As so many of you know, raising the right type of equity to build a business is hard work. Fortunately for founders and executives, there are an abundance of private capital firms with different appetites for risk across various asset classes and strategies to meet a company's needs…which ironically can sometimes make the process even harder. There are three main types of private equity firms that entrepreneurs can consider to fund their business: Venture Capital (VC), Growth Equity, and Private Equity (PE, often historically called Leveraged Buyout (LBO) or simply Buyout).
Usually the decision of which funding option to pursue ultimately boils down to one key factor – the stage of the company. Depending on where the business is in its maturity (early or late stage), its risk characteristics need to complement the underlying investment thesis of its investors. Understanding this relationship can help entrepreneurs determine what form of private equity is right for their company, and how to appropriately position their business when seeking investment.
Here's a quick rundown of each one of these private equity asset classes – similarities, differences, and the goals of the sources of capital to help explain the rationale for the investments they make.
VC-backed companies are generally characterized by having a degree of technology or business model risk. Will the technology work? Will the customers buy the product versus other available options? VC investment is broken into several stages reflecting the degree of risk: seed, early and late. Seed-stage and early-stage venture investors are adept at investing in pre-product and pre-revenue tech companies. During the earlier stages of their investment, startups build their product, establish a business model and (hopefully) achieve market fit. Late-stage venture investors seek companies that have established product-market fit and are generating revenues that are growing considerably (usually in excess of 50% annually); the business model is proven and the additional capital is used to expand sales reach and market share. Despite the stage, venture investors typically target emerging market leaders. The investment strategy is simple: pursue aggressive revenue growth and hence sizeable returns. Clearly, any VC investor will incur a significant amount of risk as they work with companies trying to prove that their business model is sustainable over the long-run.
Key considerations for entrepreneurs to make when entertaining the option of VC money:
- What is the trajectory of the business?
- Is the company targeting a large market? Can it scale up to serve that market very quickly?
- Does the business model or technology create barriers to competition?
…and the list goes on! There are a number of considerations for a business to be attractive to venture investors. One of the biggest: debt. VC-friendly companies carry limited amounts of debt on their balance sheets. Given the investment risk, venture investors naturally feel more comfortable without having to worry about creditors being paid before them in the event of a forced liquidation or sale of the company under unfavourable circumstances. Also, venture investors typically take a minority stake in the business as they back teams they believe in. The management team needs to be "a part of the furniture" and trusted to lead the business successfully. They need to remain incentivized by retaining a considerable stake in the business and operate as founders/owners, not employees. Given this minority stake, VC's seek to mitigate some of the risk in the investment by structuring certain protective provisions, typically related to approvals for key business decisions.
Unlike VC, growth equity financings are appropriate for companies with proven business models. These businesses do not have the same level of market or technology risk. Growth equity investees typically carry execution risk. For some companies, it is indeed possible for growth equity funding to be the first encounter with third-party private capital, provided management has been successful with scaling the company by bootstrapping finances.
Growth equity, very simply, is used to accelerate growth. It targets management-owned businesses that are able to generate healthy revenue increases (usually in excess of 20% annually). These entrepreneurs can benefit from growth equity by bringing an experienced partner to help expand operations, fund acquisitions, or access new markets without giving up control over their business. Businesses can be operating at breakeven or positive cash flow, but seldom at a loss. Also, companies seeking growth equity are modestly leveraged (if at all) in order to keep the interests of the company and its equity investors aligned.
Like VC's, growth equity investors take minority stakes in a business as to not assume day-to-day management responsibilities. As such, when looking to raise a growth equity round, entrepreneurs can expect the investors to structure deals so that they include the same type of protective provisions as in venture capital. It's all about mitigating the risk.
Private Equity / Buyout Equity
PE is also a distinct asset class and typically involves a complete control purchase of the underlying business from existing owners – be they founders, growth equity investors or public market investors. Typically, ideal businesses for private equity are those that operate in mature markets, generate sustainable cash flows, and are highly leveraged as debt is a key instrument used by buyout investors to enhance returns.
Buyout investors have the lowest expectation of revenue growth since the businesses are operating at the mature stage of the lifecycle (usually less than 10% annual growth). Enhanced returns come from the leverage/debt position of the purchase, and the realization of business synergies (such as acquisitions and/or cost-cutting) to improve profitability.
Despite their differences, growth and buyout investors both look to build concentrated portfolios and target clear market leaders – what varies is the amount of risk, appetite for growth, and overall business synergies.
Between VC, growth equity, and PE, entrepreneurs operating businesses at all stages have several options to meet their funding needs. There are also those who have managed to build lasting companies relying solely on debt (or perhaps no third-party capital whatsoever), but this is usually the exception rather than the norm.
It is also worth noting that VCs have LPs (these are the Limited Partners that fund that various firms) behind them, and they will also have their own definition of success on investments as markets and sectors fluctuate. A good read on the current view of the venture climate from the LP eye is this blog post by Mark Suster: What Do LPs Think of the Venture Capital Markets for 2016? (Hint: it's not all good news. More to come in next week's blog post).
Regardless of which stage your company is in, taking private capital isn't a decision to take lightly; there are a ton of considerations and compromises made. Remeber, if you ultimately decide to take third party capital, your company is going to change…hopefully this means for the better. It doesn't matter what stage your company is in, or if you're taking venture capital, growth equity or private equity, make sure your interests align with your investors as closely as you can. Always try and do business with people you want to work with. Sounds easy, right? Oftentimes, and especially for those in the early stages of growing their business, your investors will be with you for the foreseeable future (in Canada, it could anywhere from 5-10 years if you're an early stage company). Work with investors that you have confidence in, and work with people who are strategic partners for your business. Your investors can be a significant asset to the growth and success of your company, so look at your options carefully.