A Guide to Private Equity PDF

xxxxx A Guide to Private Equity A Guide to Private Equity 1 xxxxx 2 A Guide to Private Equity BVCA mission statement THE BVCA is the industry body and public policy advocate for private equity and venture capital in the UK, an industry that accounts for almost 60% of the European market. With a membership of over 450 members, the BVCA represents an overwhelming majority of UK-based private equity and venture capital firms and their advisers – from venture capital, through mid-market, to private equity/large buy-out houses. For over 26 years, the BVCA’s voice has been one of authority when speaking for, or negotiating on behalf of, the UK industry to a wide range of key stakeholders: government, the European Commission and Parliament, media and statutory bodies at home, across Europe and globally. We also promote our members’ services to entrepreneurs and investors, as well as providing valuable research, training and networking opportunities to our members. All members of the BVCA are listed in our annual ‘Directory of Members’. Other publications include reports and analysis produced by our Research team, such as the annual Performance Measurement Survey and the Report on Investment Activity. All publications are available on the BVCA website: www.bvca.co.uk A Guide to Private Equity 1 Private Equity – investing in Britain’s future Each year UK private equity firms provide billions of pounds to form, develop and reshape over 1,600 ambitious UK companies with high growth prospects. Private equity makes managers into owners, giving them the freedom, focus and finance to enable them to revitalise their companies and take them onto their next phase of growth. Private equity is committed, long-term and risk sharing. It provides companies with the personal experience of the investors and a stable financial base on which to make strategic decisions. UK private equity firms offer a wide range of sources, types and styles of private equity to meet many different needs. A great variety of businesses in different industry sectors benefit from private equity; including those operating in the high technology, industrial, healthcare, consumer services, financial and other sectors, and in different development stages from start-up to large established companies. 2 A Guide to Private Equity Preface The BVCA is the industry body and public policy advocate for the private equity and venture capital industry in the UK. With a membership of over 450 firms, the BVCA represents the vast majority of all UK-based private equity and venture capital firms and their advisors. “A Guide to Private Equity” is a key component in the range of BVCA publications. For further details about other BVCA publications and research see the Appendix on page 50 or the BVCA’s website www.bvca.co.uk Keith Arundale, formerly with PricewaterhouseCoopers LLP and now a university lecturer and independent adviser, suggested that the BVCA should have a guide to private equity which demystified the investment process - so he was duly asked to write it! The first Guide was published in 1992 and since then many tens of thousands of copies have been sent out or downloaded from the BVCA’s website. This new edition has again been updated by Keith, including the section on government sources of finance and new sections on specific considerations relating to venture capital and management buyout deals, term sheets and the working relationship between a private equity investor and management team. I would like to thank Keith for initiating the Guide and for his continuing help over the years. I would also like to thank the BVCA Executive for the production of another excellent Guide. Simon Havers BVCA Chairman February 2010 A Guide to Private Equity 3 Contents BVCA mission statement 1 Private equity – investing in Britain’s future 2 Preface 3 An introduction to private equity 6 Definition 6 How this Guide can help you 6 What is private equity? 7 Would my company be attractive to a private equity investor? 7 Some of the benefits of private equity 7 Questions to ask yourself before reading further 7 Internal and external financial resources 8 Government sources of finance for SMEs and growing businesses in the UK 8 Business angels 11 Corporate venturing 11 Investment forums and networking organisations 11 Well-know private equity backed companies 12 The advantages of private equity over senior debt 12 Private equity compared to senior debt 13 Sources of private equity 14 Private equity firms 14 Where do private equity firms obtain the money to invest in my business? 14 How may the source of a private equity firm’s money affect me? 14 How do I select the right private equity firm? 15 Selecting a private equity firm 16 Targeting 16 Stage / type of investment 16 Industry sector 17 Amount of investment 17 Geographical location 18 The business plan 19 Essential areas to cover in your business plan 19 - The market 20 - The product or service 21 - The management team 22 - Business operations 22 - Financial projections 23 - Amount and use of finance required and exit opportunities 24 The presentation of your business plan 24 Things to avoid 25 4 A Guide to Private Equity Contents The investment process 26 Reaching your audience 26 Confidentiality 26 How quickly should I receive a response? 26 How do private equity firms evaluate a business plan? 26 Presenting your business plan and negotiations 27 Valuing the business 27 Personal financial commitment 29 Types of financing structure 29 Classes of capital used by private equity firms 29 Other forms of finance provided in addition to equity 30 Additional points to be considered 30 Specific considerations relating to venture capital and management buyout deals 31 - How a venture capitalist arrives at his required equity stake 31 - Use of preference shares in structuring a venture capital deal 31 - Management buyouts 32 The Offer Letter (Term Sheet) 34 The due diligence process 37 Syndication 38 Completion 38 Additional private equity definitions 38 The role of professional advisers 40 The financial adviser’s role 40 The accountant’s role 40 The lawyer’s role 41 Professional costs 42 Your relationship with your investor 43 Private equity for growth and success 43 Hands-on approach 43 Hands-off approach 44 Help to avoid the pitfalls 44 Tips for working with your private equity investor 44 Directors’ responsibilities 45 Guidelines for success 45 Realising the investment 46 The options 46 Valuing the investment on exit 47 Before you do anything – read this! 48 Legal and regulatory issues you must comply with in raising finance 48 The Financial Services and Markets Act 48 Misleading statements 49 Appendix – further information 50 Contact details 50 BVCA publications and research 51 Other useful contacts 52 A Guide to Private Equity 5 An introduction to private equity Definition Private equity is medium to long-term finance provided in return for an equity stake in potentially high growth unquoted companies. Some commentators use the term “private equity” to refer only to the buy-out and buy-in investment sector. Some others, in Europe but not the USA, use the term “venture capital” to cover all stages, i.e. synonymous with “private equity”. In the USA “venture capital” refers only to investments in early stage and expanding companies. To avoid confusion, the term “private equity” is used throughout this Guide to describe the industry as a whole, encompassing both “venture capital” (the seed to expansion stages of investment) and management buy-outs and buy-ins. How this Guide can help you This Guide aims to encourage you to approach a source of private equity early in your search for finance. It explains how the private equity process works and what you need to do to improve your chances of raising it. It gives guidance on what should be included in your business plan, which is a vital tool in your search for funding. It also demonstrates the positive advantages that private equity will bring to your business. The main sources of private equity in the UK are the private equity firms (who may invest at all stages – venture capital and buy-outs) and “business angels” (private individuals who provide smaller amounts of finance at an earlier stage than many private equity firms are able to invest). In this Guide we principally focus on private equity firms. The attributes that both private equity firms and business angels look for in potential investee companies are often very similar and so this Guide should help entrepreneurs and their advisers looking for private equity from both these sources. “Corporate venturers” which are industrial or service companies that provide funds and/ or a partnering relationship to fledgling companies and may operate in the same industry sector as your business can also provide equity capital. Throughout the 1990s the technology hype, internet boom and massive capital investment propelled the New Economy revolution, but internet mania in the late 1990s caused technology stocks to skyrocket until the bubble burst in the year 2000. There was over-optimism, too much easy money, proven ways of doing business were replaced by irrational exuberance and private and public company market valuations were driven to unsustainable levels. The mid 2000’s saw a substantial increase in the later stages of private equity transactions with large and mega buyouts fuelled by significant amounts of debt. With the onset of the credit crunch in 2007/8 and the reduction in the general availability of bank loans, and tightening of the conditions required to obtain loan finance, there is considerably less debt available for deals in the current economic environment. Banks are reluctant to lend, particularly if they have not had the experience of going through a downturn in the leveraged, high risk market before. There is however currently no shortage of private equity funds for investment in the UK. Private equity deals going forward are likely to involve much less leverage, and therefore perceived lower risk for the banks. Excellent opportunities remain open to companies seeking private equity with convincing business proposals. Private equity firms are looking for investment opportunities where the business has proven potential for realistic growth in an expanding market, backed up by a well researched and documented business plan and an experienced management team – ideally including individuals who have started and run a successful business before. This Guide will help you to understand what private equity firms are looking for in a potential business investment and how to approach them. 6 A Guide to Private Equity An introduction to private equity What is private equity? Private equity provides long-term, committed share capital, to help unquoted companies grow and succeed. If you are looking to start up, expand, buy into a business, buy out a division of your parent company, turnaround or revitalise a company, private equity could help you to do this. Obtaining private equity is very different from raising debt or a loan from a lender, such as a bank. