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FAQs: private equity for start-ups

Private equity investment is a large part of our corporate business - we act for both investors and high-growth companies seeking investment. However, if you’re new to private equity investments, they can be very intimidating to begin with. Here we answer your most common questions on the basics of private equity.

What is private equity and how does it work?

Private equity is a term used to describe investments made in companies by private investors, such as high net-worth individuals, firms or other organisations like pension funds who usually join together in a partnership to form a private equity fund.

The objective of a private equity investor is to increase the value of the target company in which they invest, and hence increase the return on their investment. They usually invest in the form of an equity stake and/or loans, and their objective is a return over the medium term (five years or fewer), tied to the growth in profitability of the company as represented in the value of its shares. They generally realise their profits from the sale of those shares.

Typically, private equity firms hunt for businesses that have the potential to grow and become more successful. If you are looking to start a new business, expand your existing business, buy a new business or part of an existing business, carry out a management buy-out, or turn around a failing business, then private equity may be an option for you. There are over 250 private equity firms in the UK alone.

How does a private equity firm make money?

Unlike banks that make money from interest charged on loans, securing repayment by taking collateral to secure its debt, private equity is usually unsecured, and a private equity fund makes its money by helping to increase the underlying value of the company in which it has invested.

A private equity firm when it invests will realise the gain it has made when it ‘exits’ its investment, for example by:

  • Selling its stake back to the company’s management
  • Selling its shares to another company or investor
  • Floating the company

When a private equity firm decides whether or not to invest in a company, it will calculate the likely internal rate of return (IRR), consisting of potential capital gains on the shares, plus income on management fees and any dividends.

What are the advantages and disadvantages of private equity investment for your company?

One of the main advantages of private equity is that it can inject new life into an existing business. For example, if the original founders or investors have lost momentum or would like to cash in their investment, the management team may like to replace them by seeking an injection of cash to facilitate a buy-out. Alternatively, an existing business may need additional cash to grow or move in a different direction via acquisition or expansion. Or a start-up business may be seeking a longer-term partner in order to scale or grow.

Private equity investment often comes hand-in-hand with input from experienced managers who can help the business achieve its growth objectives, without seeking to control the company’s day-to-day operations. A private equity firm may also provide you with funding opportunities from other sources like banks by virtue of their contact books.

The disadvantage of private equity is that it is solely interested in capital growth in order to provide a return. It will take an entirely objective view of your company’s success, and will not necessarily be interested in your longer term future, or the role of individuals such as founders, managers or employees. In addition, the process to acquire private equity investment can be long and cumbersome, requiring extensive due diligence and the preparation of a formal business plan.

The private equity investment process

The private equity investment process generally consists of the following stages:

  1. The selection of potential private equity partners that suit your business objectives
  2. Appointment of advisors such as specialised accountants and private equity lawyers
  3. Preparation of a business plan
  4. Review of the business plan by the private equity firm
  5. Q&A by the private equity firm, negotiation of potential terms, and initial valuation of the business
  6. Due diligence process
  7. Final negotiation of a term sheet and drafting of documents for the private equity deal
  8. Negotiation and completion of documents
  9. Ongoing administration and monitoring by the private equity firm of the performance of its investment

What do private equity firms look for in an investment?

When private equity firms look to invest in a business, they will assess various factors that will have an impact on the IRR, such as:

  • How long the capital they invest will be tied up in the business
  • How they expect to exit the company, and how easy they think this will be (for example, what is the market for shares of this type)
  • What risks are inherent in the proposed investment
  • What competition there is for the proposed investment – are there other private equity firms may be interested in the potential deal?
  • How viable is the company’s underlying business, and what is the potential for growth? What is the company’s USP and is it competitive in its market?
  • How skilled, experienced and ambitious is the company’s management team, and if is it in a good position to take advantage of potential growth opportunities
  • How might any risks be offset

Finding the right private equity investor – where do you start?

In order to attract private equity investment, you first need to select some firms who may be interested in what your company has to offer. Private equity firms tend to specialise in certain types of company or deal structures, industry sectors, deal amounts or geographical locations for example so you should target those firms who most align with your own business and objectives.

Here are some categories of private equity investment sectors:

  • Seed investments – While relatively rare, private equity firms do make seed investments. Like venture capital firms, they may provide capital to bring an idea or product to market.
  • Start-ups – If your company is a start-up business, it may be worth considering private equity as a source of investment. You will need a solid business plan and/or evidence of successful trading in order to meet the requirements of a private equity investor.
  • Scaling your company – If your company is already successfully trading, but you would like to scale your business by expansion, new product or service development, or to develop your capacity, you may be able to attract development capital from a private equity firm.
  • Management buy-out or buy-in – You or your management team may wish to take over the business you manage by way of a management buy-out (MBO), or you would like to target an existing business for acquisition via a management buy-in (MBI). Certain private equity firms specialise in these forms of investment.
  • Rescue or refinance – Certain private equity firms target ailing businesses who have potential but are not currently successful, either by injecting new management strategies or providing working capital, or by re-financing existing bank debt that is holding the company back. In order to find a private equity investor that is right for your business, you can ask your accountant or lawyers for help and advice. In addition, the British Venture Capital and Private Equity Association (BVCA) compiles a directory of its members.

How is a private equity deal/transaction structured?

A private equity investment is typically a medium- to long-term investment in your company, comprising a capital injection in the form of the acquisition of ordinary shares and/or loans to the company.

