The Pros And Cons Of Private Equity: A Strategic Growth Engine Or A Costly Gamble?

What are the pros and cons of private equity? You’ll carefully weigh your options when compiling a list of potential capital sources for your early-stage startup. Before approaching any investor class, you’ll want to explore whether they’re a good fit for your new company.

A good step in the right direction is to understand the benefits they bring to the table. Think expertise, mentoring, network access, and know-how. You’ll also work out the terms and conditions for securing capital. For instance, board seats, stock that can lead to dilution, interest, preferred shares, or more.

Choosing the right investor also depends on other factors such as the specific sectors in which they prefer to work. Or, the particular growth stages they back, or even their exit strategies. Let’s explore in detail what private equity capital is. Can it be a strategic growth engine or a costly gamble?

Private Equity – A Quick Overview

A private equity firm is a class of investors that provides capital to private companies or companies not listed on the stock exchange. These PE firms typically have a General Partner (GP) who runs the institution and is responsible for managing investments.

Private equity firms have different types of investors pooling capital, such as angels, high-net-worth individuals, and family offices. Hedge funds, venture capitalists, pension funds, insurance companies, and endowments may also use PE as an investment channel.

These entities are Limited Partners (LP) in the firm and entrust the GP with screening companies for high growth potential. Participating members may have specific criteria for making investments and select their preferred PE firms accordingly.

GPs put together a portfolio or basket of startups at various growth stages and offer them capital. Their objective is to earn maximum returns and make strategic exits.

Limited partners are essentially passive investors and don’t get involved with the management aspect of the business. Their liability is limited to the capital they invest in the firm. Instead of purchasing stocks in the open market, they prefer to divert their capital to private equity firms.

The firms may invest in distressed companies, early-stage startups poised for accelerated growth, or companies entering an M&A deal. They offer the funding the acquiring entity may need to complete the purchase. PE firms also support companies needing financing for a liquidity event like an IPO.

The Pros and Cons of Private Equity – Let’s Start with Strategic Growth Engine Benefit

Partnering with the right private equity firm can have multiple advantages for an upcoming startup.

Accessing Capital

• PE firms offer capital with a longer investment horizon typically ranging from three to five years. However, in recent times, this trend has changed, with firms retaining their holdings for around 5.6 years. Several factors such as market conditions, exit strategies, and value creation approaches, may influence their decision.
• Private equity firms specifically invest in privately-owned startups that are not publicly-traded. As an early-stage startup, this investor class is the ideal target for your fundraising strategy.
• Since these firms like to diversify their risk, they’re open to investing in a broad selection of sectors. In recent years, industries like healthcare, technology, renewable energy, and crypto have attracted PE interest. These investors are also interested in backing disruptive concepts and industries with the high potential for growth and returns.
• Since private equity firms partner with several high-net-worth entities, they have substantial capital available for investing. Business loan providers or other sources of private capital may not have the same volumes of assets.
• Private equity firms are open to offering working capital to small businesses needing a quick cash infusion. You can use the money to hire new talent, product development, marketing and advertising campaigns, and scaling operations. This assistance can bridge the gap between success and failure.
• Since private equity firms support only private companies, they have valuation criteria that are not influenced by public markets. This factor can work to your advantage when securing capital since you won’t have to rely on high-interest bank loans and other capital.
• Private equity firms are interested in supporting startups at different growth stages. This is why, you can count on them to be strategic partners as your company continues to grow. You can expect them to participate in further funding rounds if you demonstrate growth and rich returns.

Strategic Advantages

• Private equity firms are committed to increasing the value of their portfolio companies during their holding periods. To make that happen, they offer assistance in acquiring IP and assets, strategic decision-making, and entering into value-centric partnerships.
• Startups can rely on their PE partners for industry-specific expertise, networking opportunities, and other resources. These assets can help build growth-oriented strategies and improve operational efficiency by adopting cost-cutting measures. Better management ultimately translates into higher profitability.
• Partnering with the right private equity firm can open channels for connecting with experts and other companies within your vertical. Opportunities like these help accelerate growth for your company.
• Most PE firms adopt a flexible investment approach, which means they may offer customized solutions, terms, and conditions. You can negotiate for a favorable term sheet suitable for your funding needs according to the milestones you’ll achieve.
• Having a reputable private equity firm on board as an investor lends credibility to your brand. The partnership can be a significant asset when you’re recruiting fresh talent and skill sets or securing additional funding.
• Private equity firms are more concerned with providing mentoring and expertise to help small startups accelerate growth. This assistance can be significantly beneficial for companies still finding their feet. You’ll refine your strategies to accelerate growth and navigate hurdles.
• Building a robust relationship with your private equity firm assures you of assistance through long-term growth and expansion. These investors are typically unconcerned with short-term performance and more focused on sustaining growth over an extended period.
• Private equity financing can help you adapt quickly to evolving market conditions. You can approach them for capital to pivot by developing a new product range that aligns with changing customer preferences. Leverage their support to stay relevant in the market.

