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4 Things To Look For When Funding Via Private Equity Firms
February 11, 2020
4 Things To Look For When Funding Via Private Equity Firms

4 Things To Look For When Funding Via Private Equity Firms

Whether it’s private equity, bridge financing, or a line of credit, how you fund your business will affect the entire organization. Therefore, regardless of how you choose to raise money, due diligence is an absolute necessity.

With private equity, it’s even more important, particularly if your deal gives your investors controlling shares of the business. In this way, looking for private equity isn’t just about obtaining funding. You’re essentially entering into a partnership when you take on private equity investors.

To help you get your bearings, we’ll outline four things you should look for when funding via private equity. First, though, a quick review. 

What is “Private Equity”?

Private equity is a share of ownership in a company that isn’t publicly owned, traded, or quoted on a stock exchange.

So, what is a private equity firm? Private equity firms are organizations that invest in privately-owned companies in exchange for an ownership share.

Although the concept of private equity is simple, it quickly gets far more complicated. Across, and even within, private equity companies, there are a wide variety of approaches to investing.

Some private equity companies may be focused on a particular niche within an industry. Others may be more open with a desire to invest money in a variety of industries. 

These companies also tend to have different investment philosophies. As a result, when you pursue funding, you may be approached with many different types of deals. 

For example, some companies may be looking for a place to park their money in exchange for an ownership interest. They might have a limited desire to be involved in company oversight.

On the other hand, you may run into private equity companies that take complete control of management. They may even provide staffing and administrative resources to help you. All this to say, private equity comes in many shapes and sizes.

How Does Private Equity Compare To Other Funding Options?

Fundamentally, the biggest differences between private equity and other funding options boil down to flexibility and ownership.

With any kind of debt financing, as long as you pay what you owe, you never give up shares of the company. Keep in mind, this is no small distinction. Giving up shares of your company means limiting your upside.

The more equity in your company you sell, the smaller your claim to profits is. That reduction in your share of profits can quickly outweigh any interest cost with traditional debt financing.

This is important to note because it shows what a large risk you’re taking when you fund your company with private equity. Too often, entrepreneurs overemphasize the risk of debt and underemphasize the risk of private equity. In fact, small mistakes in valuing your company can end up costing you millions.

All that said, the flexibility and creativity with which private equity enables you to fund your company is a game-changer.

For one, you won’t need to qualify in the same way you would for debt financing. More importantly, though, you can be much more flexible about deal structure.

This flexibility allows private equity firms to fund your business in a way that’s mutually beneficial.

What To Look For With Private Equity Processes

Even savvy entrepreneurs can be undone by private equity if they don’t enter the process with their eyes wide open.

Think about it; private equity investors are looking to buy low and sell high. When it comes down to it, that’s their core goal. If their plan doesn’t align with your business’s goals, there’s going to be problems.

However, if you get into a deal, there’s often very little you can do to get out. That’s why it’s so important to know what to look for with private equity processes.

1. Find An Investor Knowledgeable In Your Industry

As we mentioned, funding via private equity is like bringing on a new business partner. For you, the value of that partnership will depend on what it provides for you beyond money.

That’s why you want to find an investor that’s knowledgeable in your industry. Ideally, not only will your investor provide funds, but they’ll also provide expertise. 

In fact, the guidance and expertise you receive from quality private equity investors are part of what makes them so valuable. 

Of course, that’s only true if the investors are truly knowledgeable and can help intelligently guide your business.

When you’re searching for private equity, make sure you’re testing their knowledge. Ask them questions about other similar companies they’ve invested in. Find out where they think the industry is going and why your company is a good opportunity. Since you know your industry, it’ll become clear fairly quickly whether they have valuable expertise.

In addition, you also want to consider investors who may be knowledgeable in industries adjacent to yours. For example, if you need help with distribution, it’ll be valuable to bring on investors who are knowledgeable in that space. Plus, along with  their expertise, they’ll likely have relationships that you can tap into.

Find An Investor Knowledgeable In Your Industry

2. Scour Their Past Performance

It’s guaranteed that any private equity firm you work with will do their due diligence on you and your company, so you should be doing the same to them.

When evaluating firms, the New York Times suggests to:

  1. Run background checks
  2. Call their former clients
  3. Speak to members of corporate boards the firm works with

When it comes to doing your due diligence on private equity firms, the point isn’t to dig up dirt. You just want to get a full picture of the type of people you’re going to be dealing with. In other words, you don’t want any surprises. 

In addition, don’t be afraid to ask questions. You need to find out what and how they think about investing and business. Scouring their past will help you discover things you want to ask questions about.

For example, maybe a company they worked with ended up failing. Companies fail all the time for a variety of reasons, so that would be a topic you’d want to ask about.

This is a great way to weed out low-quality private equity investors. You’ll find that the best private equity people are open and willing to talk about their failures and successes.

3. Find Out If People Have Made External Investments In Them

When a person or organization has a track record of making good investments, people want to invest their money with them.

Obviously, as a potential investment yourself, you want to work with equity firms that make good investments. Their ability to increase the value of your business will determine what you get out of the relationship.

A good way to test this is to see if people have made investments in the private equity firm you’re evaluating. Although it’s not a guarantee, external investments are a good sign that you’re working with a proven firm. Not only that, the kinds of organizations or individuals invested in a private equity company will clue you into their investment style.

Typically, if a venture capital firm is backed by large, institutional investors, they’ll have a fairly narrow investment profile. Due to this, they may be more limited than other firms in terms of what types of deals they like to do.

Conversely, if the firm is backed by very wealthy individuals, they may be more flexible if the opportunity is big enough.

4. Don’t Discount Your Gut Instinct

So far, we’ve discussed the importance of conducting detailed due diligence and analysis. However, your gut instinct should play a role in your decision as well.

If you decide to move forward with private equity, they’ll become part of your business. While it’s not quite a marriage, it’s about as close as you can get. Therefore, you should feel confident in this decision before you make it.

Don’t feel pressured to work with someone just because they check all the right boxes. Your investors’ philosophy and outlook may be as (or more) important than the money they provide.

The truth is, investors are never going to care about your business the way you do. They operate to buy low and sell as high as possible in a given timeframe. While that doesn’t mean you can’t have a mutually beneficial business relationship, it’s worth keeping in mind. If your gut tells you that something doesn’t feel right, don’t do it.

You’ll have other options, and if even if you don’t right now, it’s better to keep working until you do. Even if that slows down growth temporarily, you’ll give yourself time to make the right decision.

Our Final Thoughts

Private equity isn’t for everyone. Then again, neither is any type of funding. It all depends on your business goals, personal preference, and your long term vision for your company. However, if you’re going to go the route of private equity, you must do so with eyes wide open.

Take your time, ask questions, and educate yourself on the process. Private equity can help you do great things, but only if you put the time and thought in to make it work for you. 

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Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.

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Fora Financial is a working capital provider to small business owners nationwide. In addition, the Fora Financial team provides educational information to the small business community through their blog, which covers topics such as business financing, marketing, technology, and much more. If you’d like to see a topic covered on the Fora Financial blog, or want to submit a guest post, please email us at [email protected].