New and developing enterprises are sometimes faced with the uncertain and difficult process of obtaining capital to build or grow their business. In many situations, accessing private equity is the most viable funding alternative for a growth oriented company. This article provides an overview of the benefits and/or possible disadvantages from this alternative.
Private equity investments are typically sourced from one or a combination of the following:
- Strategic investors – established companies with similar or complementary products or services looking for growth/expansion opportunities.
- Wealthy individual investors – families who have allocated a portion of their investment portfolio to direct, private investments.
- Private equity funds – investment funds comprised of institutions and wealthy individuals. These investors typically have a financial versus strategic basis for their investment, and they are driven by high returns.
It is important to note that private equity is not limited to venture capital, but also capital for leveraged buy-outs, management buy-outs, and later stage growth capital.
Because private equity is expensive (investors typically require an internal rate of return of 30% or greater), companies must carefully evaluate whether or not they should pursue this capital alternative. Other capital alternatives for private companies include bank financing, private mezzanine funding, and accessing the public debt and equity markets. Private equity is generally accessed by companies that do not have the operating history or track record to access lower cost capital alternatives, but need capital for growth or expansion. Examples include companies needing capital to develop products, implement marketing or distribution strategies, and/or expand into new markets.
A private equity infusion bas significant benefits, including:
- Growth capital without the fixed expense of debt service;
- Maintains financial flexibility – enhances borrowing capacity for other opportunities;
- Depending on the amount, is accessible earlier in an enterprise’s life cycle compared to more traditional capital alternatives (i.e., bank financing);
- An equity investor with experience in some or similar industries could be a source of synergistic opportunities; and
- Limited market risk – the cost of private equity has historically remained relatively stable.
The disadvantages to private equity include:
- Expensive – investors require a minimum internal rate of return of 30%;
- Potential significant dilution of existing shareholders;
- Governance – investor will typically want a board seat;
- Transaction timing – 4 to 6 months to close a transaction; and
- Investors will desire a 3 to 5 year strategy.
The determination of which capital alternative to pursue is a function of balancing many factors including:
- The cost of the capital alternative;
- Does the capital alternative improve or detract from your company’s financial flexibility;
- Is the capital available;
- Can it be accessed at this point in your company’s life cycle; and
- Does the capital alternative logically fit in your company’s strategic plans.
In evaluating these often competing interests, gaining recommendations on possible sourcing, and assembling a successful package to access the needed capital, professional advice and assistance is a necessary part in any CEO decision. The best approach is to seek a team of proven financial experts with the backgrounds which match your company’s needs.
As in any other company endeavor, assembling the correct expertise and resources, generally translates into a more timely and better product result.
Edward D. Hess, Partner, Arthur Andersen’s Corporate Finance Group (202-862-7623)
and A. Meriwether Partner, Arthur Andersen’s Enterprise Group, (703-734-4196).