Whether you own a start-up in need of essential funding to advance to the revenue-generation stage, or whether you head up a mature, long-established company with larger, predictable cash flows that requires a cash injection to facilitate a comprehensive strategic makeover, private equity often proves to be the ideal source of financing for a wide range of needs for your business.
In short, private equity is the investment of funds into private companies – that is, companies not publicly traded on a stock exchange. As a business owner, you may be tempted to pursue this route to access capital and grow your business. If so, it can be hugely rewarding – that said, it also requires perhaps the most amount of preparation on your side to obtain, of all major business funding options.
Private Equity – A Brief Overview
When you raise financing through private equity, the funds will usually come from a private equity firm, which will manage a private equity fund - an investment vehicle which pools money from various investors to acquire a stake in one or several private companies.
Other sources of private equity financing include angel investors who are wealthy individuals, and family office firms which manage the assets of wealthy families. In all cases, however, the investors who supply the capital will normally consist of financial institutions and other accredited investors.
In the case of private equity firms, the firm manages the private equity fund and acquires stakes in companies over a fixed investment horizon of typically a few years, with the main goal of achieving a profitable exit from its positions. For investors, moreover, private equity may offer a way to diversify their portfolios, as well as exploit highly profitable opportunities that may be absent / less frequent across publicly listed companies.
The private equity film will typically determine the buying price for a stake in your business using a variety of qualitative and quantitative methods. The most common method is discounted cash flow analysis which involves estimating your business’ cash flows based on how it is expected to perform in the future. The cash flows are then discounted to the value in the present day, invariably by using a risk-free discount rate such as the yield on the 10-year Treasury bond, or alternatively, the weighted average cost of all your capital.
Types of Private Equity
As an asset class, private equity can be divided into distinct sub-classes, each of which deploys different financial tools and strategies, and each of which invests in different stages of business growth.
Venture Capital – perhaps the best-known type of private equity investors, venture capitalists are focused on early-stage companies largely involved in developing new products, technologies and/or innovations within a specific sector, such as fintech or software.
If your business is a start-up or an early-stage company with little more than a scalable idea and a business plan – and therefore a relatively lower chance of survival than later-stage companies, but also a high potential for growth – venture capital is the most appropriate type of private equity funding.
The financing typically ranges from seed investing for the earliest stage of businesses that are mostly pre-revenue and thus carry the highest investment risk, to venture capital funds that invest in early-stage to mid-stage companies that are still risky but show more clearcut growth potential.
In general, venture capital funds will take a minority stake in your business and thus leave much of the control of the business in the hands of the existing management, although they may still provide you with guidance for your business, if so required. As your business grows, you may receive multiple rounds of funding to continue expansion.
Growth Equity – If your business has already achieved an established, stable position in the market, is already generating revenue, and is perhaps seeking to scale up operations and/or expand into new markets, growth equity funds become the most appropriate source of private equity financing.
Again, the funding is provided in return for a minority equity stake in your company. But with a more established market position, your company will represent a lower risk exposure to growth equity investors than it would as a start-up in the venture capital funding stage.
Buyout – representing the largest portion of funds within the global private equity space, buyout funds are involved with financing larger, more established companies in the market that are either publicly listed and now want to be taken private through acquisition by a private equity firm, or acquired by its incumbent management team.
Indeed, there are two broad types of buyout:
- Leveraged buyouts, whereby the fund uses substantial debt financing to acquire a majority or controlling stake in your company. As such, they depend on significant leverage in order to boost the potential rate of return.
- Management buyout, whereby the existing management team acquires a controlling share of the business’ assets. The private equity firm will invariably help to finance the purchase in exchange for a minority stake in the company.
The idea behind buyouts from investors’ point of view is often to identify undervalued assets that can be markedly improved and thus return higher profitability. This means your company may well be subjected to significant restructuring to bolster operations, and ultimately for investors to meet their targeted returns.
Once profit targets are met, the buyout fund will either selling its stake to allow investors to cash out their interests, or it will take the company public at a higher valuation.
Mezzanine – this category of private equity fund invests in companies across various stages of development (except start-ups). As the name suggests, mezzanine capital is halfway between debt financing and equity capital, with companies often accessing such financing for specific projects.
It can often pose significant risk to investors, but it may also offer higher returns if the companies achieve their growth aspirations.
Infrastructure – if you own an infrastructure-oriented business, this type of private equity enables you to raise capital from private equity investors to buy and operate assets that provide essential services, before selling them for profit. Assets include utilities (for example, electricity or water), transportation (road and rail), energy (pipelines and power plants), and social infrastructure (hospitals and schools).
And with infrastructure companies typically offering long-term financial stability, infrastructure private equity is generally deemed as low risk.
