speaking about those. And what I'm listing here in the graphic is the day in which Facebook is actually going public. That's a big day for Facebook because then the shareholders of Facebook are able to achieve some liquidity on their shares, they can sell it to anyone else in the world. Whereas before that event, there is not a well worked out marketplace for the shares of Facebook in a more public setting. Let me first talk about one important channel, probably the most important channel for many entrepreneurs. That is the concept of an acquisition or a buyout. This is obviously the phenomenon of what I'm showing here on the graphic, Oculus Rift being acquired by Facebook. And if you thought about the pros and cons from the entrepreneurial standpoint of why you would want to do this, or what would guide you to accept an acquisition offer rather than remain private or pursue some other liquidity channel. You often think about things like organizational synergy. So if you were Oculus Rift, maybe getting on the Facebook platform automatically gives you credibility, automatically gives you a large marketplace to sell your product. And will ultimately lead to faster traction in which you could grow the pie much larger than in the alternative, if you were to try to remain organic and grow your own growth. And so this logic of faster resource acquisition, a plug and play if you will, that will hook in to the existing assets of the acquiring company, is often one compelling reason from the entrepreneur's standpoint to really try to be acquired by a more established company. Now the other aspect or the other pro of a buyout is that sometimes this could offer shareholder liquidity much faster in a more clean way than any alternative. Here I'm talking about the phenomenon of basically a buyout of all cash, rather than in shares of the parent company, but what's important to note is that there's tremendous amount of heterogeneity in the way that these deals are often structured. And so it's important to be mindful of the spectrum of alternatives that is ranging from on the one hand all cash buyout, all the way to the other end of the spectrum, all shares of the parent company. And of course you can have any points in between. The big con to an acquisition type setting from the entrepreneur standpoint is clearly that you would lose control, or possibly lose control. You don't own 100% of the company, maybe you now own a small fraction of the company. As a result, you don't have the authority to really control the fine grain decisions that you may need, or to execute to your particular vision. The alternative to a buyout is initial public offering. And let me talk about the pros and cons from the entrepreneur's standpoint of this particular exit mode. So one clearer set of pros is that oftentimes this could be a name plate or credentialing type of activity. Not all companies are able to go public. And so if you thought about visibility or brand building, going public on a major exchange around the world clearly signals to the outside world that you have arrived, that you meet some minimum threshold, and consequently will automatically hopefully give you some credentialing or visibility. Another big aspect here that could make it attractive to pursue this particular route is that it could be a currency for acquisitions. So if Facebook goes public rather than being bought out, then all of a sudden it has shares and it could try to acquire companies like Instagram, Oculus Rift, what have you, with not just cash but also with Facebook stock. And another element of this, similar to what we talked about in the buyouts, is sometimes you can achieve shareholder liquidity. Now if you are a large shareholder like Mark Zuckerberg of Facebook, there's going to be some constraints as to how much you could sell Facebook stock on the open market and that's regulated. The reason being that if you're such a large shareholder, you're not allowed to unleash all of your shares. There's going to be lock up periods, etc., etc. But by and large, you're able to cash out some fraction of your ownership for much liquid cash earn outs with this form of liquidity since your just trading on the public markets. Now if you think about some of the cons associated with initial public offering, a couple come to mind. So first, the public markets are in constant flux and it's really difficult or notoriously difficult to time the market. You don't know exactly when would be the most fertile period to enter or to sell shares of your company in the open marketplace. And compounding that, there's no objective thresholds in which there are some tests which suggest now you are ready to be a public company. It's a situation in which the investment bankers and financial community try to gauge demand for a stock over time and they're trying to, as in all financial transactions here, discover the price, given this and equilibrate supply and demand. The other aspect of this, of the cons, is that there's this notion of costs. And those costs can be both direct and indirect. The direct costs are that you have to pay typically 7% of your offering to the investment bankers. There's also lawyer fees involved, marketing costs and the like. Those would be the direct costs. The indirect cost is that as the founder or CEO of your company, you're probably spending less time on product development and more time, as you try to ramp up to selling shares to the public, on promoting your shares. And so those things in terms of managerial attention can impose an indirect cost in terms of using this channel of achieving liquidity through initial public offerings. Now here are two very interesting quotes that I think are quite illustrative of the type of dynamics that can go on with the initial public offering. The first quote here is by the founder of Netflix. And what he's pointing out in this quote is that when you go public, you also have a responsibility to disclose a lot of information, both on a quarterly basis and on an annual basis. That's required, at least in the United States, by the regulators. Here in the United States it's the Securities and Exchange Commission. And that information that's disclosed can have implications for your competitive position. In this case, the competitors of Netflix could really see how well Netflix is doing, and that in itself could incur competition. The second quote of what I'm showing here, with regard to public offerings, is that there could be a tremendous amount of pressure internal to the company, in this case Google, as they are thinking about going public. Because the shareholders, in this case the employees and key executives who hold the shares of Google, are quite anxious to get some liquidity on their shares in the open market. Because they know that if the stock does