Private Equity Investment 101: All That Glitters Is Not Gold

Majority owners of successful private companies are typically focused on growing their businesses.  Maintaining a robust growth rate requires owners to reinvest in their companies, however, which in turn, often creates a need for a capital infusion.  When the need for capital to invest in the business exceeds the cash flow that the company is generating, an investment from a private equity (PE) firm may be the answer.  In return for its investment in the business, the PE firm will obtain a minority ownership stake in the company.

An investment by a PE firm can be transformative for a growth company, but this type of investment also comes with potential pitfalls that majority owners should consider carefully.  In this Blog Post, we review key concerns that majority owners will want to address in structuring the terms of a PE investment in their company.

Picking the Right Private Equity Partner – Shared Goals

The first, and perhaps most important, decision a majority owner needs to make when considering a PE investment is finding a firm that will be an effective partner.  PE firms are differentiated by many factors, including: their business and financial goals, the time horizon for achieving their desired return on investment (ROI), the amount the firm is willing to invest, the role the firm wants to take in the company after investing, and the experience the firm brings to the table regarding the industry in which the company is doing business.  Finding a firm that will be a good fit after the investment is made requires consideration of all of these factors, as well as of the personalities of the principals at the PE firm who will be involved in the business.

The following is a due diligence checklist of items for the majority owner to consider in vetting a potential PE firm.  This checklist serves as a useful guide for determining whether the goals of the PE firm and majority owner substantially align.

Track Record

Subject to a non-disclosure agreement, a PE firm will typically provide a list of the investments it has made in the preceding five years by company and amount.  The PE firm will also allow the majority owner to speak with the principals of the companies in which PE firm made these investments.It is essential for the majority owner to determine how positive (or not) the investment experience has been for other, similarly situated owners.

Knowledge Capital

The majority owner should be looking for the PE firm to provide far more than financial capital.  Of equal, if not greater, importance is the historical knowledge and experience the PE firm brings to the table regarding the industry, the marketplace, the competitors, and other key business factors.  In sum, the majority owner needs to evaluate whether the PE firm can provide the company with knowledge capital= insights, information, and guidance which will bring invaluable strategic value to the relationship.

Financial Goals

The typical PE firm has raised capital either from wealthy individuals or institutional investors.  In either case, itwill invest with the goal of providing its investors with a substantial ROI in a certain number of years.  It is therefore critical for the majority owner to calculate precisely where the investment is being made comes in the PE firm’s cycle.  If the investment is being made at time when the PE firm is expecting to cash out and pay off its investors in just a few years, that relatively short time horizon will impose significant pressure on the majority owner to achieve the desired financial results in a compressed time frame.

The investment cycle for a PE firm is quite different from a Family Office, which is not pressured to secure a return within a set number of years.  If the majority owner is looking for a long-term investment, the due diligence process should include an evaluation of whether there are Family Offices that have made private equity investments in other companies in the industry that might be open to providing this investment without similar time constraints.

The Art of the Deal – Key Terms in PE Investments

There is no cookie-cutter formula for PE deals, but there are key terms included in most investment agreements.  The following are some of the principal terms that the majority owner should focus on negotiating the structure of the PE investment.

The Valuation Proposition

The majority owner should ask two key questions when evaluating a PE investment: what amount of capital is needed, and what value does the PE firm place on the business.

By way of example, the majority owner may be seeking $10 million in growth capital for the business, and the PE firm may agree to provide this investment, but only if it receives a 40%stake in the business.  By asking for 40% of the ownership, the PE firm is valuing the company at $25 million: 40% of a $25 million value equals $10 million.  If the majority owner believes the company is worth substantially more than $25 million, accepting a $10 million investment for a 40% share of the business is probably not advisable.

If a deal is going to get done, there are at least three different ways that are commonly used to address a discrepancy in valuation between the majority owner and PE firm.  First, the parties can retain an independent business valuation expert and agree to be bound by the expert’s determination.  Second, the PE firm may agree to pay the majority owner a set fee upon a future liquidity event and then share the balance of the sale proceeds on a pro rata basis.  For example, the PE firm may agree to allow majority owner to receive the first $3 million upon a sale of the business with all remaining sales proceeds to be split between the majority owner and PE firm based on their ownership percentages.  Third, the PE firm may permit the majority owner to “take some dollars off the table” at the time of the investment and receive a bonus or one-time distribution with the balance used for the needs of the business.

The majority owner should not go forward with the deal unless the parties agree on the valuation proposition.  A bad deal rarely gets better, and the majority owner’s regret is likely to become more acute over time.  Rather than proceeding with a flawed PE investment, the majority owner should consider whether there are mezzanine loans or other forms of financing available, which avoid the need to bring a PE partner into the business on unfavorable terms.

The Scope of the PE Firm’s Control

A PE investment will inevitably come with some strings attached.PE firms do not give majority owners the unfettered right to continue running the business in their sole discretion.  These operational constraints often come in the form of Board seats and negative covenants in the deal documents.  For example, the PE firm may insist on securing veto power over the following decisions by the majority owner: (i) taking on additional debt, (ii) firing/hiring key employees, (iii) adopting employee incentive programs, (iv) increasing executive compensation or granting bonuses, and (v) issuing additional stock or membership interests to new parties.

The majority owner will want to be comfortable with the scope of control that granted to the PE firm, which will be documented in the investment agreement.  For example, during the due diligence process, the PE firm will evaluate the company’s executives and may conclude there is a need to replace one or more members of the management team.  This discussion will likely be collaborative, but the majority owner should ensure that the investment agreement provides that he/she has final decision-making authority with regard to key executives.

Redemption Rights – The Exit Strategy

As noted, the PE firm typically makes a private company investment with a defined time horizon.  This is often 7-8 years.  The PE firm will then look to exit the business through a liquidity event such as a sale, merger, or recapitalization.  If the majority owner concludes that a liquidity event is not in the company’s best interests on this schedule, the PE firm will include in the investment agreement the right to trigger a buyout of its ownership interest.

In negotiating the PE firm’s exit right, which can take many forms, the majority owner should address the following issues: (i) how the PE firm’s minority interest will be valued at the time of the PE firm’s exit, (ii) how long will the majority owner have to pay the purchase price to the PE firm,and (iii) what type of security will the majority owner be required to provide to the PE firm during the payout of the purchase price.

KEY POINT: The majority owner should also secure a redemption right to repurchase the PE firm’s minority ownership interest if the substantial conflicts develop between the parties after the investment is made.This investment should be a two-way street, and the majority owner should not be “stuck” with a minority investor who becomes a serious obstacle to the majority owner’s operation of the business.

The Measure of Success – The Win-Win Outcome

Successful PE deals achieve the goals set by both the majority owner and the PE firm.  For the majority owner, success requires a plan of action to locate the right private equity firm that will provide a good fit for the business, reach consensus on the valuation proposition, and structure an investment agreement that is fair to both sides.