How to Raise Finance From Private Equity Investors
If you are leaning towards raising capital from private equity investors, you can follow these key steps which outline the fundraising process:
1. Prepare Diligently – it is worth stressing that the private equity capital-raising process requires meticulous preparation when compared with, say, applying for a bank loan. But if you are organized and understand the process, you will be well-positioned to achieve your financing goals. As such, it is worth:
- determining which stage of growth your business currently occupies, and determining which funding source is most appropriate for your business
- understanding the different types of private equity funds and investors, and researching which private equity firms are particularly active in your business sector
- consulting your professional network for tips and advice, if necessary
- preparing a pitch for potential investors and understand exactly what private equity investors are likely to be looking for
- being aware of what the likely terms of any deal will entail
- being willing to relinquish control of some or most of your company
2. The Pitch
Having identified those investors likely to offer financing to your type of business, it then becomes your responsibility to reach out and approach them. This is when you pitch to investors why your company represents such an attractive investment opportunity, and will typically involve sending a formal proposal detailing your company, your business plan, your target market, the investment opportunity and your proposed terms for the financing.
The pitch is possibly the most important part of the entire fundraising process, as it must clearly convey the most persuasive arguments as to why investors should commit their funds towards your business. A strong pitch should also be concise – private equity investors receive many pitches and are busy people, so stick to the main relevant points – and place the bulk of the focus on cold, hard numbers and projections.
Ideally, your pitch should demonstrate all or most of the following:
- A strong business case, your business goals, and a clear plan for how you will use investor funds
- A clear path towards profitability and realistic financial projections
- A strong, passionate management team that’s motivated, able and willing to deliver the business’ goals
- An ability to generate income and repay debt in a timely manner
- A strong future outlook for your business with all potential risks being addressed and minimized
- An attractive price to earnings ratio (more applicable if your company is publicly listed at present, and wants to be taken private)
3. The Financing Process
It goes without saying that you should know the workings of your business inside and out – potential private equity investors will have a multitude of queries related to current and expected future performance that will require detailed, comprehensive answers on your part.
Once the private equity investors are satisfied that they have received all the information about your company they need, and that you have addressed all of their queries, they will then decide whether or not to proceed with an investment in your company. If they wish to move forward, what will likely follow is a series of negotiations between yourself and the investor to agree deal terms with which both parties are satisfied.
If you can come to an agreement, the final terms of the deal will be confirmed via legal documentation called a “term sheet,” which you must sign for the deal to progress. The private equity investors will also conduct background due diligence at this stage to verify all the information you have provided and assess your ability to execute on your stated projections.
Once the final investment agreement has been signed by both parties, and the investors have become shareholders in your business in exchange for providing the agreed the funding, it then becomes important to continue managing the relationship with your private equity partners through frequent contact and regular updates related to your business performance, growth and profitability.
You should also be able to adeptly respond to any questions they may have, and assuage any concerns as they arise. Clear, honest and frequent communication with your private equity backers will go a long way towards demonstrating that they have made the right decision to invest in your business. It also does no harm towards building your credibility and reputation.
Furthermore, you should remain aware that private equity investors will at some point want to realise their returns upon exiting from your business and selling their shares. As such, you should prepare for this eventuality and ensure investors can exit their positions without any problems.
4. Investor Exits
When a private equity firm wants to realise a return on its investment, it will either partially or fully exit its position in your company.
The most common exit is executed when the private equity firm sells its stake to another company in the same sector as your business, or to another private equity firm looking to invest in a company/sector with certain similar traits to those exhibited by your company.
Alternatively, the private equity firm might choose to stage an initial public offering in which it sells a portion of its stake to the public. This method is often chosen when your company is performing well and a public listing is expected to see its stock price continue to rise. Once the company is officially listed, the private equity firm will gradually unwind its ownership stake.
The final option is to sell the stake back to your management team. This is often carried out if your business is underperforming and the private equity firm wants to transfer its investment to a more attractive prospect.
Pros of Private Equity Financing
No Repayment – once you receive funding from private equity investors, there is no requirement to repay those funds as is the case with, say, a business bank loan. Instead, investors hold a stake in your business which they typically sell once your business achieves a long-term targeted level of profit. This freedom from periodic repayments may spur you to opt for private equity over debt financing.
Expertise On Hand – private equity firms have considerable and broad industry expertise, both through their internal talent and extensive network of industry contacts. This can prove essential when providing guidance for your business’ expansion, helping you to quickly scale up and perhaps even establish your business in new markets.
Strong Likelihood of High Returns – private equity firms have “skin in the game” in that they will achieve strong returns should your business achieve its growth potential. With the goals of both parties broadly aligned, then, there is considerable scope for your business to achieve high profitability, and high returns as a result.
Help With Branding – private equity investors often commit to companies they believe have a strong brand identity, or could do so in the future. As such, a private equity firm can do much to help build your brand identity.
Cons of Private Equity Financing
Loss of Ownership – with investors acquiring a potentially sizeable chunk of your business that in some instances amounts to a majority/controlling interest, you must relinquish full control over how your business is run. If you are not comfortable with such an arrangement, then private equity might not be the ideal funding option for you.
Having to Compromise – a lack of complete ownership over your business means having to compromise to ensure both you and your private equity partners are satisfied. And that will invariably mean having to make concessions to reach mutually beneficial outcomes, such that both parties feel as if they are gaining from the deal.
Lack of Liquidity – unlike publicly traded stocks, private equity investments cannot be as easily liquidated, which can make exits by investors difficult to execute at accurate valuations.
