United States: Partnering With Private Equity Firms

When should a company take capital from a private equity firm? As an owner, you have to ask yourself: What does it mean to partner with a private equity firm? What do I gain? What do I give up? There are times when an owner or a business reaches a crossroads, and money alone will not guide you in the right direction. Suppose the next logical step for your business means entering an overseas market that would stretch management to the breaking point. Suppose an obsolete plant or equipment is costing you business, but building a new facility or purchasing new equipment would entail more risk than you are willing to assume, whether or not the financing is available. Now, suppose carrying on business as usual without investing in new markets, new equipment and new technology would mean losing market share to larger competitors who are in a better position to invest.

For many mid-sized business owners, these sorts of dilemmas are more than hypotheticals. Markets change, and changing with them may be more than you want to undertake alone. This is what private equity firms look for: a business that could benefit not only from a capital infusion but also from the operational and managerial expertise that they are able to provide to their portfolio companies. Some private equity firms have overseas offices, enabling them to help outsource manufacturing and provide in-market contacts for their portfolio companies or possibly facilitate sales into those countries. Partnering with a private equity firm may mean giving up a controlling interest, possibly economic and voting, in your company. It may mean gaining a partner that can not only provide professional oversight but also share the expenses and the risks of growing your business—a risk that many business owners tend to underestimate. If you are like many entrepreneurs, you have a significant portion of your net worth tied up in your business. An investment by a private equity firm could provide a way to turn your hard work into liquid assets and diversify your personal financial risks.

Private Capital Takes Many Forms

As we will see in the next chapter, private equity firm investments come in many different flavors. For instance, there are non-control investments that are sometimes referred to as "growth capital" investments. There are control investments in which the private equity firm will acquire 100 percent of the equity and permit or require the management team to "roll over" or reinvest in the company. Under any scenario, keep in mind that, first and foremost, private equity firms are investing in management. This means you!

Depending on the purpose of the proposed investment and the needs of the company, you may also be able to negotiate how much equity and how much control you are able to retain. Just as the structuring of an investment by a private equity firm comes in a variety of flavors, so do private equity firms themselves. The kind of relationship you develop with the principals in the private equity firm will determine the nature and extent of the intrusion in your business. Selecting a private equity firm is key since you will be accepting more than capital—you will be receiving a new partner who will work to play a positive and constructive role in the execution of your business strategy. Because the funds are stewards of other people's money, the principals in a private equity firm are hands-on with the businesses in which they invest. It will be a brave new world for you. However, the combination of a new partner, with capital, who plays an active role in your company, can be a very positive relationship.

The Growth Equity Model

In a typical growth equity or non-control investment, the private equity firm and management will seek to agree on how to determine valuation, which is always an "interesting" exercise. Although several different methods are used to arrive at a valuation, including a discounted cash flow analysis, comparables or a multiple of earnings before interest, taxes, depreciation and amortization (referred to as EBITDA), private equity firms generally use adjusted or normalized EBITDA to value a business.

That is only the beginning of the process. The private equity firm will issue a term sheet or letter of intent, called an "LOI," that will be non-binding and will set forth the principal terms of the investment. The private equity firm will generally acquire a preferred security, which will provide for a dividend that will accrue, a return of capital plus a preference payment, and participation on a pro rata basis with all equityholders. The other principal terms typically include one or more board seats, as well as certain "protective" or "consent" rights, which will require the company to obtain the consent or approval of the private equity firm to certain material transactions, including a sale of the company and other fundamental transactions. These consent provisions can be intrusive and, for that reason, are usually heavily negotiated.

Another standard provision is called a "right of redemption," which refers to the right of the private equity fund to require the company to repurchase the fund's interest after a period of time (usually five years after the investment). Even though this is not a debt instrument, there is a "maturity date." Other provisions will be negotiated, too. In addition, an investment by a private equity firm may, or may not, include a debt component. Even though LOIs are non-binding, once they have been signed, it is very challenging to renegotiate issues covered in the LOI. The seller or company will lose a significant amount of leverage at this point.

If you are actively managing your company but are not yet ready to move on or retire—and you want to take some money off the table—private equity firms may also provide that opportunity in either a non-control or control scenario. In fact, because middle-market private equity firms look for a platform investment in an industry that they believe has the potential to grow, the addition of a private equity firm as an investor may provide you with the potential to manage a much bigger company. The type of company they usually seek is reasonably well-established and has the capacity to grow exponentially through acquisition. Then, they buy other companies in the same industry, with a strategy—for example, growing geographically or increasing market share. The math is simple: A bigger company can get better terms from lenders and suppliers and, when it's time to sell, a higher valuation in the market. To achieve that growth, private equity firms rely on executives and managers who know the business intimately. They are not interested in running your business on a day-to-day level; they want to invest in it (and, more importantly, in you and your management team), help make it better and sell their stake at a premium within four to six years. This strategy makes your potential "second bite at the apple" much sweeter.

Duane Morris Private Equity: The Owner's Manual

This article is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. Each legal matter should be considered to be unique and subject to varying results. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

Duane Morris LLP, a full-service law firm with more than 700 attorneys in 24 offices in the United States and internationally, offers innovative solutions to the legal and business challenges presented by today's evolving global markets. Duane Morris LLP, a full-service law firm with more than 700 attorneys in 24 offices in the United States and internationally, offers innovative solutions to the legal and business challenges presented by today's evolving global markets. The Duane Morris Institute provides training workshops for HR professionals, in-house counsel, benefits administrators and senior managers.

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