Higher Valuation

As explained earlier, private equity funds can access substantial amounts of capital. Not only do they manage capital contributions from limited partners but they also leverage debt financing if needed. As a result, they are open to backing startups that demonstrate high potential for growth.

If your startup has a dedicated customer base, low customer acquisition costs, and an extended runway, they will offer capital. PE firms focus more on the company’s viability and long-term prospects instead of just valuation.

This is why they are open to paying premium for robust investment opportunities. This factor results in higher valuation for your company. If you’re considering exit strategies, you can expect to receive a higher price when selling to a PE firm than to a competitor or another buyer business.

The PE firm could even offer you terms where you can retain a small ownership stake in the company. As a result, you can participate in its future earnings or even stay on as a part of the management.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that founders worldwide are using to raise millions below.

Can Private Equity Funding Prove to be a Costly Gamble?

When exploring the pros and cons of private equity, you’ll scrutinize why it can be a costly gamble. Understanding the potential downsides can help you come up with workarounds to minimize the risks. Here’s what you need to know.

For starters, understand that creating a pitch for private equity investors and getting approval is a complex process. You can expect to go through multiple evaluation stages before the firm accepts your request. Expect the process to take three to six months or even longer.

This duration depends on the size and complexity of the deal, particularly because of the valuation methods. Valuing publicly-traded companies is more streamlined because of their market pricing. Not so with private companies, which makes fundraising challenging and time-consuming.

Short-Term Holding Patterns

Private equity firms intend to hold their investment for around 5.6 years. This is why they hope to earn maximum returns within this short time. Sectors like healthcare, technology, and renewable energy typically involve extensive research before developing marketable products.

They are capital intensive, and it could take years before investors see any actual returns. If this is you, choose your investors with care. Make sure they understand the industry where you work and are prepared for longer holding times.

Don’t compromise on growth and long-term stability to demonstrate short-term financial performance and deliver returns quickly.

Decision-Making and Controlling Rights

• Although most private equity firms offer strategic advice and growth assistance, they may also require a controlling interest. When negotiating terms, be clear about the decision-making and voting rights included in the conditions.
• Some PE firms prefer a more hands-on approach when it comes to the company management. They may want to influence the direction in which the company grows. Agreeing to these terms can cause conflicts if their ideas don’t align with your vision and mission statement. Read the term sheet and understand the conditions carefully before agreeing to them.
• Scrutinize the term sheet for restrictive covenants and other provisions that may interfere with future funding rounds. Also, be wary of the dilution aspect when issuing stock to investors.
• PE firms are known to purchase the controlling stake in a company to conduct extensive restructuring and operational changes. If this isn’t something you planned for, make sure your investors are on the same page before accepting their capital. Be wary of strategies that can cause more harm than good to the company.

Private equity funds are just one of the different investor classes you can approach for capital. If you’re looking for more information about the types of investors out there, check out this video I have made.

Investor Exit Strategies

As explained earlier, private equity firms typically have short holding times. To understand how that works, you’ll dive into their organizational structure. Limited partners in PE firms normally lock in their capital for 10 years.

This is why firms focus on investing and generating returns in the initial five years. The latter five years are spent phasing out the holding via strategic exits. When weighing the pros and cons of private equity, factor in their exit methods and their impact on your company.

These exit strategies depend on the PE firm’s objectives, overall market conditions, and your startup’s performance. For instance:

• Secondary sale is when the private equity firm sells its stake to another PE firm.
• Partial exit is when the PE firm sells a portion of its stake to other investors. However, it retains a portion of its ownership stake.
• Trade sale is where the PE firm sells the company to a strategic acquirer or another company.
• Management buyout is where the company’s management purchases the PE firm’s stake.
• IPO is where the company’s shares are listed on the public stock exchange. Public investors purchase the shares, allowing the PE firm to liquidate its stake gradually.

Why is this concerning? New investors with an ownership stake in the company may have differing views and strategies for managing it. Their objectives may not align with yours. Founders typically evaluate investors carefully to ensure they are entering strategic partnerships.

They aim to derive value over the long term with access to much more than just capital. However, you cannot predict the exit’s long-term fallout on your company. Consider including failsafe provisions in the agreement for protection against such situations.

The Takeaway!

Choosing the right investor partners for your early-stage startup is complex and challenging. You’ll weigh the pros and cons of private equity and other capital sources carefully before finalizing your list of investors.

Your expert fundraising advisor will advise extensive research to gather data about the companies they have backed in the past. Also examine the typical terms and conditions, success stories, and exit strategies.

Evaluate the potential for dilution and the decision-making rights you’re open to offering. At the same time, you’ll balance the benefits the investors will bring to the partnership. Whatever your decision, you’ll base it on your vision for the company’s long-term success and scalability.

Private equity–a strategic growth engine or a costly gamble–weigh your options carefully.

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