Becoming private equity backed is the biggest financial decision most business owners will ever make. I’ve probably written quite a bit already on why an entrepreneur or business owner should consider it, but I thought it would be helpful to discuss how I think they should go about investigating their options – and what actually changes once the deal is done.
What Becoming Private Equity Backed Actually Means
Private equity backing comes in two basic shapes. In a majority deal, the PE firm buys control (typically 60-100%), you take most of your chips off the table, and you usually stay on for three to five years under an earn-out or with rolled equity. In a minority deal, the firm takes 20-49%, you keep control of the day-to-day, and the money funds growth rather than your retirement. The two are very different lives. A majority deal means you have a boss now – a polite, data-driven boss who flies in for board meetings, but a boss. A minority deal means you have a partner with opinions and a seat at the table, but you still run the place.
Either way, expect leverage. PE firms will put debt on your business because that’s how the returns math works. A business that used to run debt-free may suddenly carry 3-4x EBITDA of it. That disciplines spending wonderfully – and it means your sleepy balance sheet now has covenants attached.
How to Investigate Your Options
- I’d recommend avoiding the intermediaries (brokers, advisers, investment bankers, etc). My reason is that middle-men inherently introduce new layers of costs and complexity and in most instances, a business owner is sophisticated enough to deal directly with potential partners and becoming private equity backed. However, with that said, I fully acknowledge that there are cases where an intermediary can add significant value. Such examples may be where a family estate wants to sell a business, or where the business owner is very technical and hasn’t had to be commercial in their role.
- Talk to the principals of different investment firms to get a feeling for their mandate, intellect, philosophies, but most importantly, make sure they have direct skill and experience in your industry. Also ask their thoughts on being private equity backed. If the firm says they have secondary associations with people in your industry who can help, don’t buy it. Make sure someone on their direct investment team will be able to help extract the most from your business. Even if you just want to sell and get out, most private equity firms will tie you into earn outs and such, so this is still very important.
- When progressing discussions, make sure you understand the firm’s intentions with your business before you commit to private equity backing. That is, ask to see their first draft strategy and gauge the value of it. Use your intuition here and don’t let yourself be bullied. A lot of value can be created with a private equity firm partner, but you want to find the one that can add the most value. Similarly, if the firm’s intentions seem overly risky, then don’t go for it. Your chances of losing value are also much higher with a new business partner.
- Talk to the relevant private equity association, ask their opinions about different firms and ask to see a list of registered firms and their mandates. This will help to narrow down your initial contact list. In Europe, the applicable body is the European Private Equity & Venture Capital Association, whereas in the States the applicable body is the National Venture Capital Association.
- If you’re given access, talk to the principals of current and past investees of the firm. This is a fair request but one that private equiteers rarely receive. While references may not give you the full picture (people generally do not talk negatively about others), body language and some reading between the lines will give you valuable data points in making your decision. Further, you get another very important data point on transparency if the private equity firm denies your request.
What Changes After the Deal
Reporting. The days of running the business off the bank balance are over. Expect monthly management accounts within two weeks of month-end, a proper budget cycle, and KPI dashboards the firm actually reads. Most owners find this painful for six months and then wonder how they ever ran the business without it.
Governance. There will be a board, and it will meet monthly or quarterly. The PE firm will take seats and will expect decisions on hiring senior people, big capex and acquisitions to run through it. This is where the deal structure you signed starts to matter – vetoes and reserved powers live in the shareholders’ agreement, not in the vibe of the negotiations.
Exit clock. A PE fund has a life of its own – typically ten years – and your business is an asset inside it. From the day the deal closes, there is a rough exit window in the background, usually three to five years out. Understand where their fund sits in its life cycle, because a fund in year two and a fund in year seven will behave very differently with your company.
Timing and Price
Owners ask when the right time is to take PE money. The honest answer: when your growth story is provable but not finished. Firms pay for the future they can underwrite, so you want three years of clean accounts, a credible pipeline, and at least one engine of growth that does not depend on you personally. Sell too early and you price in none of the upside; sell too late and the buyer prices in the risks of a business that has plateaued.
On price, remember that the headline number is only half the deal. A $50m offer paid in cash at completion is worth more than a $60m offer with $20m deferred in an earn-out you do not control. Deferred elements – earn-outs, vendor loans, rolled equity – shift risk back to you. Rolled equity in particular can be the best or worst part of the deal: you are betting on the PE firm’s ability to sell your business for a better price in a few years’ time, with their leverage and their playbook. If you believe in them, rolling 20-30% is often where the real money is made. If you don’t, take the cash and walk.
What PE Firms Look For in an Owner
It cuts both ways. While you are interviewing them, they are interviewing you. A PE firm backing an owner-manager is underwriting you as much as the business, so expect them to probe three things. First, self-awareness: do you know what you’re good at and where the business needs someone else? Founders who claim to be world-class at everything scare investors. Second, coachability: will you actually take input from a board, or is every suggestion a three-week argument? They would rather back a B+ operator who listens than an A+ operator who doesn’t. Third, alignment on the endgame: if you want to run the business for fifteen more years and they need an exit in four, that conversation is better had now than in year three. The owners who get the best deals are the ones who are clear on what they want out of the partnership before the term sheet arrives.
Questions to Ask Before You Sign
- How much dry powder does the fund have, and how much is reserved for follow-on investment in my business?
- Where is the fund in its life cycle, and when do you realistically need to exit?
- What does the first-100-days plan look like, in writing?
- Which of your portfolio CEOs can I call – including one where it went badly?
- What happens to my earn-out if you sell the business early?
I’m sure there’s much more to think about when approaching private equity firms, but these are a few tips that I hope would provide comfort around the process of being private equity backed.