well in the marketplace, then they are able to convert their previously illiquid assets and shares of Google into something that's quite liquid that could then lead to all kinds of beach vacations and the like. Let me tell you a little bit about the US public offering process. And some aspects of this process also generalize to the rest of the world. And at the very high level, these underwriters, these investment banks, try to market the offering, the entrepreneurial company stock, to various investor communities. These underwriters are usually organized in a syndicate with a lead. So a syndicate is a group of investment bankers. There's usually a lead that's designated that will be staffed with really trying to take charge and to lead the marketing of the offering. And there's a multi-faceted set of duties that the lead underwriter takes on. And this an exchange for the 7%, in the United States, direct cost of doing an initial public offering. So there's a certain amount of due diligence associated with the process. Duties associated with marketing the offering, trying to understand possible demand at different price points. Essentially, trying to discover what the demand curve for the shares an offering might be at various different prices. There's also responsibility for compliance at the regulatory level, and disclosing all the different risks and opportunities associated with a stock. Ultimately, the lead underwriter is charged with determining the offering size, allocating shares to the different investors, and ultimately pricing the offering. One very important aspect for entrepreneurs is a phenomenon that's known as underpricing. And what is underpricing? It's typically the difference between the price of a stock at the beginning of trading and the close of that stock at the end of the trading day. To the extent that there's a big difference, typically a run up in the price of the stock, that value that's created to the holders, the secondary holders of the stock, those gains are not realized by the entrepreneurial company. And so rather than those gains accruing to the entrepreneurial company, those gains accrue to the day traders or the holders of the stock. That's a phenomenon known as underpricing. And underpricing, there's various theories as to why underpricing takes place, but you'll note that underpricing is actually detrimental to the entrepreneurial company because rather than capturing that values to the entrepreneurial company, those gains go to the outside community. There's disagreement among financial economists as to why underpricing takes place. One leading theory is that underpricing takes place to reward the risk that these early investors take on as to the price of the stock after it starts trading. The other duties of the underwriter are to monitor the price and to offer price supports along the way. Let me tell you about a little bit of research that I've actually conducted on this topic of entrepreneurial exits and the relationship with innovation. The research question is, does it actually matter from the entrepreneur's standpoint which exact liquidity mode or exit mode you choose if you are looking to be innovative in the future? Now what's often difficult here is establishing a counterfactual. That is, if you conducted an IPO, or initial public offering, you cannot almost by definition do the thought experiment of what your innovative profile would have looked like had you been acquired by another company. And so, what we tried to do in this study is to really try to build a control group that tries to compare what if Oculus Rift had decided to conduct its own initial public offering rather than being acquired by Facebook? What would be the innovative profile of these two alternate paths? And to get some insight into that exact question, what we did was we built a longitudinal data set in the biotechnology industry of around 400 companies. Some of these companies completed an IPO or a merger and acquisition. Others nearly completed one of these events, and they did not complete these events for reasons unrelated to issues to do with their innovative potential, but for market changing conditions, regulatory reasons and the like. And so, we end up comparing the profile of companies that nearly completed an IPO with companies that actually completed an IPO. And just to summarize the key findings of the study. We find, and again here, we're measuring innovation through patenting, and that's an important clear marker in the context of the biotechnology industry. We find that private ownership yields the best outcomes in terms of innovation, with public ownership the worst, and M&A is in between. And we have some theories as to why we see these patterns. One leading theory is that private ownership, you're operating In the veil of secrecy. You're not disclosing to the public what you're doing. As a consequence, you're not incurring competitive reaction, much like what we talked about in the Netflix example. You're also, in addition to not being focused on the near term, what results are you going to be presenting to the shareholders next quarter or next year? You're shielded from those pressures, and as a consequence one thing we know about innovation is that you need to be able to have the freedom to experiment, and that is perhaps widely done or most effectively done under private ownership. Public ownership has precisely the opposite characteristics there, and perhaps M&A with some middling type of profile. And so this is suggestive evidence that not only should we think about liquidity and exits in the form of the shareholders and what's happening inside of your organization. But in terms of the strategic value of the exit mode and what path you're placed on as a consequence of the exact liquidity mode that you tried to achieve, may also have some implications for your going forward profile as suggested in this more specific study that I've outlined here. So to conclude this lecture on entrepreneurial exits, two main takeaways. The first takeaway is that thinking about liquidity is very important because the shareholders of the company, whether they be your investors, your executives, your employees who own shares in your company, are illiquid up until that point. And so, thinking about the exact form of your liquidity mode, exit mode, is going to be important from that perspective. Secondly, the other aspects here is that the exact form of liquidity mode, whether that be initial public offering versus a buyout, versus an acquisition, will have implications. Not only at the level of strategy and the incentives that are achieved or imported in your organization, but it can have dramatic implications as well on the type of behavior that likely ensues, including the innovative profile of the company going forward.
