Private Equity 101: Answering Your Top Questions About Private Equity
Let’s say you’ve hit a major revenue milestone for your company. Competition in your industry is fierce and to stand still is to die a slow death.
But you’ve reached a crossroads. Going to the “next level” requires additional debt (i.e. a loan from your bank with your personal guaranty on it). You’re not ready to push all your chips back on the table, but you’re not ready to throw the keys at a new owner and retire to the lakehouse just yet.
Enter: the private equity transaction.
Maybe you’re fielding calls left and right from private equity buyers; maybe you’ve never heard from one (and you’re not exactly sure what they do). We’ve got you covered: read on for a quick Private Equity 101 to understand what a private equity firm is, how a private equity transaction works, and whether you should consider pursuing one.
What is a private equity group?
Private equity groups — or PEGs, as we affectionately call them — assemble a pool of funds from a variety of sources. That could include college endowments, pension funds, wealthy individuals, etc. They use those funds to make investments in privately held companies.
What are private equity buyers looking for?
A PEG’s investment criteria varies depending on the firm. Some focus on certain industries or geographies; some prefer companies in a certain stage. But generally, their top three conditions in in determining whether to invest in a company are:
- Consistent and stable revenue growth.
- An EBITDA margin of over 10% (EBITDA is earnings before interest, taxes, depreciation, and amortization)
- An experienced management team that is committed to the company and willing to invest with the PEG in moving the company forward.
Is my company too small for a private equity sale?
Twenty years ago, most PEGs looked for companies with a minimum of $10 million in EBITDA. About 15 years ago PEGs emerged willing to invest at $5 million. Now we find a number of firms stating that they focus on companies with EBITDA as low as $1 million.
With the advent of PEGs, a hybrid buyer — a strategic buyer owned by a PEG — has emerged. This buyer systematically makes add-on acquisitions of similar companies with no minimum EBITDA.
So for the entrepreneur who has no succession plan in place and would previously have had to sell to a third party through a business broker, PEGs can present an attractive alternative.
How does a private equity transaction work?
Typically the transaction works such that the PEG values your company at a multiple of cash flow (EBITDA), usually ranging between 4-6x. Any long term debt and out of term payables are deducted from the valuation and any excess cash is added to determine the “equity value”.
The PEG then proposes to pay the owners 70-80% of that value and let the owners retain the balance. As part of the transaction, the PEG secures a new lender to replace any existing debt, and the owners no longer have to be personally liable for any bank debt.
The owners are able to take the cash proceeds from the sale of their interests and reinvest into a variety of diversified assets such as stocks, municipal bonds, real estate, etc. and minimize the risk they had from being solely invested in their company.
What happens after a private equity transaction?
For years stories circulated about the entrepreneur who sold out to the Wall Street guys who then fired everybody, broke the company into pieces and tried to sell the assets shortly thereafter to the “greater fool.” While this sequence of events has certainly taken place, it’s definitely more the exception than the rule.
PEGs have matured over the years to the extent that they frequently hire ex-CEOs as part of their core team or as part of an advisory board. In turn, they analyze companies from an operating perspective as well as from a financial perspective. While their end objective is to sell to another PEG, have an IPO (Initial Public Offering) or sell to a larger company, they typically intend to grow the company for at least five years after a transaction takes place.
But the bottom line is that the PEG has made this investment because it believes in the company, its products and its management team. The PEG does not want to run the company. Together, the PEG and the management team devise a plan to grow the company. Any additional debt is backed by the company’s assets and that of the PEG. If the plan is successful, in many cases the residual 20- 30% ownership of the original shareholders becomes worth more than they received in the initial transaction.
Want to learn more about how private equity transactions work? Give us a call at 423.266.7490 or email Managing Director Andy Stockett at firstname.lastname@example.org