When to Turn to Private Equity

Most owner-managed businesses fund themselves through retained profit, bank debt and asset finance for as long as they can, and that is usually the right order. There comes a point, though, where lenders will go no further, or where the plan needs more than money: experience, contacts, or a partner to share the risk. That is when private equity enters the conversation. It can be the right answer, but it changes the business and the owner's position in it, and both need to be understood before the first meeting.

When debt is no longer enough

Debt has to be repaid on a schedule, whatever happens to trading. That makes it a poor fit for some situations:

• A turnaround that will take longer to deliver cash than lenders are willing to wait.
• A growth plan, such as an acquisition or a new site, where the risk is too high for a lender's appetite.
• A business already carrying as much secured borrowing as its assets will support.
• An owner who wants to take some money out, or plan an exit, while the business keeps growing.

Equity is not repaid in instalments. The investor takes a share of the business and gets its return when it sells that share. That gives the business room, but the investor will want to be confident it gets that return.

What private equity expects

Control, or at least influence. Investors usually take a seat on the board and often appoint a chair. The investment agreement will list decisions that need their consent, typically including budgets, borrowing, large capital spend, senior hires and any sale of the business. Even a minority investor can have a great deal of say through these rights.

Reporting. Expect monthly management accounts, produced promptly, with a commentary against budget and forecast. Many owner-managed businesses are not set up for this and find it a heavy load at first. Our piece on turning data into information covers the measures that matter.

An exit horizon. Investors raise money from their own backers for a fixed period and need to return it. They will want to agree, at the outset, how and roughly when they expect to sell: to a trade buyer, to another investor, or back to management. That timetable will shape decisions throughout.

A management team they back. Investors back people as much as plans. If they see gaps, they will want them filled, sometimes by bringing in a finance director or chair of their own choosing.

What it costs the owner

The cost of private equity is less obvious than an interest rate, but it is real.

• Ownership. You give up a share of the business and of its future value.
• Structure. Deals often combine ordinary shares with loan notes or preference shares that carry a fixed return and rank ahead of ordinary shareholders. The headline percentage you keep can overstate what you actually receive on exit.
• Ratchets and leaver terms. Management's share may rise or fall depending on performance, and directors who leave early can lose some or all of their shares at a low price.
• Warranties. You will be asked to give warranties about the business and may be personally exposed if they prove untrue.
• Freedom. Decisions you once made alone now need a board, and sometimes the investor's consent.

These terms vary widely between investors and between deals. Your lawyers and accountants should review them before anything is signed, and their advice on tax and structure is essential.

The alternatives

Private equity is one option among several. Depending on the situation, it is worth considering:

• Mezzanine or growth debt, which sits behind senior lenders and costs more, but leaves ownership largely intact.
• Regional and publicly backed funds, which often invest smaller sums in local businesses.
• Private investors and family offices, who may take a longer view and ask for less control.
• A strategic partner or customer, who may invest for reasons beyond financial return.
• A sale of part or all of the business, or a management buyout. Our comparison of MBO, MBI and trade sale sets out the main routes.

Prepare before investors look

The work you do before approaching investors has more effect on the terms you get than anything you do in the negotiation.

• Get the numbers right. Clean, reconciled accounts and a forecast you can defend line by line.
• Write the plan down. What the money is for, what it will achieve, and how the investor gets its return.
• Fix the obvious weaknesses. Customer concentration, a key person dependency, lapsed certifications or poor stock records will all be found in due diligence. Better to address them, or explain them, first.
• Strengthen the team. Show that the business does not rely on one person.
• Know what you want. Decide how much control you are prepared to give up and what a good outcome looks like for you personally.

We help owners decide whether private equity is the right step, prepare the business and the plan, and introduce them to investors and alternative funders through our finance sector network. Read more about our turnaround and finance services or get in touch.