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of your success or failure. Private equity is invested in exchange for a stake in your company and, as shareholders, the investors’ returns are dependent on the growth and profitability of your business. Private equity in the UK originated in the late 18th century, when entrepreneurs found wealthy individuals to back their projects on an ad hoc basis. This informal method of financing became an industry in the late 1970s and early 1980s when a number of private equity firms were founded. Private equity is now a recognised asset class. There are over 250 active UK private equity firms, which provide several billions of pounds each year to unquoted companies. Would my company be attractive to a private equity investor? Many small companies are “life-style” businesses whose main purpose is to provide a good standard of living and job satisfaction for their owners. These businesses are not generally suitable for private equity investment, as they are unlikely to provide the potential financial returns to make them of interest to an external investor. “Entrepreneurial” businesses can be distinguished from others by their aspirations and potential for growth, rather than by their current size. Such businesses are aiming to grow rapidly to a significant size. As a rule of thumb, unless a business can offer the prospect of significant turnover growth within five years, it is unlikely to be of interest to a private equity firm. Private equity investors are only interested in companies with high growth prospects, which are managed by experienced and ambitious teams who are capable of turning their business plan into reality. However, provided there is real growth potential the private equity industry is interested in all stages, from start-up to buy-out. Some of the benefits of private equity Private equity backed companies have been shown to grow faster than other types of companies. This is made possible by the provision of a combination of capital and experienced personal input from private equity executives, which sets it apart from other forms of finance. Private equity can help you achieve your ambitions for your company and provide a stable base for strategic decision making. The private equity firms will seek to increase a company’s value to its owners, without taking day-to-day management control. Although you may have a smaller “slice of cake”, within a few years your “slice” should be worth considerably more than the whole “cake” was to you before. Private equity firms often work in conjunction with other providers of finance and may be able to help you to put a total funding package together for your business. Questions to ask yourself before reading further Does your company have high growth prospects and are you and your team ambitious to grow your company rapidly? Does your company have a product or service with a competitive edge or unique selling point (USP)? Do you and/or your management team have relevant industry sector experience? Do you have a clear team leader and a team with complementary areas of expertise, such as management, marketing, finance, etc? Are you willing to sell some of your company’s shares to a private equity investor? If your answers are “yes”, private equity is worth considering. A Guide to Private Equity 7 An introduction to private equity Internal and external financial resources Before looking at new external sources of finance, make sure you are making optimal use of your internal financial resources. Ensure that you have good cash flow forecasting systems in place Give customers incentives to encourage prompt payment Adhere to rigorous credit control procedures Plan payments to suppliers Maximise sales revenues Carefully control overheads Consider sub-contracting to reduce initial capital requirements (if appropriate) Assess inventory levels (if appropriate) Check quality control Then think about the external options. Your own and your co-directors’ funds Friends’ or business associates’ funds The clearing banks – overdrafts, short or medium-term loans Factoring and invoice discounting Leasing, hire purchase Investment banks – medium to long-term larger loans Public sector grants, loans, regional assistance and advice Business angel finance Corporate venturing Private equity But please don’t get the impression that private equity is a last resort after you have exhausted your own, your friends’, your business colleagues’ and your bank’s resources. There are many advantages to private equity over bank debt. Private equity firms can of course work in conjunction with the other external sources as part of an overall financing package. Some of the alternative sources of external finance are elaborated on below for your information. These may particularly apply if you are looking for finance at the lower end of the so-called ‘equity gap’, say up to £250,000 or £500,000. The ‘equity gap’ is widely regarded as being between £250,000 and £2 million where it can be difficult to secure venture capital finance simply because of the amount of time and effort required to appraise an investment proposition by a venture capital firm. For smaller amounts of finance it is not simply worth their while, unless there will be further financing rounds required later. More recently the UK has addressed the range of financing towards the upper end of the equity gap with the Enterprise Capital Funds (ECFs) – see below – that can provide up to £2 million of financing. Government sources of finance for SMEs and growing businesses in the UK These include the following: Enterprise Finance Guarantee (EFG) The Enterprise Finance Guarantee (EFG) replaced the Small Firms Loan Guarantee Scheme (SFLG) and provides loans from £1,000 up to £1 million, repayable over 10 years, compared to an upper limit of £250,000 for the SFLG, and supports businesses with a turnover of up to £25 million, compared to £5.6 million under SFLG. The EFG can be used to support new loans, refinance existing loans or to convert part or all of an existing overdraft into a loan to release capacity to meet working capital needs. The Government will guarantee 75% of the loan. EFG is available to viable businesses that in normal circumstances would be able to secure lending from banks but who cannot secure bank lending in the current times. Most businesses in most sectors are eligible for the scheme. However, the state aid rules exclude businesses in the agriculture, coal and steel sectors. 8 A Guide to Private Equity An introduction to private equity Regional Venture Capital Funds (RVCFs) The Regional Venture Capital Funds (RVCFs) were set up to address small to medium enterprises (SMEs) seeking relatively small-scale investment of up to £500,000 (subsequently raised to £660,000). The RVCFs operate on a regional basis with the objective of testing whether returns can be earned from having regionally focused investment teams targeting equity gap investment. The funds cover the North East, North West, London, Yorkshire and the Humber, South East and South West, East Midlands, West Midlands and East of England regions of the UK. The last RVCF ceased making new investments in December 2008 but the funds are still able to support existing portfolio businesses. The Enterprise Capital Fund (ECF) programme has now superseded the RVCFs. Enterprise Capital Funds (ECFs) Enterprise Capital Funds (ECFs) are a UK government initiative aimed at bridging the equity gap by improving access to growth capital for small and medium-sized enterprises by applying a modified US Small Business Investment Company (SBIC) model to the UK, a difference being that with the UK scheme the government has downside protection with a priority return of 4.5% per annum plus a minor profit share. ECFs are privately managed and use a limited partnership model with two variants: a professional FSA authorised fund manager who acts on behalf of passive investors an active investor model (e.g. business angels) who invest and manage their own funds through ECFs (maybe without FSA authorisation). There are now eight ECFs in operation and a further fund was recently awarded ECF status. Responsibility for the management of ECFs was transferred to Capital for Enterprise Limited (CfEL) in 2008. ECFs receive their funding from the UK government and private sources. There is no maximum fund size for an ECF, but the government will commit no more than £25 million to a single fund or no more than twice the private capital, whichever is lower. Equity investments of up to £2 million per deal can be made but to avoid the problems of dilution experienced by many early stage investors ECFs are allowed to invest more than £2 million in a single company if not to do so as part of a subsequent funding round would dilute their exiting stake in the company. To access support from an Enterprise Capital Fund contact your local Business Link or contact the relevant fund manager. The eight currently operational ECFs are: IQ Capital Fund 21st Century Sustainable Technology Growth Fund The Seraphim Capital Fund The Amadeus Enterprise Fund The Catapult Growth Fund Dawn Capital ECF Oxford Technology Management ECF MMC Venture Managers. CfEL also has responsibility for the Enterprise Finance Guarantee scheme (above) and includes a number of funds in its portfolio, additional to the ECFs. These include: Capital for Enterprise Fund (CFE) (mezzanine debt and equity support for established growth businesses across the UK) Aspire Fund (targeting women led businesses across the UK) Bridges Social Entrepreneurs Fund and the Bridges Sustainable Property Fund (specific strategies to achieve a positive social and/or environmental impact). Early Growth Funds (below). A Guide to Private Equity 9 An introduction to private equity Early Growth Funds Early growth funds are regional and national funds provided through the Small Business Service (SBS). They can provide up to £100,000 for innovative and knowledge-intensive start-up and early-stage businesses as well as other growth businesses. In most cases they must be matched by at least the same amount of private sector investment. Grants for Business Investment (GBI) Grants for Business Investment (GBI) (formerly known as Selective Finance for Investment in England or SFIE grants) are discretionary grants available from Government through the Department for Business, Innovation & Skills (BIS) to support businesses with investment projects which will increase productivity, skills and employment in deprived areas in England. The GBI grants are managed by the Regional Development Agencies. SFIE itself replaced the former Regional Selective Assistance Scheme. The scheme is designed for businesses that are looking at