Going For The “Second Bite”: How To Tell If Private Equity Is The Right Growth Strategy
January 24, 2023 | Stefan Palios
If you’re thinking of private equity as a growth strategy, there are a few specifics to keep in mind. Speaking with TechExit.io, Kristin Smith, Principal at Novacap, explained how to tell if private equity is the right growth strategy for you.
- VC is for big-risk, big-reward opportunities. Growth capital is for retaining ownership. And private equity (PE) is for cashing out while seeking the “second bite.”
- Many PE firms want to collaborate with founders to grow the business for up to five years after the initial investment or acquisition.
- The best time to exit to PE is when the business is performing well but there are still opportunities for the next owner to grow.
Every founder hits an inflection point where the question is either to keep growing or find a way out. For those that want to keep growing, multiple choices exist—something that’s both comforting and confusing for a lot of founders.
VC, growth capital, and PE (oh my!)
When it comes to growing a company, founders have a few routes ahead of them. In the tech world, three of the most common routes are to take on venture capital, to fundraise growth capital, or to partially exit to private equity.
Here’s how Kristin describes the three options:
Venture capital (VC): this path is “big risk, big reward” for companies with a solution that has a huge scale opportunity but are generally in start-up mode. Kristin said venture investment is typically all primary equity, meaning it’s intended to bring additional cash into the company to fund growth activities that will eventually lead to a large exit or IPO. Rarely does venture capital include taking money off the table in the form of cashing out founders (referred to as secondary equity). Often times the equity invested is preferred, which means it has certain rights that put it ahead of the founder equity upon liquidation.
Growth capital: this path is typically intended to help an already-strong company grow to new heights, but generally represents a minority investment in the business. As the name suggests, this type of capital is primarily focused on growth activities often for businesses that are still burning cash. However, Kristin said on occasion some money can be used to partially cash out founders or other investors.
Private equity (PE): this path is all about what Kristin calls the “second bite,” meaning that private equity companies typically want to buy some of your company and work with you to grow toward another exit—the second bite—that is often a larger payout for all parties than the first exit. The PE route always includes some cashing out for existing shareholders and founders and the general expectation is that a “second bite” will happen within five years.
“When looking to grow, how you raise capital can be different,” said Kristin. “You need to understand the different paths in front of you.”
Choosing the right path for you
Guides exist on the keys to a successful exit or avoiding fundraising mistakes, but private equity can feel like a black box to many founders. Kristin said these are the questions founders should ask themselves to identify if PE is right for their business.
What do you need to continue growing? PE can be valuable if you also need mentorship or collaboration from a talent perspective since many firms bring high-value operators to their relationships. If your company simply needs capital but otherwise has the talent it needs to capture the next phase of growth, you might get along well with growth equity or a large VC round.
What’s your business model and current position? Private equity usually looks for businesses that are already strong and cash flow positive if not profitable. That means young pre-revenue startups are usually disqualified from PE until they’ve grown more, said Kristin. But if your business has growing revenues with the potential to grow further, PE could be a lucrative path.
What type of exit do you want? Working with PE means giving up partial, if not majority, control of your company. In return, the PE firm is expected to bring significant value to the table in terms of expertise, reach, or innovation, all driving toward that “second bite of the apple” to make it even more profitable than the first exit. This type of exit allows an entrepreneur to diversify their personal wealth away from one main asset, but this can be a tough transition, particularly for bootstrapped founders who are used to calling all the shots, therefore finding a true partner is key.
The biggest factor to be aware of when choosing PE is that collaboration is the norm. Kristin said while some PE firms might take on a majority stake and install their own team, most (including Novacap) prefer to collaborate with founders to roll some of their equity forward. So if you’re looking to exit completely, there are options in the PE world, but you need to be upfront about your needs.
Take some money off the table, but leave some, too
Kristin said that Novacap actively encourages founders to cash out some of their equity during the first exit. She explained that if all of your wealth is tied up in your company, you might feel differently about taking certain risks or pursuing aggressive growth, both things that are necessary to reach the “second bite.” But if you’ve taken money off the table to secure your family, lifestyle, or retirement, you will have a different mentality.
But even as you secure your own financial future, Kristin cautioned founders to make sure they are leaving some opportunity on the table as well. She explained that the best time to exit is not when the business has been exhausted but when it’s performing well and there’s a clear path to ongoing value creation. This will not only help with exit valuations but also ensure a productive collaboration between founders and future owners.
“You always want to ensure there’s a good opportunity for the next buyer to create value,” said Kristin. “Secure your own personal wealth, but keep some skin in the game.”