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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

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

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.

Angel investors

An
angel investor is an affluent individual who provides capital for a business
start-up, usually in exchange for convertible debt or ownership equity.

 

Conclusion

 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

Dilzer Consultants

Sources

https://www.indiafilings.com/learn/guide-to-private-equity-for-startups/

https://keydifferences.com/difference-between-private-equity-and-venture-capital.html#KeyDifferences