the possibility of investing in an area of high deprivation but need financial help to go ahead. It is awarded as a percentage of eligible project expenditure and is provided as a grant towards capital costs such as fixed assets, land, property and machinery. Grants can be used for start-ups, modernising through introducing technological improvements, expanding an existing business, or taking a new product /service/ process from the development stage to production. The amount of support you will be awarded will depend on the specific needs of your project, the quality of the project and its impact on productivity and skills. The project must create new jobs or safeguard existing employment if seeking support of £100,000 or more. University Challenge Seed Fund Scheme The aim of the Government’s University Challenge Seed Fund Scheme is to fill a funding gap in the UK in the provision of finance for bringing university research initiatives in science and engineering to the point where their commercial viability can be demonstrated. Certain charities and the government have contributed around £60 million to the scheme. These funds are divided into 19 University Challenge Seed Funds that have been donated to individual universities or consortia and each one of these has to provide 25% of the total fund from its own resources. If you are looking into the commercialisation of research at a UK university which is in receipt of a fund, contact your university administration to enquire about the application process. Follow-on finance may be provided by business angels, corporate venturers and private equity firms. Grants for Research & Develpment Grants for Research & Development (previously the DTI ‘Smart’ scheme) aim to help start-ups and SMEs carry out research and development work on technologically innovative products and processes. They are administered by the nine English Regional Development Agencies. There are four different types of research and development project that a grant can be awarded for with grants varying from up to a maximum of £20,000 to up to a maximum of £500,000. UK Innovation Investment Fund (UKIIF) The Government is in the process of setting up a venture capital-based £150 million Innovation Investment Fund as a vehicle to encourage growing small businesses, start-ups and spin-outs in high- tech businesses. The new scheme will invest alongside private sector investment on a pari-passu basis; it is the Government’s belief that this could leverage enough private investment to build a fund of up to £1 billion over the next 10 years. Two fund of funds managers have recently been appointed to operate the scheme with responsibility for ensuring that investment is directed at companies with “strong survival and growth prospects”. Individual fund managers will be told to target the “sectors of the future” – businesses in the life sciences, low-carbon, digital and advanced manufacturing businesses, in the search for worthwhile investments. It is hoped that the fund of funds approach will avoid competing with other public sector investment initiatives such as the Enterprise Capital Funds. 10 A Guide to Private Equity An introduction to private equity Enterprise Investment Scheme The Enterprise Investment Scheme which was set up by the UK government to replace the Business Expansion Scheme (BES) and to encourage business angels to invest in certain types of smaller unquoted UK companies. If a company meets the EIS criteria (See http://www.hmrc.gov.uk/eis/), it may be more attractive to business angels, as tax incentives are available on their investments. Under the Enterprise Investment Scheme, individuals not previously connected with a qualifying unlisted trading company (including shares traded on the Alternative Investment Market (AIM)) can make investments of up to £500,000 in a single tax year and receive tax relief at 20 % on new subscriptions for ordinary shares in the company, and relief from CGT on disposal, provided the investment is held for three years. Venture Capital Trusts (VCTs) Venture Capital Trusts (VCTs) which are quoted vehicles to encourage investment in smaller unlisted (unquoted and AIM quoted) UK companies. Investors receive 30% income tax relief on VCT investment on a maximum investment amount of £200,000 in each tax year provided the investment is held for five years. Shares in VCTs acquired within the annual limit are also exempt from capital gains tax on disposal at any time. For further information on the above UK government grants and others available visit the website of the Business Links at www.businesslink.gov.uk. In addition to providing advice on the various grants available to SMEs and growth companies the Business Links provide advice, help and an entry point to the various schemes run by the Department for Business, Innovation and Skills (BIS). New businesses (particularly those using new technology) can get help with premises and management from the various Business Incubation Centres in the UK or from one of the UK Science Parks. You may also be eligible for EU grants if you are in an innovative business sector or are planning to operate in a deprived area of the UK or a region zoned for regeneration. Apart from Business Links your local Chamber of Commerce and town hall should have lists of grants and available property. Business angels Business angels are private investors who invest directly in private companies in return for an equity stake and perhaps a seat on the company’s board. Research has shown that business angels generally invest smaller amounts of private equity in earlier stage companies compared with private equity firms. They typically invest between £20,000 and £200,000 at the seed, start-up and early stages of company development, or they may invest more than this as members of syndicates, possibly up to £1.5 million. Business angels will usually want a “hands-on” role with the company that they invest in, maybe as an adviser and/or a non-executive director or they may even take on an executive role. Many companies find business angels through informal contacts, but for others, finding a business angel may be more difficult, as the details of individual business angels are not always available. The British Business Angels Association (BBAA) lists its members on its website (www.bbaa.org.uk) so this is a good place to start to help you find business angel investor networks in the UK. Corporate venturing Corporate venturing has developed quite rapidly, albeit sporadically, in recent years but still represents only a small fraction when compared to private equity investment activity. Direct corporate venturing occurs where a corporation takes a direct minority stake in an unquoted company. Indirect corporate venturing is where a corporation invests in private equity funds managed by an independent private equity firm. Corporate venturers raise their funds from their parent organisations and/or from external sources. A Guide to Private Equity 11 An introduction to private equity Investment forums and networking organisations In addition to business angel networks you can also find angel investors (and venture capitalists) at various investment forums that are organized in the UK. Typically at these events entrepreneurs seeking capital get to present their propositions to an audience of VCs, angels, corporate investors and advisors. Presenters have around 10 to 15 minutes to make their presentation (a sort of extended ‘elevator pitch’). Depending on the prestige and size of the event there may be a selection process to decide which companies get to make presentations and payment may or may not be required. Some of these events are put on by the larger conference organizers, others are organized by universities and business schools and networking clubs. Usually, in addition to the company presentations, there will be one or more plenary sessions from invited guest speakers, including successful entrepreneurs on topical issues. Do speak to friends, business contacts and advisers as well as your local Business Link. Do remember there are many misconceptions about the various sources of finance, so obtain as much information as possible to ensure that you can realistically assess the most suitable finance for your needs and your company’s success. Well-known private equity backed companies Agent Provocateur Alliance Boots Autonomy Birds Eye Iglo Cambridge Silicon Radio CenterParcs Earls Court & Olympia Findus Group (Foodvest) Fitness First Jimmy Choo Merlin Entertainments Group Moto National Car Parks New Look Odeon & UCI Cinemas Phones4U Pizza Express/Zizzi/Ask – Gondola Group Plastic Logic Poundland Pret A Manger The AA/Saga Travelex Travelodge UCI Cinemas/Odeon Cinemas Weetabix West Cornwall Pasty Co. The advantages of private equity over senior debt A provider of debt (generally a bank) is rewarded by interest and capital repayment of the loan and it is usually secured either on business assets or your own personal assets, such as your home. As a last resort, if the company defaults on its repayments, the lender can put your business into receivership, which may lead to the liquidation of any assets. A bank may in extreme circumstances even bankrupt you, if you have given personal guarantees. Debt which is secured in this way and which has a higher priority for repayment than that of general unsecured creditors is referred to as “senior debt”. 