The private equity investors will commit funds to the company until their desired objectives have been achieved and they exit the company. The deal will be structured so that the investors achieve their IRR, and the terms will be tailored to the individual business so as to maximise the company’s success. Private equity investors are normally unsecured, so they will stand behind secured creditors such as banks if the company becomes insolvent. They will seek some involvement and oversight of the company, so are partners with you in the running of the company, although they will not normally seek positions on the board or interfere in the company’s day-to-day operations.

How do loan notes work in a private equity transaction?

In certain circumstances, as well as taking an equity stake in your business, a private equity company may make loans as part of their investment. These loans will attract interest, and may be secured or unsecured, and be convertible into shares. They will normally rank behind banks in terms of the priority given to them in the event of insolvency and may be called debentures. They may be repayable only in the event of an exit by the private equity investor.

What legal agreements and documents are needed in a private equity deal?

Private equity investment deals follow a structured and formal process, and both your management team and the private equity fund will need separate legal representation. The contracts and documents that form part of the private equity process are as follows:

  1. Offer letter and term sheet. These describe the commercial terms on which the private equity fund is willing to invest, and is usually negotiated at the outset of the transaction, once due diligence has taken place
  2. Shareholders’ agreements
  3. Investors’ rights agreements
  4. Warranties and indemnities given by management and/or shareholders in the business to the private equity fund
  5. Loan or debenture agreements
  6. Directors’ service agreements
  7. Disclosure letters and confidentiality agreements/NDAs
  8. In the case of a new company, constitutional documents such as the memorandum and articles of association

What is a term sheet in private equity?

If you have successfully convinced a private equity fund to make an investment in your company by presenting a business plan and responding to enquiries, the next step in the process will be their issuing an offer letter and term sheet in which they propose the terms on which they are willing to invest.

While the term sheet isn’t legally binding, and may change as due diligence progresses, it does represent an initial proposal for funding terms, and will consist of a great deal of detail on the proposed capital injection. Once it has been finalised, the term sheet will be used to prepare the legal documents required to document the private equity funding.

Here are the likely areas to be covered in a typical term sheet:

  • The capital structure of the business before, and following the investment, the amount of the investment, the type of shares involved (ordinary or preferred for example)
  • The valuation of the business
  • Details of any preferences or other rights that may be attached to their shares, for example, rights to a dividend, rights on liquidation, conversion rights, anti-dilution provisions, rights of pre-emption, redemption rights
  • Management provisions, for example composition of the board of directors, management reporting, any consents or vetoes that may be needed for certain decisions of the board
  • Representations and warranties
  • Fees, confidentiality and conditions to investment

Is it better to get corporate loans than private equity?

The motivations of a private equity investor are different from those of banks or corporate lenders. Lenders are normally solely motivated by the rate of return on their loan in the form of interest, and often loans are secured on assets of the company, and even the assets of directors or company owners.

Banks and secured lenders rank higher than shareholders when it comes to insolvency or liquidation proceedings, and secured lenders will receive repayment of their loans before unsecured creditors so banks tend to be less interested in a company’s success than a private equity investor as, to a degree, their interests are protected if the company fails.

What are the main private equity exit strategies?

These are the principal exit routes for a private equity investor:

  • An IPO or flotation where the target company offers its shares for sale on a public exchange
  • A trade sale of the company’s shares to another company, possibly a competitor
  • A sale of the company’s shares back to the company or to the management team
  • A sale of the company’s shares to a different investment company or investor
  • Insolvency or liquidation of the company

Differences between private equity and venture capital

Some private equity investors focus on early-stage companies, and in that sense are similar to venture capital firms that specialise in newer companies that are focussed on growth.

Generally though, venture capital is used to describe investments made in seed or start-up businesses that wish to use outside funds to help them in their initial stages, whereas private equity firms generally focus on more mature companies for their investment.

Differences between private equity and hedge funds

Whereas private equity investors are interested in making strategic investments in individual companies in order to help them grow over the medium-term, hedge fund investors are interested in short-term returns in order to maximise profits. A hedge fund will use pooled funds and use various strategies and different types of investment in multiple companies and different types of products (bonds, commodities futures, currencies, shares and derivatives) to generate profits.

Differences between private equity and mutual funds

Mutual funds are organisations that are set up to buy and trade shares in traded companies in order to generate profits for their investors. They are managed by fund managers who pick shares that offer the potential for growth or dividends and who manage a portfolio of various traded shares. Investors in mutual funds are typically ordinary individuals or institutions who wish to use the expertise of the fund manager to make a return.

Unlike private equity funds, mutual funds are highly liquid, and investors can receive their investment back at any time. Investors play no role in the companies in which the mutual fund has invested.

Are private equity firms regulated?

Yes, private equity firms in the UK are regulated by the Financial Conduct Authority and are subject to rules relating to oversight and disclosure.

Are private equity firms considered to be institutional investors?

While private equity firms are not themselves considered to be institutional investors, many institutional investors such as pension funds, insurers, endowment funds and sovereign wealth funds invest in private equity funds because of their particular characteristics and opportunity for growth.

Are private equity firms considered to be investment companies?

Because private equity firms take more of a hands-on role in the companies in which they invest, they are considered to be more like an investment company than, say, a hedge fund that is only interested in short term, speculative gains.

Are private equity funds open ended or closed ended?

Private equity funds are closed-end funds.

Can private equity funds invest in public companies?

Yes, private equity funds can invest in public companies, as their principal objective is to achieve a good return by injecting new impetus into an existing business, whatever its nature. Private equity funds may purchase controlling interests in public companies in order to convert them back to private companies if this is deemed appropriate.

Can private equity firms go public?

Yes, either the management company of a private equity firm or the private equity fund itself can achieve a public listing.

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