Private equity groups often invest in businesses with the goal of helping them grow and exiting with a profit. If your business needs a cash infusion and operational expertise — and management wants to retain some ownership — private equity may be the answer.
Venture capital, or private equity, remains a viable alternative, or addition, to traditional forms of finance that may open the gates for opportunities to find cash infusions for your business while you remain at the helm.
At some point in their business cycles, mid-sized companies often find they lack the financial resources or management skills to cut overhead and spark growth. Equity funding can be derived from a number of areas such as superannuation funds, overseas investors, other companies, high net worth investors or venture capital firms.
While private equity groups may have a reputation for investing in companies to break them up and sell them off, many take an entirely different tack. They work with existing management to enhance shareholder value by finding profit solutions, including plant and equipment upgrades, new product development, and process improvements that shorten lead times.
Typically, private equity is suitable for less mature companies with developing or under developed concepts or revenue. However equity finance can also be used for more established companies looking to finance expansion or turnaround strategies
If your company receives an offer from a private equity investment firm, here are some considerations:
Risks. What are the financing conditions? Can the deal be financed at the leverage level proposed? How will that leverage affect the business and its ability to achieve goals? Will the business be over-leveraged?
Financing Structure. Some private equity groups may want to include earn-outs, convertible preferred investments, clawbacks and guaranteed return instruments.
Management Details. What terms are being proposed for keeping current management?
Chemistry. Given a choice, businesses should examine the chemistry with potential investors. Also important is a knowledge of the company’s industry and investors that can add value rather than simply offer financial re-engineering.
Normally equity investments lack security and as a consequence venture capitalists will be looking for high returns on their investment which means they will be aiming to identify companies with high growth potential and strong track records to add to their portfolios of companies. Some private equity investors specialise in certain industries.
The terms of the deal depend on fundamentals such as the company’s financial position, management team, business plan, growth strategy, customer base, and objectives for the capital infusion.
Private equity investors often partner with accounting firms and other professional service providers to help identify target businesses, close transactions and provide operational assistance to companies in their portfolios. Services include:
- Due diligence;
- Business valuation;
- Tax planning and preparation of returns;
- Internal controls to prevent and detect fraud;
- Financial statement audits;
- Consulting to strengthen financial processes and identify profit opportunities;
- Information technology solutions; and
- Compliance with federal and provincial regulations.
In addition to providing expertise, some private equity investors operate a purchasing group, which allows their portfolio companies to buy certain goods and services at lower prices than they can obtain themselves.
Retaining Some Control
If the existing business owners hope to retain management after the transaction closes, they must consider the private equity group’s horizon for involvement. Generally, a private equity firm stays engaged for three to seven years, after which it expects a solid return on its investment.
The investor’s exit plan and ideas should match the vision of existing management. A private equity deal can eventually result in a third party acquisition, a management buyout, an initial public offering, or other exit strategy.
The level of a private equity firm’s financial and operational contributions — and a factor business owners must closely evaluate — often depends on the approach investors plan to take: hands-on or hands-off.
With a hands-on, active approach, the goal is to become a business partner. Although day-to-day operational control isn’t usually part of the deal, private equity firms expect to have a seat on their portfolio companies’ boards. They may also want businesses to:
- Provide forward-looking managerial information, such as budgets, cash flow and sales goals, as well as copies of the minutes of board meetings.
- Be advised by outside professionals hired to help identify critical problems and opportunities — and take action to solve or take advantage of them.
- Allow consultation, involvement in, and veto power over major business decisions such as large capital purchases, changes in strategic direction, business acquisitions and disposals, debt levels and leadership.
In a hands-off, passive, approach, the investing firm basically allows management to run the business until the exit time. However, the firm still expects regular financial reports. And if a business fails to meet agreed targets, defaults on payments, or runs into other difficulties, the private equity investors typically become more involved.
Consult with your adviser. If your business needs financing, private equity investment may help ensure your enterprise thrives where bank debt may be too restrictive on cash flow or even impossible to obtain. Private equity may also offer employees and management a chance to share in the company’s success through incentive-based programs that allow them to buy or earn equity.