12 A Guide to Private Equity An introduction to private equity By contrast, private equity is not secured on any assets although part of the non-equity funding package provided by the private equity firm may seek some security. The private equity firm, therefore, often faces the risk of failure just like the other shareholders. The private equity firm is an equity business partner and is rewarded by the company’s success, generally achieving its principal return through realising a capital gain through an “exit” which may include: Selling their shares back to the management Selling the shares to another investor (such as another private equity firm) A trade sale (the sale of a company shares to another company) The company achieving a stock market listing. Although private equity is generally provided as part of a financing package, to simplify comparison we compare private equity with senior debt. Private equity compared to senior debt Medium to long-term. Short to long-term. Committed until “exit”. Not likely to be committed if the safety of the loan is threatened. Overdrafts are payable on demand; loan facilities can be payable on demand if the covenants are not met. Provides a solid, flexible, capital base to meet A useful source of finance if the debt to equity your future growth and development plans. ratio is conservatively balanced and the company has good cash flow. Good for cash flow, as capital repayment, Requires regular good cash flow to service dividend and interest costs (if relevant) are interest and capital repayments. tailored to the company’s needs and to what it can afford. The returns to the private equity investor depend Depends on the company continuing to service on the business’ growth and success. The its interest costs and to maintain the value of the more successful the company is, the better the assets on which the debt is secured. returns all investors will receive. If the business fails, private equity investors will If the business fails, the lender generally has first rank alongside other shareholders, after the call on the company’s assets. banks and other lenders, and stand to lose their investment. If the business runs into difficulties, the private If the business appears likely to fail, the lender equity firm will work hard to ensure that the could put your business into receivership in company is turned around. order to safeguard its loan, and could make you personally bankrupt if personal guarantees have been given. A true business partner, sharing in your risks and Assistance available varies considerably. rewards, with practical advice and expertise (as required) to assist your business success. A Guide to Private Equity 13 Sources of private equity There is a wide range of types and styles of private equity available in the UK. The primary sources are private equity firms who may provide finance at all investment stages and business angels who focus on the start-up and early stages. In targeting prospective sources of finance and business partners, as in any field, it works best if you know something about how they operate, their structure, and their preferences. Private equity firms Private equity firms usually look to retain their investment for between three and seven years or more. They have a range of investment preferences and/or type of financing required. It is important that you only approach those private equity firms whose preferences match your requirements. Where do private equity firms obtain the money to invest in my business? Just as you and your management team are competing for finance, so are private equity firms, as they raise their funds from a number of different sources. To obtain their funds, private equity firms have to demonstrate a good track record and the prospect of producing returns greater than can be achieved through fixed interest or quoted equity investments. Most UK private equity firms raise their funds for investment from external sources, mainly institutional investors, such as pension funds and insurance companies, and are known as independents. Private equity firms that obtain their funds mainly from their parent organisation are known as captives. Increasingly, former captives now raise funds from external sources as well and are known as semi-captives. These different terms for private equity firms now overlap considerably and so are increasingly rarely used. How may the source of a private equity firm’s money affect me? Private equity firms’ investment preferences may be affected by the source of their funds. Many funds raised from external sources are structured as limited partnerships and usually have a fixed life of 10 years. Within this period the funds invest the money committed to them and by the end of the 10 years they will have had to return the investors’ original money, plus any additional returns made. This generally requires the investments to be sold, or to be in the form of quoted shares, before the end of the fund. Some funds are structured as quoted private equity investment trusts, listed on the London Stock Exchange and other major European stock markets (see www.lpeq.com for more information), and as they have no fixed lifespan, they may be able to offer companies a longer investment horizon. Venture Capital Trusts (VCTs) (see above) are quoted vehicles that aim to encourage investment in smaller unlisted (unquoted and AIM quoted) UK companies by offering private investors tax incentives in return for a five-year investment commitment. If funds are obtained from a VCT, there may be some restrictions regarding the company’s future development within the first few years. 14 A Guide to Private Equity Sources of private equity How do I select the right private equity firm? Some private equity firms manage a range of funds (as described above) including investment trusts, limited partnerships and venture capital trusts, and the firms’ investment preferences are listed in the BVCA Directory of members. A fully searchable version of the Directory is available to those seeking private equity investment on www.bvca.co.uk. It lists private equity firms, their investment preferences and contact details. It also lists financial organisations, such as mezzanine firms, fund of funds managers and professional advisers, such as accountants and lawyers, who are experienced in the private equity field. Your advisers may be able to introduce you to their private equity contacts and assist you in selecting the right private equity firm. If they do not have suitable contacts or cannot assist you in seeking private equity, obtain a copy of the Directory and refer to the professional advisers listed in the “Associate Members” section. As far as a company looking to raise private equity is concerned, only those whose investment preferences match your requirements should be approached. Private equity firms appreciate it when they are obviously targeted after careful consideration. You may find it interesting to obtain a copy of the BVCA’s Report on Investment Activity which analyses the aggregate annual investment activity of the UK private equity industry. It looks at the number of companies backed and the amounts they received by stage, industry sector and region. The next chapter will take you through the selection process in more detail. A Guide to Private Equity 15 Selecting a private equity firm Firstly, decide whether or not to hire an adviser (see the section on ‘The role of professional advisers’). Targeting The most effective way of raising private equity is to select just a few private equity firms to target with your business proposition. The key considerations should be to assess: 1. The stage of your company’s development or the type of private equity investment required. 2. The industry sector in which your business operates. 3. The amount of finance your company needs. 4. The geographical location of your business operations. You should select only those private equity firms whose investment preferences match these attributes. The BVCA Directory of members specifies their investment preferences and contact details. It also includes the names of some of the companies in which they have invested. 1. Stage/type of investment The terms that most private equity firms use to define the stage of a company’s development are determined by the purpose for which the financing is required. Seed To allow a business concept to be developed, perhaps involving the production of a business plan, prototypes and additional research, prior to bringing a product to market and commencing large-scale manufacturing. Only a few seed financings are undertaken each year by private equity firms. Many seed financings are too small and require too much hands-on support from the private equity firm to make them economically viable as investments. There are, however, some specialist private equity firms which are worth approaching, subject to the company meeting their other investment preferences. Business angel capital should also be considered, as with a business angel on a company’s board, it may be more attractive to private equity firms when later stage funds are required. Start-up To develop the company’s products and fund their initial marketing. Companies may be in the process of being set up or may have been trading for a short time, but not have sold their product commercially. Although many start-ups are typically smaller companies, there is an increasing number of multi- million pound start-ups. Several BVCA members will consider high quality and generally larger start-up propositions as well as investing in the later stages. However, there are those who specialise in the start- up stage, subject to the company seeking investment meeting the firm’s other investment preferences. Other early stage To initiate commercial manufacturing and sales in companies that have completed the product development stage, but may not yet be generating profits. This is a stage that has been attracting an increasing amount of private equity over the past few years. Expansion To grow and expand an established company. For example, to finance increased production capacity, product development, marketing and to provide additional working capital. Also known as “development” or “growth” capital. 16 A Guide to Private Equity Selecting a private equity firm Management buy-out (MBO) To enable the current operating management and investors to acquire or to purchase a significant shareholding in the product line or business they manage. MBOs range from the acquisition of relatively small formerly family owned businesses to well over £100 million buy-outs. The amounts concerned tend to be larger than other types of financing, as they involve the acquisition of an entire business. Management buy-in (MBI) To enable a manager or group of managers from outside a company to buy into it. Buy-in management buy-out (BIMBO) To enable a company’s management to acquire the business they manage with the assistance of some incoming management. Institutional buy-out (IBO) To enable a private equity firm to acquire a company, following which the incumbent and/or incoming management will be given or acquire a stake in the business. This is a relatively new term and is an increasingly used method of buy-out. It is a method often preferred by vendors, as it reduces the number of parties with whom they have to negotiate. Secondary purchase When a private equity firm acquires existing shares in a company from another private equity firm or from another shareholder or shareholders. Replacement equity To allow existing non-private equity investors to buy back or redeem part, or all, of another investor’s shareholding. Rescue/turnaround To finance a company in difficulties or to rescue it from receivership. Refinancing bank debt To reduce a company’s level of gearing. Bridge financing Short-term private equity funding provided to a company generally planning to float within a year. For recent information on the actual amounts invested at each stage of investment, see the “BVCA Report on Investment Activity”, available at: http://www.bvca.co.uk/Research 2. Industry sector Most private equity firms will consider investing in a range of industry sectors – if your requirements meet their other investment preferences. Some firms specialise in specific industry sectors, such as biotechnology, computer related, clean tech and other technology areas. Others may actively avoid sectors such as property or film production. 