What you should know about raising money from a Private Equity firm
When it comes to investing money in a company, there are generally three ways one can do it. The first is through the stock exchange where small units (or more) of a company can be bought at prevailing market prices. The second one is venture capital; it enables new companies that are not quoted to raise capital for stakes in the company. A third option is private equity.
Private Equity (PE) firms are much like venture capital firms. The only difference is that while venture capital firms invest in early-stage companies, private equity investors invest in all kinds of companies. They could either have a fund as a group or source capital as required to buy into companies.
Private equity over the years has enjoyed growth and high rates of return through the standard practice of buying businesses and selling them after steering them through a transition of rapid performance improvement. The core of private equity’s success is a strategy that combines business and investment portfolio management.
Here’s how it works:
Step 1: Attract equity investor’s interest
The first way to attract a PE firm to invest in your company is to attract their interest. At the foundation, your business should be viable; it must have a growth potential to be able to yield gains for investors.
While PE firms understand that the business terrain could be tough, making a majority of businesses susceptible to failing, they want a level of confidence that they are investing in something that works. This is how you get their attention.
Step 2: Valuation and Assessment of Return
When private equity investors have been attracted and become interested in investing in a firm, they usually assess the value of the private firm from two perspectives. The first is its current prospects, and the second, its expected prospects. A company needs to have a valid financial model that can be used to value its current and projected worth. This will enable the PE firm to know how to invest in it.
Unlike the standardized stock market, PE firms often negotiate before arriving at a purchase value of a stake in the company. They also tend to invest a lot at the current period with the aim of selling/buying out at a later date for a profit. As such, they also make profits based on the earnings of the company. To this end, they also tend to provide business advice and turnaround strategies for the company.
This is as simple as providing advice or as drastic as changing the entire management of the company. Usually, this will be based on the amount of shares they have in it (like if they have controlling interest stake).
There are a myriad of ways to value a company. Some of the popular ones include determining a price-earnings multiple, looking at publicly traded firms in the same business, to assess the value of the firm or using discounted cash flow models of valuation.
Step 3: Structuring the Deal
Two factors often form the basis of negotiation in structuring the deal to bring private equity into a firm. First, the private equity investor has to determine what proportion of the company or business value they will demand in return for the private equity investment and the owners of the firm.
On the other hand, it needs to determine how much of the firm they are willing to give up in return for the stated capital. In these assessments, the amount of new capital being brought into the firm should be measured against the estimated firm value.
The second factor is that the private equity investor usually imposes constraints on the management of the firm. In this case, the investment is being made in order to ensure that the private equity investors are protected. The aim is that they have a say in how the firm is run.
Step 4: Post-deal Management
Once the private equity investment has been made in a firm, the private equity investor will often take an active role in the management of the firm. Private equity investors and venture capitalists bring not only a wealth of management experience to the process but also contacts that can be used to raise more capital and get fresh business for the firm.
Step 5: Exit
Private equity investors and venture capitalists usually invest in private businesses. This is because they are interested in earning a high return on these investments. There are three basic ways in which a private equity investor can profit from an investment in a business.
The first and most lucrative alternative is an initial public offering made by the private firm. Although venture capitalists do not usually liquidate their investments at the time of the initial public offering, they can sell a portion of their holdings after trading.
The second alternative is to sell the private business to another firm. In this case, the acquiring firm might have strategic or financial reasons for the acquisition. A third alternative is to withdraw cash flows from the firm and liquidate the firm over time. This strategy would not be appropriate for a high growth firm. However, it may make sense if investments made by the firm no longer earn excess returns.
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