Part 1 of this series focused on how private company owners can make their businesses attractive to private equity (PE) investors like those on the hit TV show “Shark Tank.” The discussion picks up after the PE firm has made its investment and the Post considers what steps private company owners can take to get the most out of their business relationship with the PE investor.
As a starting point, it is critical for the business owner to appreciate that PE firms are not lenders, and that a PE investment is not similar to a loan. Lenders want to be sure that the company operates efficiently enough to repay the debt with interest. By contrast, by investing in the business, PE investors secure an ownership stake in the company, they are seeking to achieve a much more robust return on their investment than simple interest, and they will be much more hands-on regarding the company’s business plan, operations and financial performance.
The private company owner needs to view the PE investment as entering into a business partnership with an investor/owner rather than forming a traditional debtor/creditor relationship with a lender.
Finding the Right PE Investor (or PE Firm)
When looking for a traditional loan, the goal for the business owner is to obtain a low-interest rate and a favorable repayment schedule. When the business owner is evaluating PE firms for a potential capital investment in the company, however, the objective is not nearly as clear-cut. The following are helpful guidelines for the business owner to consider:
- The PE Firm should be one that shares the owner’s vision for the company. For example, if the owner’s goal is to increase the company’s manufacturing capacity while the PE investor favors growth in licensing of the product, this lack of alignment will not foster a good partnership.
- Understanding the time horizon for the PE investment is critical. Most PE firms operate under an investment time cycle for a liquidity event after the investment, which often tracks to a 5-7 year time frame. Therefore, accepting a PE investment from a firm that is already in year 3 or 4 of its investment cycle may be ill-advised if the company owner expects to require a longer time frame in which to achieve the desired liquidity event/cash-out for the PE investor.
- Finally, the ideal PE investor is one that has had successful industry-specific experience with other similar companies. The PE firm that brings a successful track record of investing in the industry to the table will contribute invaluable knowledge capital to the company, which provides benefits well beyond the amount of the dollars invested.
The Importance of Due Diligence
The only way for the business owner to determine the PE firm’s goals and its experience with previous investments is to conduct thorough due diligence. The key is to understand what experience the PE firm has had working in the specific industry. This requires the business owner to speak with the principals of other companies in which the PE firm invested to assess the PE firm’s track record in prior investments. The time the owner spends compiling and analyzing this information is crucial in determining the right PE partner. To help assess this information, it is often advisable for the business owner to secure input from from the company’s outside business counsel, CPA’s and financial advisors.
Any PE firm that resists disclosing its past investments, providing access to its former clients or providing details regarding its specific business goals in making the proposed investment is sending out warning flags. If PE firm is not forthcoming to the company before making an investment, it is unlikely it will show more transparency after the investment is made.
The Devil is in the Details, Which must be Addressed Up Front
Once the majority owner concludes which PE firm will make a good partner, the investment agreement needs to be prepared and all terms need to be hammered out. The following questions need to be considered and addressed before the investment is investment agreement is finalized:
- Who from the PE firm will be the point person interfacing with the Company?
- How many board (manager) seats will PE firm require and what will their impact be?
- What is the PE firm’s financial projection (pro forma) for the Company going forward?
- What does the PE firm believe needs to be “fixed” at the Company to achieve success?
- Does the majority owner retain right to buy out PE investor’s stake in the company?
These points will help confirm an investment agreement that reflects the desired alignment between the business owner’s goals and the PE investor’s financial objectives. The company and PE investor will be poised for mutual success when the company’s mission statement and corporate culture is consistent with the PE firm’s investment strategy and business plan.
Don’t Forget to Focus on Exit Strategy
As noted above, most PE investments last for time period in the range of 3 to 7 years. The anticipated investment time frame should therefore be a key point of discussion with the PE investor to confirm the PE investor’s anticipated exit plan. This exit planning conversation with the PE firm should also include how a business divorce from the investor would take place if things do not go as well as planned before the agreed exit period arrives.
A company’s business divorce from a PE investor involves many more business issues than the simple repayment or restructuring of a loan. At a minimum, the business divorce will need to address the following business points: (1) when the divorce will take place, (2) the value of the business and the amount to be paid to the PE firm for its ownership interest (3) the terms for repayment and (4) the collateral the majority owner will agree to put up to secure the PE firm during the repayment period.
When a business owner decides that his or her company needs a capital investment, it can be tempting for the owner to accept investment capital from the first PE firm that expresses an interest. This is often a mistake, however, because a growing, solid company will be attractive to multiple PE firms, and the owner should wait to secure an investment until it is clear the PE investor shares the owner’s vision for the business, is committed to developing a strong relationship with the company, and brings the right skill set and industry expertise to the business.
As a final note, the best business relationship is one in which the company owner and the PE firm representatives are able to speak candidly with each other. This kind of openness will help the owner and the PE firm confront the inevitable bumps in the road that arise and which were not part of the business plan.