Private Equity and Venture Capital are types of financial assistance provided to the companies at various stages. Often, they are taken as one and the same thing. However, Private Equity involves larger investments in the matured companies. While , Venture Capital makes relatively small sized investments in the companies passing through initial stages of their development.
Private Equity fund refers to an unregistered investment vehicle via which investors combine their money for investment purposes. On the contrary, venture capital financing involves funding to those ventures which are started by new entrepreneurs and who need money to give shape to their ideas.
Guide to Private Equity for Start ups
The popularity of Private Equity investment has grown rapidly over the last few years. Private equity investment refers to an equity investment in a potentially successful company that is not traded publicly in the stock market. However recently, private equity firms are investing in a broad array of technology companies, early- to mid-stage profitable and unprofitable companies that a few years ago would have been unable to secure interest from these buyout firms.
Mentioned below are a few pointers about private equity for start ups.
Where from do private equity firms raise funds from?
Private equity firms raise funds from institutional investors, pension funds, endowments, and investment companies and high networth individuals. They help fund managers and high net worth individuals to diversify their portfolio and reduce risk.
Private equity investment stages
- Seed stage investment: Capital is provided for a business idea to support product development and market research.
- Early stage investment: In early stage, capital is provided for companies moving into operations and before any sales have started.
- Formative stage investment: In formative stage investment, capital is provided for starting of operations.
- Later stage investment: In later stage investment, capital is provided for further expansions prior to the company going public.
How private equity firms value companies?
The shares of a private company are not traded in public. Value of the shares of a private company is the outcome of a negotiation process between a private equity firm and the founders. To ascertain value, private equity firms use a number of valuation techniques. The selection of an appropriate valuation technique depends on the stage of investment. Here are some of the well known valuation techniques used by private equity firms for evaluating a start up.
Discounted Cash Flow Method
The value of the company is estimated by discounting expected future cash flows of the company at an appropriate cost of capital (discount rate). High risk will translate to a higher discount rate and a lower valuation for the company.
Relative Value Method
Earnings multiples of comparable publicly traded companies are used to determine the earnings of target company. Earnings multiples are calculated by averaging the earnings and value of similar companies, traded in stock markets. Few used multiples are Price/Earnings (P/E), Enterprise Value/EBITDA, Enterprise Value/Sales.
Replacement Cost Method
Replacement cost method estimates the value of a business by calculating the estimated cost to recreate the business as it stands as on the valuation date. Replacement cost method is usually used to calculate the value of companies operating in the seed or early stage.
Features adapted by private equity investment that help the private equity firm control the portfolio company
Corporate Board Seats: If a private equity firm or strategic investor invests in the company, it will introduce a person from the Private Equity firm on the Board of Directors of the company so that the private equity firm’s interests are protected in case of major corporate procedures like share sale, restructuring, IPO, bankruptcy, or liquidation.
Noncompeting Clause: Noncompeting clauses prevent the founders from restarting the same activity during a pre-defined period of time.
Reserved Strategic Decisions: Some strategic decisions such as change in business plan, acquisitions or divestitures are subject to approval by the private equity firm.
How private equity firms return the capital to investors?
Exit from the company is the most critical element to unlock value in private equity investment. Most private equity firms consider their exit options prior to investing. The following are some of the exit options for private equity investors:
Initial Public Offering (IPO): It provides higher valuation multiples, enhances liquidity and provides the business with more funding to fuel further growth.
Secondary Market: Secondary market sale is sale of the shares held by the private equity firm to a financial investor or to other financial investors or to strategic investors. Secondary market exits are the most common type of exit.
Management Buyout: Management buyout is purchase of the shares held by the private equity firm by the management group by raising debt or other type of funds.
Liquidation: This is the worst case option wherein the private equity firms liquidate their shareholding in the company at floor price if the company is no longer viable.
Strategic investors are meant to complement existing owners and partners. Strategic investors become involved in the management and operations of the company in addition to providing capital. Based on needs, strategic investors can get on board at any stage of the business. For example, one may want to bring in an investor who’s an expert in financial management and can guide with regard to financial decisions (in which the founder may be lacking skills).
How to find Private Equity and Strategic Investors? How to get access to private equity and strategic investors?
To find private equity investors, one has to hire an investment bank with specialties in exit opportunities. Strategic investors can be found within the industry or a neighbouring industry.
If the need is significant capital, then the founder of the start up needs to demonstrate high upside potential for the next two to three years with substantially less downside risk than a venture-stage investment.
An angel investor is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity.
It is important to be aware of the possibility of potential loss of ownership before engaging with private equity or a strategic investor. By conducting research and considering options, one should be able to make an informed decision about whether private equity or strategic investors will be a good choice or not.
Debalina Roy Chowdhury