3. Amount of investment The majority of UK private equity firms’ financings each year are for amounts of well over £100,000 per company. There are, however, a number of private equity firms who will consider investing amounts of private equity under £100,000 and these tend to include specialist and regionally orientated firms. Companies initially seeking smaller amounts of private equity are more attractive to private equity firms if there is an opportunity for further rounds of private equity investment later on. A Guide to Private Equity 17 Selecting a private equity firm The process for investment is similar, whether the amount of capital required is £100,000 or £10 million or more, in terms of the amount of time and effort private equity firms have to spend in appraising the business proposal prior to investment. This makes the medium to larger-sized investments more attractive for private equity investment, as the total size of the return (rather than the percentage) is likely to be greater than for smaller investments, and should more easily cover the initial appraisal costs. Business angels are perhaps the largest source of smaller amounts of equity finance, often investing amounts ranging between £20,000 and £200,000 in early stage and smaller expanding companies. 4. Geographical location Several private equity firms have offices in the UK regions. Some regions are better served with more local private equity firms than others, but there are also many firms, particularly in London, who look to invest UK-wide. 18 A Guide to Private Equity The business plan A business plan’s main purpose when raising finance is to market your business proposal. It should show potential investors that if they invest in your business, you and your team will give them a unique opportunity to participate in making an excellent return. A business plan should be considered an essential document for owners and management to formally assess market needs and the competition; review the business’ strengths and weaknesses; and to identify its critical success factors and what must be done to achieve profitable growth. It can be used to consider and reorganise internal financing and to agree and set targets for you and your management team. It should be reviewed regularly. The company’s management should prepare the business plan. Its production frequently takes far longer than the management expects. The owner or the managing director of the business should be the one who takes responsibility for its production, but it should be “owned” and accepted by the management team as a whole and be seen to set challenging but achievable goals that they are committed to meeting. It should emphasise why you are convinced that the business will be successful and convey what is so unique about it. Private equity investors will want to learn what you and your management are planning to do, not see how well others can write for you. Professional advisers can provide a vital role in critically reviewing the draft plan, acting as “devil’s advocate” and helping to give the plan the appropriate focus. Several of the larger accounting firms publish their own detailed booklets on how to prepare business plans. However, it is you who must write the plan as private equity firms generally prefer management driven plans, such as are illustrated in this chapter. Essential areas to cover in your business plan Many businesses fail because their plans have not been properly thought out, written down and developed. A business plan should be prepared to a high standard and be verifiable. A business plan covering the following areas should be prepared before a private equity firm is approached. Executive Summary This is the most important section and is often best written last. It summarises your business plan and is placed at the front of the document. It is vital to give this summary significant thought and time, as it may well determine the amount of consideration the private equity investor will give to your detailed proposal. It should be clearly written and powerfully persuasive, yet balance “sales talk” with realism in order to be convincing. It needs to be convincing in conveying your company’s growth and profit potential and management’s prior relevant experience. It needs to clearly encapsulate your company’s USP (i.e. its unique selling point – why people should buy your product or service as distinct from your competitors). The summary should be limited to no more than two to three pages (i.e. around 1,000 to 1,500 words) and include the key elements from all the points below: 1. The market 2. The product or service 3. The management team 4. Business operations 5. Financial projections 6. Amount and use of finance required and exit opportunities A Guide to Private Equity 19 The business plan Other aspects that should be included in the Executive Summary are your company’s “mission statement” – a few sentences encapsulating what the business does for what type of clients, the management’s aims for the company and what gives it its competitive edge. The mission statement should combine the current situation with your aspirations. You should also explain the current legal status of your business in this section. You should include an overall “SWOT” (strengths, weaknesses, opportunities and threats) analysis that summarises the key strengths of your proposition and its weaknesses and the opportunities for your business in the marketplace and its competitive threats. 1. The market You need to convince the private equity firm that there is a real commercial opportunity for the business and its products and services. This requires a careful analysis of the market potential for your products or services and how you plan to develop and penetrate the market. Market analysis This section of the business plan will be scrutinised carefully; market analysis should therefore be as specific as possible, focusing on believable, verifiable data. Include under market research a thorough analysis of your company’s industry and potential customers. Include data on the size of the market, growth rates, recent technical advances, Government regulations and trends – is the market as a whole developing, growing, mature, or declining? Include details on the number of potential customers, the purchase rate per customer, and a profile of the typical decision-maker who will decide whether to purchase your product or service. This information drives the sales forecast and pricing strategy in your plan. Finally, comment on the percentage of the target market your company plans to capture, with justification in the marketing section of the plan. Marketing plan The primary purpose of the marketing section of the business plan is for you to convince the private equity firm that the market can be developed and penetrated. The sales projections that you make will drive the rest of the business plan by estimating the rate of growth of operations and the financing required. Explain your plans for the development of the business and how you are going to achieve those goals. Avoid using generalised extrapolations from overall market statistics. The plan should include an outline of plans for pricing, distribution channels and promotion. Pricing How you plan to price a product or service provides an investor with insight for evaluating your overall strategy. Explain the key components of the pricing decision – i.e. image, competitive issues, gross margins, and the discount structure for each distribution channel. Pricing strategy should also involve consideration of future product releases. Distribution channels If you are a manufacturer, your business plan should clearly identify the distribution channels that will get the product to the end-user. If you are a service provider, the distribution channels are not as important as are the means of promotion. Distribution options for a manufacturer may include: Distributors Wholesalers Retailers (including on-line) Direct sales - such as mail order and ordering over the web, direct contact through salespeople and telemarketing. Original Equipment Manufacturers (OEM), integration of the product into other manufacturers’ products. Each of these methods has its own advantages, disadvantages and financial impact, and these should be clarified in the business plan. For example, assume your company decides to use direct sales because of the expertise required in selling the product. A direct salesforce increases control, 20 A Guide to Private Equity The business plan but it requires a significant investment. An investor will look to your expertise as a salesperson, or to the plans to hire, train and compensate an expert salesforce. If more than one distribution channel is used, they should all be compatible. For example, using both direct sales and wholesalers can create channel conflict if not managed well. Fully explain the reasons for selecting these distribution approaches and the financial benefits they will provide. The explanation should include a schedule of projected prices, with appropriate discounts and commissions as part of the projected sales estimates. These estimates of profit margin and pricing policy will provide support for the investment decision. Promotion The marketing promotion section of the business plan should include plans for product sheets, potential advertising plans, internet strategy, trade show schedules, and any other promotional materials. The private equity firm must be convinced that the company has the expertise to move the product to market. A well-thought-out promotional approach will help to set your business plan apart from your competitors. It is important to explain the thought process behind the selected sources of promotion and the reasons for those not selected. Competition A discussion of the competition is an essential part of the business plan. Every product or service has competition; even if your company is first-to-market, you must explain how the market’s need is currently being met and how the new product will compete against the existing solution. The investor will be looking to see how and why your company can beat the competition. The business plan should analyse the competition (who are they, how many are there, what proportion of the market do they account for?). Give their strengths and weaknesses relative to your product. Attempt to anticipate likely competitive responses to your product. Include, if possible, a direct product comparison based on price, quality, warranties, product updates, features, distribution strategies, and other means of comparison. Document the sources used in this analysis. All the aspects included in the market section of your business plan must be rigorously supported by as much verifiable evidence as possible. In addition to carrying out market research and discussions with your management team, customers and potential customers, you may need input from outside marketing consultants. 