Sources of finance: Private Equity
Private equity is capital that is put into a new or growing business in return for part-ownership of the business and a share of the profits. Typically, a private equity or venture capital investor does not want permanent ownership of your business. They want to “exit” your business within five to seven years by selling the shares you gave them, and they want a return on investment of at least 35% per year. In other words, if they invest R1 million in your business, they want to get at least R2,75 million when they sell their shares in five years’ time.
Venture capital >is a form of private equity that focuses on relatively high-risk businesses, in the expectation that the profits will be above average.
Private equity is usually attracted by businesses demonstrating the prospect of rapid growth, often through some kind of product innovation.
For most small to medium-sized businesses, such funding goes hand-in-hand with changes of a fundamental nature. A business has to become a separate legal entity from its owners if people other than partners are to invest in it. To issue shares, a business needs to be registered as a limited company. The potential rewards are great, but small business owners must be prepared to make the sacrifices that go with reporting to outside investors and delegating to a larger management team.
Private equity and venture capital in South Africa
In South Africa, private equity fund managers are very conservative. The investors are usually banks or funds owned by families or individual entrepreneurs who have made it big in the past. Because of the low levels of trust in South Africa – and, until recently, pessimism about the economic future of South Africa – only about R2 billion of the R8 billion available for private equity investment was actually put to use. And then it was only used for very safe deals, such as corporate buy-outs and mergers. The fund managers are scared stiff of investing in small businesses.
Venture capital funds overseas generally take the following approach: out of every ten investments they make, six will probably fail, three will “break even” (won’t fail, but won’t make a killing either), and one will make a lot of money for the venture capitalist. South African venture capitalists don’t have the stomach for such a model and rather tend to play it very safe.
Recently, private equity is being used increasingly to fund BEE deals, when white owners want to sell part of their businesses to black entrepreneurs. This has yet to filter down to smaller businesses.
So should you even bother with private equity or venture capital?
It depends. If you have a fantastic concept or a business that you just know is going to grow enormously, and you have an above-average knack for convincing other people of this, then it may be worth a try when the time is right.
You will need to have some proof of your potential success. In other words, you will need to have a formal business that is profitable already. Or, if you are not yet in business, you would need to hold a patent of an amazing invention, and you will need an impressive CV reflecting above-average entrepreneurial and management abilities.
Increasingly, black entrepreneurs may find private equity investors willing to buy a stake in a white business on their behalf, and the black entrepreneur can then slowly buy the stake from the private equity fund through the dividends earned. This is, of course, also an opportunity for white business owners who are looking for a black partner.
If you do apply for private equity finance, don’t get your hopes up. Some funds investigate about a dozen possible deals a year, and then only invest in one.
Advantages and disadvantages of private equity
|You won’t need to pay any interest, as you would with a loan.
||Your business will be expected to generate substantial profits, so that equity partners earn good dividends on a regular basis.
|Your private equity partners could bring new networks, useful contacts and management assistance.
||You will be required to regularly generate detailed information on your business’s performance and prospects.
|The involvement of the private equity in your business usually makes it easier to get other forms of finance, should you need it.
||The cost of complying with financial regulations can be high.
|It focuses your business’s objectives and ensures structure, discipline and a stable base for strategic decision-making.
||It requires you to give up a share of the business, and to share decision-making and profits.
|The capital injected strengthens your balance sheet and reduces the gearing (the proportion of debt relative to equity).
||The demand for high returns may introduce the danger of short-term thinking.
What do private equity companies look for?
- Return on investment – usually at least 35 per cent internal rate of return;
- People with vision, self-confidence, drive and energy, with aspirations to grow the business;
- A clear team leader and team with complementary expertise, such as management, marketing and finance;
- Market knowledge, a growing market, or an innovative product;
- A product or service with a competitive edge or unique selling point; and
- An exit route, that is, a chance to sell the shares within five to seven years, either back to the business itself, to another investor, or to the public by a listing on a stock exchange.
Obtaining private equity
A clear and comprehensive business plan needs to be presented. This needs to sell the idea and the strategy. The plan must include:
- An executive summary;
- The product or service;
- The management team;
- Business operations;
- Financial projections;
- Marketing strategy; and
- The amount and purpose of finance required, as well as exit opportunities.
Preparation is likely to be a long, drawn-out process requiring a lot of effort. It will be useful to produce an executive summary of the points covered in the business plan. It is important that you focus on private equity sources that meet the needs of your business.
If the proposal is of interest, the private equity practitioner is likely to commission a more in-depth investigation upon which to base a final decision. The investor may commission a consultant to carry out an independent study. The private equity practitioners will start taking a close interest in the business. There will be frequent visits and the investor will expect management to be completely candid about the business’s affairs. This is also a testing of relations from both points of view. Equity investments are frequently a partnership where mutual trust and respect is essential.
Negotiating the investment
Should the investigations prove fruitful, the investor will aim to close the deal as a written legal agreement. This will extend into changes that might be necessary in terms of the company structure. This is clearly a critical phase where good professional support is essential.
It is crucial that the business can provide regular and up-to-date information to the investor. This will include monthly management accounts, minutes of board meetings, notification of major management decisions, etc.
Professional support you may need
Fund raising via a share issue is governed by strict regulations and professional advice will always be required. Some investments will be governed by financial regulations, so the advice of a lawyer and an accountant will usually be needed.
A lawyer can advise the business on its position and rights when negotiating the legal agreement for the investment. The business will also need to comply with the law if its legal status is changing.
The various funding packages available can be complicated and independent financial advice may be necessary to evaluate the options. New accounting systems may need to be introduced to ensure the investor can monitor performance.
Many new businesses have used experienced business advisers to help them put a growth funding package together. Such advisers have contacts in a variety of funding organisations which allows them to help the small business to negotiate an interdependent funding package comprising grants and loans as well as equity. Such support will also give the investor added confidence.
Sources of private equity
Some private equity funds will consider start-up propositions, innovative products at an early stage in their development, or they might specialise in a particular industry. Others finance the expansion of rapidly growing businesses or management buy-outs. It is important to target the right source of private equity for the requirements of the business.
For instance, one of the most active sources of private equity in South Africa is Business Partners (previously the Small Business Development Corporation). They offer:
- Free initial evaluation of your proposal;
- Free initial consultation on your options for developing your business;
- Independent strategic advice;
- Risk capital, focused on the growth of your business;
- Finance for restructuring of family ownership, divisional spin-offs, management buy-outs and management buy-ins;
- Listing your enterprise on a stock exchange;
- Arrangement of trade sales; and
- Assistance with mergers and acquisitions.
Talk to the SA Venture Capital and Private Equity Association for details of their members and what they offer.
Professional private equity practitioner
Whatever route the business takes, the funding source will frequently operate through an intermediary, normally an experienced private equity company. This allows the investor to benefit from the experience of the private equity practitioner in making the investment decision. The private equity company may also represent the investor on the board and/or provide financial and management consultancy support to the business.
Points to remember
- It is important to assess whether private equity is suitable for the business. Other sources of finance should also be explored (such as grants, loans and factoring).
- A private equity practitioner could be a major help with international contacts and experience.
- Before approaching private equity sources, be clear about how much private equity you need and what it will be used for. Most funds specialise and have minimum and maximum investment levels.
- Raising capital takes time, effort and money. Don’t expect (or worse, rely on) any quick decisions.