Entrepreneurs seek partnerships with private equity (PE) firms for a variety of strategic reasons, primarily centered around accelerating growth and realizing value. Wondering if this avenue makes sense for you and your company? We gathered insights from two different private equity investors,Kristin Smith (Novacap) and Narbe Alexandrian (Define Capital) to answer some common questions founders might have.
Key takeaways:
- Understanding the difference between PE and other funding options like growth capital and venture capital, as well as evaluating different styles of PE firms, is an important first step.
- Clarifying your intentions and desired role as a founder post-transaction is key to structuring a deal that makes sense for both parties.
- Thinking about what you want your company to look like after selling is another consideration in bringing on the right PE partner.
There are a lot of factors to be aware of in bringing on a private equity (PE) partner. And as a founder, you probably have a lot of questions around whether (and how) to pursue that path. Two private equity investors, Kristin Smith (Principal at Novacap) and Narbe Alexandrian (Founder and CEO of Define Capital), shared some insights with us based on their extensive experience working with tech and software companies.
Today, we’re drawing on their expertise to answer some FAQs and offer advice around private equity for founders.
FAQ #1: How Does PE Differ from Other Growth or Exit Options?
“When looking to grow, how you raise capital can be different,” said Kristin. “You need to understand the different paths in front of you.” Here are three options she outlined:
Venture capital (VC): A “big risk, big reward” path for companies (generally startups) with a solution that has a huge scale opportunity. This typically comprises primary equity, i.e., additional cash intended to fund growth and a path towards a large exit or IPO. Often, the equity invested is preferred, meaning it has certain rights that put it ahead of founder equity upon liquidation.
Growth capital: Usually aimed at helping already-strong companies grow to new heights, but typically represents a minority investment in the business. Often, these businesses might still be burning cash. Occasionally, some of this money may be used to partially cash out founders or other investors.
Private equity (PE): With this route, Kristin outlines the usual play as the “second bite”: typically, PE companies want to buy some of your company and grow it with you toward another exit—the second bite—that is often a larger payout for all parties than the first exit. This option always includes some cashouts for existing shareholders and founders, with the general expectation being that this “second bite” will occur within five years.
That being said, not all PE firms operate in the same way. For example, Define Capital’s mandate is about offering founders a permanent home for their company rather than aiming at that “second bite.” So when considering options, it’s important to assess the long-term vision and goals for both the company and the founder. Which brings us to our next question…
FAQ #2: How Do I Assess If a PE Partner Is a Good Fit?
Deciding which firm is the right next home for your company requires an understanding of how the acquirer operates, and what they are planning to do with your organization after they acquire it. For example, Narbe’s firm, Define Capital, takes a “permanent capital” approach that aims to preserve the legacy of small and mid-market businesses, but not all firms have the same intent. Aligning on a shared vision, values, and growth goals are all important to ensure that you’re dealing with the right type of partner.
The amount of involvement from a PE partner often surprises founders. Kristin advises that while working with PE entails giving up partial, if not majority, control of your company, the process is also highly collaborative and most PE firms prefer to work with founders to roll some of their equity forward. For bootstrapped founders who are used to calling all the shots, this can be tough to get used to, so finding a true partner is key.
However, from the PE side, the expectation is to offer significant value in terms of expertise, reach, or innovation, driving toward that “second bite of the apple” to make it even more profitable than the first exit. As such, evaluating their specific industry or vertical experience is crucial.
FAQ #3: Is PE Right for My Company Right Now?
Kristin shared these two questions for founders to ask themselves to assess whether PE is the right fit for their business.
“What’s our business model and current position?” PE investors typically look for businesses that are already strong and cash flow positive (if not profitable) with high growth potential. So if you’re pre-revenue, you might not qualify until you’ve grown a bit more.
“What do we need to continue growing?” Many PE firms bring high-value operators to the table, so PE can be valuable if you need mentorship or collaboration from a talent perspective. But if you simply need capital and are confident in your ability to leverage it towards the next phase of growth, growth equity or a VC round might be a better fit.
FAQ #4: Does PE Make Sense for Me Personally Right Now?
Reflecting on your own goals, financial situation, and next steps as a founder is another important part of the picture.
Narbe advises considering the following as a founder:
- Personal finances: A business sale will not only incur taxes, but also remove a future income stream. It’s important to plan for how you will pay for your lifestyle, for example, with dividend-paying investments (which carry different tax rules than earned income), and deal with certain expenses (which you will no longer be able to run through your corporation).
- Seller readiness: A business is a significant part of a founder’s life, and typically a big source of pride as well. Founders have “gone through trials and tribulations,” said Narbe. “They’ve sacrificed missing their kid’s hockey games and soccer games, and instead staying at work to fix something for a customer.” He advises founders to “make sure that they actually want to go down this path,” and that “it’s something that they’re comfortable with.” If not, he suggests thinking about the balance of cash off the table and level of involvement they might be looking for.
Kristin offers another approach: At Novacap, they encourage founders to cash out some of their equity during the first exit, explaining that if all of their wealth is tied up in the company, it might impact the way they feel about taking certain risks or pursuing aggressive growth, which are both necessary to reach the “second bite.” But if they’ve secured the money they need to support family, lifestyle, or retirement, they are likely to have a different mentality.
At the same time, she advises balancing this security with opportunity, explaining that the best time for an exit is actually when a business is performing strongly and there’s a clear path to ongoing value creation. This simultaneously helps with exit valuations and creates a productive collaboration between founders and future owners.
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