2. The product or service Explain the company’s product or service in plain English. If the product or service is technically orientated this is essential, as it has to be readily understood by non-specialists. Emphasise the product or service’s competitive edge or USP. For example, is it: A new product? Available at a lower price? Of higher quality? Of greater durability? Faster to operate? Smaller in size? Easier to maintain? Offering additional support products or services? With technology companies where the product or service is new, there has to be a clear “world class” opportunity to balance the higher risks involved. Address whether it is vulnerable to technological advances made elsewhere. A Guide to Private Equity 21 The business plan If relevant, explain what legal protection you have on the product, such as patents attained, pending or required. Assess the impact of legal protection on the marketability of the product. You also need to cover of course the price and cost of the product or service. If the product is still under development the plan should list all the major achievements to date as well as remaining milestones to demonstrate how you have tackled various hurdles and that you are aware of remaining hurdles and how to surmount them. Specific mention should be made of the results of alpha (internal) and beta (external) product testing. Single product companies can be a concern for investors. It is beneficial to include ideas and plans for a “second generation” product or even other viable products or services to demonstrate the opportunities for business growth. 3. The management team Private equity firms invest in people – people who have run or who are likely to run successful operations. Potential investors will look closely at you and the members of your management team. This section of the plan should introduce the management team and what you all bring to the business. Include your experience, and success, in running businesses before and how you have learned from not so successful businesses. You need to demonstrate that the company has the quality of management to be able to turn the business plan into reality. The senior management team ideally should be experienced in complementary areas, such as management strategy, finance and marketing and their roles should be specified. The special abilities each member brings to the venture should be explained. This is particularly the case with technology companies where it will be the combination of technological and business skills that will be important to the backers. If some members have particular flair and dynamism, this needs to be balanced by those who can ensure this occurs in a controlled environment. A concise curriculum vitae should be included for each team member, highlighting their previous track records in running, or being involved with successful businesses. Identify the current and potential skills’ gaps and explain how you aim to fill them. Private equity firms will sometimes assist in locating experienced managers where an important post is unfilled – provided they are convinced about the other aspects of your plan. Explain what controls and performance measures exist for management, employees and others. List your auditors and other advisers. The appointment of a non-executive director (NED) should be seriously considered. Many surveys have shown that good NEDs add significant value to the companies with which they are involved. Many private equity firms at the time of their investment will wish to appoint one of their own executives or an independent expert to your board as an NED. Most private equity executives have previously worked in industry or in finance and all will have a wide experience of companies going through a rapid period of growth and development. The BVCA’s 2007 Economic Impact Survey (available at www.bvca.co.uk/Research) reveals that generally over three-quarters of the private equity backed companies feel that the private equity firms make a major contribution other than the provision of money. Contributions cited by private equity backed companies include private equity firms being used to provide financial advice, guidance on strategic matters, for management recruitment purposes as well as for their contacts and market information. 4. Business operations This section of the business plan should explain how your business operates, including how you make the products or provide the service. It should also outline your company’s approach to research and development. Include details on the location and size of your facilities. Factors such as the availability of labour, accessibility of materials, proximity to distribution channels, and the availability of Government grants and tax incentives should be mentioned. Describe the equipment used or planned. If more equipment 22 A Guide to Private Equity The business plan is required in response to production demands, include plans for financing. If your company needs international distribution, mention whether the operations facility will provide adequate support. If work will be outsourced to subcontractors – eliminating the need to expand facilities – state that too. The investor will be looking to see if there are inconsistencies in your business plan. If a prototype has not been developed or there is other uncertainty concerning production, include a budget and timetable for product development. The private equity firm will be looking to see how flexible and efficient the facility plans are. The private equity firm will also ask such questions as: If sales projections predict a growth rate of 25% per year, for example, does the current site allow for expansion? Are there suppliers who can provide the materials required? Is there an educated work force in the area? These and any other operational factors that might be important to the investor should be included. 5. Financial projections Developing a detailed set of financial projections will help to demonstrate to the investor that you have properly thought out the financial implications of your company’s growth plans. Private equity firms will use these projections to determine if: Your company offers enough growth potential to deliver the type of return on investment that the investor is seeking. The projections are realistic enough to give the company a reasonable chance of attaining them. Investors will expect to see a full set of cohesive financial statements – including a balance sheet, income statement and cash-flow statement, for a period of three to five years. It is usual to show monthly income and cash flow statements until the breakeven point is reached followed by yearly data for the remaining time frame. Ensure that these are easy to update and adjust. Do include notes that explain the major assumptions used to develop the revenue and expense items and explain the research you have undertaken to support these assumptions. Preparation of the projections Realistically assess sales, costs (both fixed and variable), cash flow and working capital. Assess your present and prospective future margins in detail, bearing in mind the potential impact of competition. Assess the value attributed to the company’s net tangible assets. State the level of gearing (i.e. debt to shareholders’ funds ratio). State how much debt is secured on what assets and the current value of those assets. Include all costs associated with the business. Remember to split sales costs (e.g. communications to potential and current customers) and marketing costs (e.g. research into potential sales areas). What are the sale prices or fee charging structures? Provide budgets for each area of your company’s activities. What are you doing to ensure that you and your management keep within these or improve on these budgets? Present different scenarios for the financial projections of sales, costs and cash flow for both the short and long term. Ask “what if?” questions to ensure that key factors and their impact on the financings required are carefully and realistically assessed. For example, what if sales decline by 20%, or supplier costs increase by 30%, or both? How does this impact on the profit and cash flow projections? If it is envisioned that more than one round of financing will be required (often the case with technology-based businesses in particular), identify the likely timing and any associated progress “milestones” which need to be achieved. Keep the plan feasible. Avoid being over optimistic. Highlight challenges and show how they will be met. You might wish to consider using an external accountant to review the financial projections and act as “devil’s advocate” for this part of the plan. A Guide to Private Equity 23 The business plan 6. Amount and use of finance required and exit opportunities You need to determine how much finance is required by your venture as detailed in your cash flow projections. This needs to be the total financing requirement, including fixed asset and working capital requirements and the costs of doing the deal. Ascertain how much of this can be taken as debt as this is a cheaper form of finance than equity. This will depend on the assets in the business that can be used to secure the debt, the cash flow being generated to pay interest and repay amounts borrowed and the level of interest cover, ie. the safety margin that the business has in terms of being able to meet its banking interest obligations from its profits. Then determine how much management can invest in the venture from your own resources and those of family and friends. Include any government sources of finance available to you also. The balance is then the amount you are seeking from the venture capitalist. In this section of the business plan you need to: State how much finance is required by your business and from what sources (i.e. management, private equity firm, banks and others) and explain for what it will be used. Include an implementation schedule, including, for example, capital expenditure, orders and production timetables. Consider how the private equity investors will make a return, i.e. realise their investment. This may only need outlining if you are considering floating your company on a stock exchange within the next few years. However, it is important that the options are considered and discussed with your investors. The presentation of your business plan Bear the following points in mind when you are writing your business plan. Readability Make the plan readable. Avoid jargon and general position statements. Use plain English – especially if you are explaining technical details. Aim it at nonspecialists, emphasising its financial viability. Avoid including unnecessary detail and prevent the plan from becoming too lengthy. Put detail into appendices. Ask someone outside the company to check it for clarity and “readability”. Remember that the readers targeted will be potential investors. They will need to be convinced of the company’s commercial viability and competitive edge and will be particularly looking to see the potential for making a good return. Length The length of your business plan depends on individual circumstances. It should be long enough to cover the subject adequately and short enough to maintain interest. For a multi-million pound technology company with sophisticated research and manufacturing elements, the business plan could be well over 50 pages including appendices. By contrast, a proposal for £200,000 to develop an existing product may be too long at 10 pages. It is probably best to err on the side of brevity – for if investors are interested they can always call you to ask for additional information. Unless your business requires several million pounds of private equity and is highly complex, we would recommend the business plan should be no longer than 15 pages. Appearance Use graphs and charts to illustrate and simplify complicated information. Use titles and sub-titles to divide different subject matters. Ensure it is neatly typed or printed without spelling, typing or grammar mistakes – these have a disproportionately negative impact. Yet avoid very expensive documentation, as this might suggest unnecessary waste and extravagance. 