Private equity guide for startups

How does private equity work?

Private equity firms raise funds through institutional investors (like pension funds or endowments) and accredited investors (individuals or entities with significant financial resources). These funds are then used to invest in companies with growth potential or those requiring restructuring.

Here’s how private equity investments generally work:

• Acquisition: A PE firm identifies a company with strong potential for improvement or growth and invests in it. The firm may take a majority or minority stake, depending on the strategy.
• Improvement: The PE firm works with the company’s management to improve operations, profitability, or market position. This often involves streamlining processes, restructuring, or providing capital for growth.
• Exit: After a set investment horizon (usually 4-7 years), the PE firm exits the investment, aiming to generate high returns.

Common private equity strategies

Some common private equity strategies include:

1. Buyouts of mature companies

In a buyout, the PE firm acquires a controlling interest (more than 50%) in a mature company. Often, the company is taken private, meaning its shares aren’t traded on the stock exchange anymore.

For example, in leveraged buyouts (LBOs), the firm uses both debt and equity financing to purchase the company. The debt is placed on the company’s balance sheet, making the company responsible for repaying it. The PE firm focuses on turning the business model profitable enough to handle this debt and generate a return.

While buyouts sometimes involve cost-cutting or restructuring, not all cases result in layoffs or negative outcomes. Successful buyouts improve the company’s performance and increase its value before an exit.

2. Investments in growing companies

Growing companies may need additional capital to scale operations, launch new products, or expand to new markets. In this strategy, the PE firm typically takes a minority stake, meaning the company’s founders or entrepreneurs retain control.

These investments are less risky than venture capital because the company often has a proven track record and steady revenue. The PE firm’s role is to provide funds and expertise to help the company achieve its next growth milestone.

3. Seed funding for startups (venture capital)

Venture capital (VC funds) is a form of private equity that focuses on early-stage startups with high growth potential. Startups usually lack access to traditional financing, so venture capitalists provide essential capital in exchange for equity (ownership shares).

While venture capital investments carry higher risks due to the unproven nature of startups, they can deliver substantial returns if the startup succeeds.

How private equity firms exit investments

A critical part of private equity is the exit strategy, which determines how and when the firm will sell its stake to realize a return. Exit strategies depend on factors like the company’s performance, market conditions, and investor goals.

Common exit routes

Some common exit strategies that focus on maximizing returns within the firm’s investment timeline are:

1. Trade sale: Selling the company to another business or strategic buyer.
2. Secondary sale: Selling the company to a different private equity firm.
3. Management buyout: The company’s management buys out the PE firm’s stake.
4. Initial public offering (IPO): Listing the company on a public stock exchange and selling shares to public investors. This allows the PE firm to sell its stake gradually.
5. Partial exit: Selling a portion of the stake to external investors while retaining some ownership.

Private equity & startups

Private equity (PE) firms traditionally invest in established businesses that have a good track record and steady cash flow. These companies are usually looking for capital to scale operations or restructure. However, in recent years, PE funds are showing growing interest in early-stage companies—especially those with high growth potential in sectors like technology, healthcare, and renewable energy.

Why private equity firms are entering the startup space?

• High growth potential: Startups offer the chance for significant returns if they succeed. PE firms often look for businesses with innovative ideas and the ability to grow quickly with the right funding and support.
• New investment opportunities: With many established markets becoming saturated, PE firms are turning to startups for fresh opportunities. Startups in emerging industries often bring untapped potential.
• Strategic influence: Unlike venture capital firms, which focus on early-stage startups, PE firms tend to invest in later-stage startups that are closer to profitability. They provide funding and operational expertise to help these startups achieve stability and scale further.

Benefits & risks for startups

Private equity can provide startups with the funding they need to grow, but it also comes with its challenges. Before choosing this path, it’s important to understand the advantages and risks that private equity brings and how it can impact your business in the long run.

Benefits of private equity for startups

Some pros of going with private equity are:

• Access to capital: Private equity gives you access to huge funds that can be used for product development, hiring, marketing, or scaling operations. For startups struggling to raise funds through traditional channels, this can be a significant advantage.
• Strategic guidance: Private equity firms often bring more than money. They offer expertise, connections, and operational support. Their experience in scaling businesses can help you navigate challenges, refine your strategy, and accelerate growth.
• Long-term focus: Unlike public markets, private equity investors take a long-term approach. They are less concerned with short-term financial performance and more focused on creating sustainable growth over several years.
• Improved business operations: Private equity firms often work closely with startups to improve operations. They may help streamline processes, reduce costs, or introduce better management practices, increasing your business's efficiency and profitability.
• Unique growth opportunities: Partnering with a private equity firm can open doors to markets, partnerships, and customers that may have been out of reach. Their networks and industry connections can help you expand faster than you could on your own.

Risks of private equity for startups

In contrast, some cons of going with private equity are:

• Loss of control: Private equity investors typically take a share of ownership in your company, which may reduce your decision-making power. They often expect a say in major business decisions and operations, which could conflict with your vision.‍
• High expectations and pressure: Once you accept private equity funding, the pressure to deliver results increases. Investors expect strong performance and a clear growth path, which can add stress and affect your management team’s focus.‍
• Valuation challenges: Determining the value of your startup can be complex. Unlike public companies, private businesses don’t have market prices, so valuations are often a negotiation between you and angel investors. This process can be challenging and time-consuming.‍
• Risk of mismanagement: Private equity firms may impose operational changes or strategies that don’t align with your company’s needs. If poorly executed, these changes can harm the business instead of improving it.‍
• Long-term commitment: Private equity involves locking in capital for years. If you are looking for flexibility or short-term results, this type of funding may not be the best fit.‍
• High stakes for founders: While private equity can offer funding and expertise, it also brings added pressure on startup founders. Fundraising itself can be a tough process filled with rejections, and once the funds are secured, you’ll need to prove your business’s worth and growth potential.

Wrap up

Private equity involves investing in companies with the goal of improving their performance and exiting for a profit.

Whether through buyouts, growth investments, or venture capital funds, PE firms play a significant role in helping small businesses grow, restructure, or reach their full potential. The exit strategy is what ultimately determines the success of the investment.