Every successful small business eventually reaches a growth ceiling or begins exploring how to get outside capital to fund further expansion. This capital can come from a variety of sources, one of which is private equity firms. As business owners evaluate their funding options, it helps to understand small business private equity — and dispel some myths about it along the way.
The idea of private equity funding might sound enticing, and there’s no shortage of articles online discussing how companies can best position themselves for those opportunities. But for the majority of small to medium-sized businesses, the reality is that if you’re looking to sell your business or attract investment to grow, working with private equity is too high-level an idea to be realistic.
Let’s break down some of the capital-raising options that coexist with small business private equity.
How does private equity financing work?
Private equity financing is a general term for funding for small, mid-sized or large closely held businesses in which an investment group buys the company’s common or preferred stock. This is distinct from investing in the stock of a publicly traded company or lending to a business.
Typically, the investor buys the stock with the expectation that they will get their money back, with an investment return, through the sale of the company to a larger company or another investment group 5-7 years after the initial investment.
Types of small business private equity
When small to medium-sized companies are seeking capital, they traditionally consider four types of private equity investors:
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- Venture capital or angel investors: These investors are looking to buy minority interest in a small, high-growth company. Their capital might help fund sales efforts, marketing or product development that help the company grow rapidly and become more profitable. Ideally, they’d like to see a company grow to 10 times its current value in 3-4 years’ time and sell to a larger company.
- Growth equity: Growth equity investors work with companies that have reached maturity and are already profitable. They’re looking for minority interest in exchange for providing the funds to help a company grow much faster than it would otherwise. Ideally, they’d like to see a company grow to 5 times its current value in 3-4 years’ time and sell to a larger company.
- Buyout investors: Buyout investors are interested in buying a majority of a company and using bank debt to finance a substantial percentage of the purchase price. They want the company’s cash flow to pay off their bank debt as the business grows. It is common that companies owned by buyout investors try to grow both by increasing sales and through further business acquisitions. Ideally, the investors will sell the company in about five years at 2-3 times its current value, most likely to a larger company in the same industry.
- A larger company: Sometimes a small business has the opportunity to sell itself to a larger company in the same industry (which could be owned by a private equity firm). When that happens, the small business’s future growth is no longer relevant, since it will be assisting the bigger company’s growth by becoming a new division or product line. Meanwhile, the small business enjoys the benefits of the bigger company’s management and infrastructure.
Alternatives to private equity for small businesses
There are many alternatives to private equity, and as the term “equity” implies, the alternatives are generally not structured as investments in the company’s stock. Instead, if the alternative is financing, then the relationship is structured as some kind of debt, with a fixed maturity date for repayment and regular interest due. If the alternative is a sale of the full business, it is a purchase by a larger company.
Puncturing myths about private equity
The lure of small business private equity is partly rooted in what small business owners assume comes along with it — in particular, the guiding influence of a more seasoned group of businesspeople.
But the truth is, investors typically don’t bring much to the table in addition to money, and financial returns are the lens through which they evaluate businesses.
At Oaklyn Consulting, we often hear from people who express an interest in selling to private equity and leaving their business. What we tell them is that small business private equity investors simply aren’t equipped to take over a business that isn’t already self-sufficient; they’re money suppliers, not problem-solvers. When a business owner says they sold to private equity and left their business, what they really mean is that they sold to a larger company backed by private equity, which created an opening for them to leave.
Another common myth among small business owners is that their company is a candidate for direct ownership by outside investors, rather than a bigger company. It might not be possible for some companies to grow enough in absolute terms, as opposed to percentage terms, to be worthwhile as a pure investment. Investment funds need their investments to be big enough in absolute dollars to be worth the time and effort required to structure the deals, monitor the companies and ultimately sell them to another owner.
How Oaklyn Consulting can help you
Many clients we work with at Oaklyn Consulting aren’t ideal candidates for private equity. It’s common for us to work with companies that haven’t achieved their hoped-for growth trajectory, have navigated a downturn in their business or are grappling with the best alternatives for leadership succession. The owners of these businesses are at a critical decision point of how to proceed — and the best path forward may or may not include a sale.
One of our recent clients, Atlanta-based catering company Proof of the Pudding, proved to be an exception to the rule. By all measures, Proof of the Pudding has been a successful business. They’ve been in existence since 1979 and oversee more than 20,000 events and experiences every year, serving hundreds of thousands of customers. Proof of the Pudding has also received numerous awards and industry recognitions over the years for culinary, operational and creative excellence.
Proof of the Pudding came to Oaklyn Consulting because they were considering outside investment to fund large growth ambitions and complete a generational succession plan. We helped them evaluate their options and facilitated a deal with Bruin Capital, a growth equity fund that bought two-thirds of the company, enabling Proof of the Pudding to grow in an industry where Bruin had lots of connections. As part of the deal, Proof of the Pudding’s leadership team continues to run the business.
Any owner of a small or medium-sized business who is contemplating a sale or seeking investment capital needs to be asking one important question: Do I have something that’s attractive to private equity investors? If you can’t demonstrate a trend of steady growth or don’t have a continuity plan in place so that the investment group can easily assume ownership, you may not be a good fit for this type of capital and you should evaluate other alternatives.
For business owners who can’t answer this one question with a clear yes or no, we at Oaklyn Consulting are here to help. Let us be your partner as you navigate critical decisions in the life of your business.