24 A Guide to Private Equity The business plan Things to avoid! On a lighter note, the following signs of extravagance and non-productive company expenditure are likely to discourage a private equity firm from investing and so are best avoided: Flashy, expensive cars Company yacht/plane Personalised number plate Carpets woven with the company logo Company flag pole Fountain in the forecourt “International” in your name (unless you are!) Fish tank in the board room Founder’s statue in reception. The above signs are common signs of a company about to go ‘bust’. As one company liquidator commented: ‘ the common threads I look for in any administration or liquidation are as you drive up to the premises there’s a flagpole, when I’m in reception, a fish tank and in between typically I walk passed a lot of number plates that are personalized so if they’ve got all three, there’s no hope of recovery’. A Guide to Private Equity 25 The investment process The investment process, from reviewing the business plan to actually investing in a proposition, can take a private equity firm anything from one month to one year but typically it takes between three and six months. There are always exceptions to the rule and deals can be done in extremely short time frames. Much depends on the quality of information provided and made available to the private equity firm. Reaching your audience When you have fully prepared the business plan and received input from your professional adviser, the next step is to arrange for it to be reviewed by a few private equity firms. You should select only those private equity firms whose investment preferences match the investment stage, industry, location of, and amount of equity financing required by your business proposition. Confidentiality If you wish to use a confidentiality letter, an example of one can be obtained from the BVCA’s website. The general terms of this letter have been agreed by BVCA members and with your lawyer’s advice you can adapt it to meet your own requirements. You can then ask the private equity investor to sign it, before being sent the full business plan. We would recommend, however, that you only ask for a confidentiality letter when the potential investor has received your Executive Summary and has shown an interest in giving your proposal detailed consideration. How quickly should I receive a response? Generally you should receive an initial indication from the private equity firms that receive your business plan within a week or so. This will either be a prompt “no”, a request for further information, or a request for a meeting. If you receive a “no”, try to find out the reasons as you may have to consider incorporating revisions into your business plan, changing/strengthening the management team or carrying out further market research before approaching other potential investors. How do private equity firms evaluate a business plan? They will consider several principal aspects: Is the product or service commercially viable? Does the company have potential for sustained growth? Does management have the ability to exploit this potential and control the company through the growth phases? Does the possible reward justify the risk? Does the potential financial return on the investment meet their investment criteria? 26 A Guide to Private Equity The investment process Presenting your business plan and negotiations If a private equity firm is interested in proceeding further, you will need to ensure that the key members of the management team are able to present the business plan convincingly and demonstrate a thorough knowledge and understanding of all aspects of the business, its market, operation and prospects. Assuming a satisfactory outcome of the meeting and further enquiries, the private equity firm will commence discussions regarding the terms of the deal with you. The first step will be to establish the value of your business. Valuing the business There is no right or wrong way of valuing a business. There are several ways in which it can be done. Calculate the value of the company in comparison with the values of similar companies quoted on the stock market. The key to this calculation is to establish an appropriate price/earnings (P/E) ratio for your company. The P/E ratio is the multiple of profits after tax attributed to a company to establish its capital value. P/E ratios for quoted companies are listed in the back pages of the Financial Times, and are calculated by dividing the current share price by historic post-tax earnings per share. Quoted companies’ P/E ratios will vary according to industry sector (its popularity and prospects), company size, investors’ sentiments towards it, its management and its prospects, and can also be affected by the timing of year-end results announcements. The private equity investment process Entrepreneur and Stage Entrepreneur Private Equity Firm Reports Private Equity Firm Approaching the private Appoint advisers Review business plan equity firm/evaluating the Prepare business plan Business Plan business plan Contact private equity firms Initial enquires Provide additional Meet to discuss business Conduct initial enquires and negotiation information plan Value the business OFFER LETTER Build relationships Consider financing Negotiate outline terms structure Due diligence Liaise with accountants / Initiate external due Consultants’ Reports Liaise with other external diligence Accountants’ Reports consultants. Final negotiation Disclose all relevant Negotiate final terms Draw up completion Disclosure Letter and completion business information Document constitution documentation Warranties and Indemnities and voting rights Memorandum and articles of assertion Shareholders agreement Monitoring Provide periodic Seat on Board? Management management accounts Monitor investment accounts Minutes of Communicate regularly Constructive input Board and other Key with investor/s Involvement in major Meetings EXIT decisions A Guide to Private Equity 27 The investment process An unquoted company’s P/E ratio will tend to be lower than a quoted company’s due to the following reasons. Its shares are less marketable and shares cannot be bought and sold at will. It often has a higher risk profile, as there may be less diversification of products and services and a narrower geographical spread. It generally has a shorter track record and a less experienced management team. The cost of making and monitoring a private equity investment is much higher. The following are factors that may raise an unquoted company’s P/E ratio compared with a quoted company. Substantially higher than normal projected turnover and profits growth. Inclusion in a fashionable sector, or ownership of unique intellectual property rights (IPR). Competition among private equity firms. Calculate a value for your company that will give the private equity firms their required rate of return over the period they anticipate being shareholders. Private equity firms usually think in terms of a target overall return from their investments. Generally “return” refers to the annual internal rate of return (IRR), and is calculated over the life of the investment. The overall return takes into account capital redemptions, possible capital gains (through a total “exit” or sale of shares), and income through fees and dividends. The returns required will depend on the perceived risk of the investment – the higher the risk, the higher the return that will be sought – and it will vary considerably according to the sector and stage of the business. As a rough guide, the average return required will exceed 20% per annum. The required IRR will depend on the following factors. The risk associated with the business proposal. The length of time the private equity firm’s money will be tied up in the investment. How easily the private equity firm expects to realise its investment – i.e. through a trade sale, public flotation, etc. How many other private equity firms are interested in the deal (i.e. the competition involved). By way of illustration, assume an investor requires 30% IRR on an equity investment of £1,175,000. £1,175,000 becomes: At end of: Year 1 plus 30% 1,527,500 Year 2 plus 30% 1,985,750 Year 3 plus 30% 2,581,475 Year 4 plus 30% 3,355,918 Year 5 plus 30% 4,362,693 Therefore the investor needs to receive 3.7 times his money after 5 years to justify his investment risk, ie. an IRR of 30% is equivalent to a multiple of 3.7 times the original investment. Pre money and post money valuations As the person seeking private equity finance you will be focused on the value of the company at the point in time that you are offering a stake in the company to the private equity firm in return for its investment in your company. This is the pre-money valuation, ie. the value of the business or company before the particular finance raising round has been completed. The post-money valuation is the value of the business after the finance raising round has been completed, ie. after the private equity firm has made its investment. The private equity firm will be more focused on this than the pre-money valuation, as it is the post-money valuation that will be used as the benchmark for any subsequent rounds of financing or indeed for the eventual exit. To achieve the required return the private equity firm will be concerned at too high a post-money valuation. 