Private equity companies have been deeply involved in a number of the biggest and most notable business deals of recent years, but while the activity appears to be primarily focused on the more prominent boutiques, the market leaders are actually much closer than many people think. In fact, a look at the portfolios of some of these biggest names reveals a common thread that has emerged through all of their activity – they are seeking out strong and underutilized tech companies. Tech companies are some of the least leveraged assets in the marketplace, and the high number of unprofitable businesses pursuing tech investments means that those companies will continue to draw substantial fees from investors looking for return on investment. As an effect, tech market leaders are also some of the most attractive business opportunities available to private equity investors.
There are a number of reasons why the gap between the value provided by the typical venture capital funding source and the real value provided by high end tech companies. First, the typical VC funding sources typically have an inflexible view of what counts as a viable business model in the marketplace. For example, some lenders may believe that it is necessary to purchase a large number of patents or sign large contracts in order to secure a strong business case for an IPO. While this may be true in the short term, there is no substitute for solid organic growth in core markets that have long-term potential.
Further, while venture capitalists generally seek out the best businesses that are generating strong sales growth, they tend to underrate the importance of management leadership in the face of market headwinds. This is because most successful venture capital firms rarely make money through the first few years of operations, as they tend to focus on generating a high return on equity (ROI) and making a lot of high quality investments. As a result, the pace at which these companies run through the start up phase is significantly less than their subsequent years of operation. In this light, it is not uncommon for private equity firms to provide early-stage funding that is insufficient to payoff a majority of their debt obligations.
Finally, the major companies in the private equity sector tend to focus on providing high returns to corporate borrowers. Unlike the more traditional business lenders who typically finance small businesses with traditional business loans, the venture capital financing source is primarily motivated by two things: a desire to earn a very large return on equity and a lack of negative implications for the company’s credit risk profile. As such, most private equity clients are able to obtain the type of credit facilities and interest rates that the larger banking institutions provide. While banks typically do not make aggressive loans to small businesses, they do place restrictions on the types of investments that they will provide and also limit the amount of debt that they will permit a company to issue. As a result, the typical private equity financing scenario does not involve banks acting as venture capitalists but as co-investing investors.
This absence of bank intervention makes the private equity sector a very attractive investment vehicle for both senior management and the most senior members of the board of directors. As noted earlier, because most private equity deals have only a limited number of potential buyers and because those buyers are usually wealthy individuals who have strong business experience, the companies seeking to raise capital are often able to attract and secure the attention of seasoned C-level executives with strong negotiating capabilities. Because senior management and the C-level executives whom they typically hire have expertise in financial matters, many of them are willing to enter into equity transactions that do not require them to provide a large upfront payment or to borrow huge amounts of cash from outside investors.
For inexperienced entrepreneurs, seeking out senior level investment companies to raise capital can be a very difficult and time consuming process. Typically, entrepreneurs are not aware of the options that they have available to them. The lack of direct involvement by the private equity company in the day-to-day operations of the organization can create difficulties when it comes to raising capital from third party investors. Often times, entrepreneurs need to raise capital in partnership with third party investors in order to bypass the difficult questions that need to be answered during the underwriting process.
In most instances, private equity deals will also involve significant negotiations between the buyer and seller as well as between the seller and buyer in order to determine the appropriate price for the equity transaction. Most importantly, it is not uncommon for borrowers to become deeply involved in the negotiations in order to ensure that they receive the best deal possible. Of course, if a company’s equity structure does not provide a high enough level of leverage for the borrower to successfully negotiate a satisfactory deal, they may not be able to obtain financing for their business venture. On the other hand, if a company is leveraged in such a way as to give them significant control over the sale, they may be able to successfully negotiate a sale with significant financing. The key is determining which circumstances are most likely to allow an entrepreneur access to the private equity capital that they are seeking in order to fund their business ventures.
In closing, it should be noted that there are a wide range of funding sources that can be used to facilitate the acquisition of equity financing for a business venture. Some common methods include angel investors, venture capitalists and traditional lenders such as commercial banks. However, as a general rule, entrepreneurs should not expect to immediately find and obtain any type of equity financing for their business unless they have developed a winning deal with a highly leveraged investor or organization. Additionally, an entrepreneur must possess the negotiating and business savvy required to effectively seek out these types of funding sources and to negotiate the best deal possible in a timely manner. If this does not happen, the entrepreneur may find themselves facing difficulties in obtaining the capital they need to launch their new venture.