Guide to Private Equity for Startups
The popularity of Private Equity investment has grown rapidly over the last decade. Private equity investment usually refers to an equity investment in a potentially successful company that is not traded publicly in the stock market. Private equity investments are usually made by private equity firms and high networth individuals in a business operating as a Private Limited Company. In this article, we review of the basics of Private Equity investment and the must-knows about private equity for startups.
Where private equity funds come from?
Private equity firms raise funds from institutional investors, pension funds, endowments, and investment companies and high networth individuals. Private equity firms allow fund managers and high networth individuals to diversify their portfolio and reduce risk. Private equity firms are expected to return the capital back to investors within 10 years with handsome profits.
How private equity firms operate?
Stages of private equity investment
- Seed stage investment: In seed stage, capital is provided for a business idea. The capital generally support product development and market research.
- Early stage investment: In early stage, capital is provided for companies moving into operations and before commercial sales have occurred.
- Formative stage investment: In formative stage investment, capital is provided for starting or scaling up of operations.
- Later stage investment: In later stage investment, capital is provided for further expansions and scaling up prior to the company going public.
How private equity firms value companies?
Unlike shares of public limited companies that are traded on stock market, the shares of a private company are not traded in public. Hence, value of the shares of a private company cannot be evaluated readily and is the outcome of a negotiation process between a private equity firm and the founders. To ascertain value, private equity firms use a number of valuation techniques. The selection of an appropriate valuation technique depends on the stage of investment. The following are some of the well known valuation techniques used by private equity firms for evaluating a startup.
Discounted Cash Flow Method
In discounted cash flow method, the value of the company is estimated by discounting expected future cash flows of the company at an appropriate cost of capital (discount rate). High risk will translate to a higher discount rate – a lower valuation for the company.
Relative Value Method
In relative value method, earning multiples of comparable publicly traded companies are applied to the earnings of target company. Earning multiples are calculated by averaging the earnings and value of similar companies, traded in stock markets. Commonly used multiples are Price/Earnings (P/E), Enterprise Value/EBITDA, Enterprise Value/Sales.
Replacement Cost Method
Replacement cost method estimates the value of a business by calculating the estimated cost to recreate the business as it stands as of the valuation date. Replacement cost method is usually used to calculate the value of companies operating in the seed or early stage.
To know more about business valuation methodologies, read the article on business valuation.
How private equity firms manage their investment companies?
The following are some of the features of private equity investment that help the private equity firm control the portfolio company:
Corporate Board Seats: Inducting a person from the Private Equity firm on the Board of Directors of the company will ensure the private equity firm’s interests are protected in case of major corporate events like share sale, business takeover, restructuring, IPO, bankruptcy, or liquidation.
Non-compete Clause: Non-compete clauses are imposed on founders and prevents the founders from restarting the same activity during a pre-defined period of time.
Preferred dividends and liquidation preference: Private equity firms generally come first when distribution take place, and maybe guaranteed a minimum multiple of their original investment before other shareholders receive their returns.
Reserved matters: Some strategic decisions such as change in business plan, acquisitions or divestitures are subject to approval or veto by the private equity firm.
How private equity firms return the capital to investors?
Exit from the company is the most critical element to unlock value in private equity investment. Most private equity firms consider their exit options prior to investing. The following are some of the exit options for private equity investors:
Initial Public Offering (IPO): IPO is among the most favorite exit option for private equity firms as it provides higher valuation multiples, enhances liquidity and provides the business with more funding to fuel further growth.
Secondary Market: Secondary market sale is sale of the shares held by the private equity firm to a financial investor or to other financial investors or to strategic investors. Secondary market exits are the most common type of exit.
Management Buyout: Management buyout is purchase of the shares held by the private equity firm by the management group by raising debt or other type of funds.
Liquidation: This is the worst case option wherein the private equity firms liquidate their shareholding in the company at floor price if the company is no longer viable.
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