28 A Guide to Private Equity The investment process As an example consider an entrepreneur who owns 100% of a company and is seeking an initial investment of £5 million from a venture capital firm. The venture capitalist reviews the proposition and offers to invest £5 million in return for a 40% stake in the entrepreneur’s company. Based on what the venture capitalist is prepared to invest in the company a 100% shareholding must be worth £12.5 million post investment. This is the post-money valuation. The remaining 60% of the shares, held by the entrepreneur, are therefore worth £7.5 million. But before the investment by the venture capitalist the entrepreneur held 100% of the shares in the company. The venture capitalist has therefore valued the business before he makes his investment at £7.5 million. This is the pre-money valuation. If the venture capitalist is concerned that the post-money valuation is too high, he will either put less money into the venture for the same equity stake or indeed increase his equity stake. Other valuation methods Private equity firms also use other ways of valuing businesses, such as those based on existing net assets or their realisable value. Personal financial commitment You and your team must have already invested, or be prepared to invest, some of your own capital in your company to demonstrate a personal financial commitment to the venture. After all, why should a private equity firm risk its money, and its investors’, if you are not prepared to risk your own! The proportion of money you and your team should invest depends on what is seen to be “material” to you, which is very subjective. This could mean re-mortgaging your house, for example, or foregoing the equivalent of one year’s salary. Types of financing structure If you use advisers experienced in the private equity field, they will help you to negotiate the terms of the equity deal. You must be prepared to give up a realistic portion of the equity in your business if you want to secure the financing. Whatever percentage of the shares you sell, the day-to-day operations will remain the responsibility of you and your management team. The level of a private equity firm’s involvement with your company depends on the general style of the firm and on what you have agreed with them. There are various ways in which the deal can be financed and these are open to negotiation. The private equity firm will put forward a proposed structure for consideration by you and your advisers that will be tailored to meet the company’s needs. The private equity firm may also offer to provide more finance than just pure equity capital, such as debt or mezzanine finance. In any case, should additional capital be required, with private equity on board other forms of finance are often easier to raise. The structure proposed may include a package of some or all of the following elements. Classes of capital used by private equity firms The main classes of share and loan capital used to finance UK limited liability companies are shown below. Share capital The structure of share capital that will be developed involves the establishment of certain rights. The private equity firm through these rights will try to balance the risks they are taking with the rewards they are seeking. They will also be aiming to put together a package that best suits your company for future growth. These structures require the assistance of an experienced qualified legal adviser. Ordinary shares These are equity shares that are entitled to all income and capital after the rights of all other classes of capital and creditors have been satisfied. Ordinary shares have votes. In a private equity deal these are the shares typically held by the management and family shareholders rather than the private equity firm. A Guide to Private Equity 29 The investment process Preferred ordinary shares These may also be known as “A” ordinary shares, cumulative convertible participating preferred ordinary shares or cumulative preferred ordinary shares. These are equity shares with preferred rights. Typically they will rank ahead of the ordinary shares for both income and capital. Once the preferred ordinary share capital has been repaid and then the ordinary share capital has been repaid, the two classes would then rank pari passu in sharing any surplus capital. Their income rights may be defined; they may be entitled to a fixed dividend (a percentage linked to the subscription price, e.g. 8% fixed) and/or they may have a right to a defined share of the company’s profits – known as a participating dividend (e.g. 5% of profits before tax). Preferred ordinary shares have votes. Preference shares These are non-equity shares. They rank ahead of all classes of ordinary shares for both income and capital. Their income rights are defined and they are usually entitled to a fixed dividend (e.g. 10% fixed). The shares may be redeemable on fixed dates or they may be irredeemable. Sometimes they may be redeemable at a fixed premium (e.g. at 120% of cost). They may be convertible into a class of ordinary shares. Loan capital Loan capital ranks ahead of share capital for both income and capital. Loans typically are entitled to interest and are usually, though not necessarily, repayable. Loans may be secured on the company’s assets or may be unsecured. A secured loan will rank ahead of unsecured loans and certain other creditors of the company. A loan may be convertible into equity shares. Alternatively, it may have a warrant attached that gives the loan holder the option to subscribe for new equity shares on terms fixed in the warrant. They typically carry a higher rate of interest than bank term loans and rank behind the bank for payment of interest and repayment of capital. Other forms of finance provided in addition to equity Clearing banks – principally provide overdrafts and short to medium-term loans at fixed or, more usually, variable rates of interest. Investment banks – organise the provision of medium to longer-term loans, usually for larger amounts than clearing banks. Later they can play an important role in the process of “going public” by advising on the terms and price of public issues and by arranging underwriting when necessary. Finance houses – provide various forms of installment credit, ranging from hire purchase to leasing, often asset based and usually for a fixed term and at fixed interest rates. Factoring companies – provide finance by buying trade debts at a discount, either on a recourse basis (you retain the credit risk on the debts) or on a non-recourse basis (the factoring company takes over the credit risk). Government and European Commission sources – provide financial aid to UK companies, ranging from project grants (related to jobs created and safeguarded) to enterprise loans in selective areas – see above. Mezzanine finance – loan finance that is halfway between equity and secured debt. These facilities require either a second charge on the company’s assets or are unsecured. Because the risk is consequently higher than senior debt, the interest charged by the mezzanine debt provider will be higher than that from the principal lenders and sometimes a modest equity “up-side” will be required through options or warrants. It is generally most appropriate for larger transactions. Additional points to be considered By discussing a mixture of the above forms of finance, a deal acceptable to both management and the private equity firm can usually be negotiated. Other negotiating points are often: Whether the private equity firm requires a seat on the company’s board of directors or wishes to appoint an independent director. 30 A Guide to Private Equity The investment process What happens if agreed targets are not met and payments are not made by your company? How many votes are to be ascribed to the private equity firm’s shares? The level of warranties and indemnities provided by the directors. Whether there is to be a one-off fee for completing the deal and how much this will be? Who will bear the costs of the external due diligence process? Specific considerations relating to venture capital and management buyout deals 1. How a venture capitalist arrives at his required equity stake In the case of a venture capital investment, in order to illustrate how a venture capitalist arrives at his required equity stake in a company, assume that we have an early-stage investment proposition that is looking for £10 million of investment and is projected to earn £20 million in year 5 which is the year the venture capitalist wishes to exit his investment. Similar quoted companies in the industry sector have average P/E ratios of 15. The venture capitalist discounts this by, say, 20% to allow for the fact that the company in which he proposes to invest is private and is a relatively early stage company and applies this discounted P/E to his investment’s earnings in year 5 to give a terminal value on exit of £240 million. The venture capitalist needs to discount this to the present day value based on his target IRR, using the formula: Present value = Terminal value / ( 1 + Target IRR)* where * is the number of years of the investment. The venture capitalist sets the target IRR at 50%, commensurate with the risk of investing in this early-stage venture. This therefore gives a present day, or discounted terminal value, of : 240 million / (1 + 50%)5 = £31.6 million The venture capitalist’s required stake in the venture is therefore his investment of £10 million divided by the present day value of £31.6 million, ie nearly a third of the equity (31.6%). The deficiencies in using this method to arrive at the investor’s required equity stake are that the use of quoted company current P/E ratios may not reflect the state of the market at the time of the venture capitalist’s exit from the investment in a few year’s time and that the discount factor applied to the P/E ratio to reflect that the investee company is not quoted and different in other ways from the larger company are quite subjective. Of course the venture capitalist can play around with different discount factors and required IRRs to see how these affect the required equity stake. 2. Use of preference shares in structuring a venture capital deal Venture capital finance is normally provided as a mixture or ordinary and preference shares with possibly debt hybrids and variations in classes of shares. How much of the venture capitalist’s equity is the form or ordinary shares or preference shares is open to negotiation. Preference shares rank ahead of ordinary shares for both income and capital. The venture capitalist can attach various rights to the preference shares and these are discussed under the term sheet considerations below. These rights are not available to ordinary shareholders and can include, for example, rights with regard to liquidation preferences, or the right to receive cumulative or non-cumulative dividends or the right to convert their shares into o

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