1. Private equity (PE) financing is money in exchange for part ownership of a company and a share of the profit.
PRIVATE EQUITY PRIMER FOR COMPANY OWNERS
5. The PE process is like getting married.
Private equity, or PE, is a form of equity investing that is not traded on a stock exchange. PE funds invest in start-up, growth or mature companies with the goal of making a profit. Private investors invest money into funds, which then invests in a portfolio of companies. Generally speaking, equity investors may consider companies considered too risky for banks.
QUESTION: FIRST, WHAT IS PRIVATE EQUITY?
NOTE: Although joint ventures (JVs) and merger and acquisitions (M&As) are forms of equity investing, PE investors (usually a fund) invest in existing companies.
KEY POINTS OF LEARNING
6. To attract equity, you must “pitch” your company.
3. PE is different from debt. And PE investing is different from JVs and M&As.
2. PE is coming to Africa and can be a huge driver of economic growth, especially for SMEs.
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4. Bringing on an investor can be a strategic move to help your company grow.
7. To successfully pitch your company, you must know your numbers, business, market and investors and exude trust and confidence.
ANSWER: INVESTING IN PRIVATE COMPANIES IN EXCHANGE FOR SHARES.
ANSWER: BECAUSE PRIVATE EQUITY IS COMING TO AFRICA! Private equity is coming to Africa and Ethiopia. Africa ranks as one of the top investment destinations now for many global investors. The
QUESTION: WHY SHOULD YOU CARE ABOUT PRIVATE EQUITY?
PURPOSE Private equity (PE) is a major source of capital in developed and emerging economies and is becoming a recognized source of capital in Sub-Saharan Africa. PE is a relatively new concept for many stakeholders in Ethiopia. This primer is for companies that wish to learn more about PE financing, the benefits of PE financing and the added value PE investors bring to companies in which they invest.
main drivers of this are better macroeconomic conditions and a more welcoming investment climate. However, countries must attract investors, or it may go to other countries. This is one of the government’s key roles. They can improve their score by making policy changes, and by making positive first and last impressions on investors.
QUESTION: WHAT IS THE DIFFERENCE BETWEEN DEBT AND EQUITY?
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~Ernst & Young Report Private Equity Round Up
ANSWER: EQUITY IS RISKIER, AND THEREFORE REQUIRES BETTER RETURNS, THAN DEBT. Private equity initially has lower costs than debt, but, if you are successful, may have higher costs in the future. This is because equity is considerably riskier than debt; therefore, there must be a tradeoff between risk and reward.
“The $3.3 billion in private equity funding raised last year for African ventures is the highest annual amount since 2007 and represents a 136 percent increase since 2012.”
QUESTION: WILL PRIVATE EQUITY BENEFIT ETHIOPIA?
PE Funds +$25M VC Funds $3M 25M Angels $100K - $3M PE Helps Companies Grow
ANSWER: ALMOST DEFINITELY. ESPECIALLY FOR SMES! PE will benefit Ethiopia by being a source of growth capital for SMEs. SMEs generally cannot get financing from banks for business expansion (usually just trade financing). PE can unlock pent-up growth potential in the economy, create jobs, generate tax revenue, and accelerate development.
3 PIPELINE MANAGEMENT TOOL | 1 Valuation Equations POST = PV (exit value) The value of your company immediately after the investment is made. PRE = POST – INV The value of your company before the investment is made. f = INV/POST The percentage of ownership the investors will have of your company. Shares investor = Shares owner X (f/[1-f]) The number of shares to be issued to the investor. Share Price = INV/shares investor The price per share paid by the investor. Debt Equity Payment: Fixed, monthly interest and principal Deductions: Interest is deductible Deductions: Dividends are not deductible Posture: Transactional Posture: More emotional Focus: Going concern. Incomes from interest payments and principal repayment. Focus: Growth of the company Control: None, unless you break a covenant Control: Board role, information rights, other rights Value addition: More loans if you perform, and other services Value addition: Business efficiencies, access to more capital, strategic support When paid: First When paid: After debt How much: Interest based on your risk, amount based on collateral How much: Percentage of your company you negotiated based on valuation QUESTION: WHAT HAPPENS WHEN SOMEONE INVESTS IN A COMPANY? ANSWER: YOU SHARE INFORMATION, CONTROL AND PROFIT WITH THEM. 1 Source: US Capital Partners, adapted from revenuebasedfinance.com R E W A R D R I S K ( + ) ( - ) ( - ) ( + ) Equity Debt Debt Equity Nothing Business Success Business Failure R E W A R D R I S K ( + ) ( - ) ( - ) ( + ) Equity Debt Debt Equity Nothing Business Success Business Failure
ANSWER: THERE ARE MANY, BUT WE THINK SOME IMPORTANT ONES ARE...
Private equity investors believe they can add value to the companies in which they invest. They do this in three ways: 1) the ability to “reengineer” the company, 2) the ability to obtain more favorable financing, and 3) superior alignment between management team and owners.
Benefits
PE is riskier than debt, so you may be able to get financing when debt is not an option.
QUESTION: WHAT ARE THE BENEFITS OF HAVING AN EQUITY INVESTOR?
You have a hard time finding trusted managers You and your board recruit strong managers and consultants to help you grow
QUESTION: WHAT ARE THE IMPORTANT PE TERMS I SHOULD KNOW?
Owning a business – Before Leading a company – After You are the owner and manager You are a part owner and manager You make all the decisions You make many of the decisions, but specific decisions are made by your board
ANSWER: INVESTORS HELP STRENGTHEN GOVERNANCE, MANAGEMENT TEAMS AND FINANCING.
When an equity investor invests in a company, they receive shares. Their shares give them rights to information, decisions and profit. When an owner/operated company brings on an equity investor, things change.
PE investment managers have business consulting skills and will help you with financial management and marketing and branding. Taking on a PE investor signals to others “growth” and often attracts more capital.
PE investment managers are aligned with your interests – to see the company grow. They often help you improve your performance with consulting and getting more financing.
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PE investors are often well-connected and will help you find and win new clients and enter new markets.
You pay yourself when you want You get a salary, and if you are an owner, you get an annual dividend. You may get performance bonuses as well
You have access to foreign investors and other sources of capital You have to report to the government You report to the government and the investors You have to go find new markets and customers You and your board find new markets and new customers
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You use retained earnings or local debt to finance your growth (or grants)
EXIT: When the investor sells their shares. Exit routes include, from highest valuation to lowest, IPO, secondary sale, MBO, liquidation.
COUNTRY: (1) Economic activity; (2) Depth of the capital market; (3) Taxation; (4) Investor protection and corporate governance; (5) Human and social environment; (6) Entrepreneurial culture and deal opportunities2 . Also: Macroeconomic indicators; signs The Global Venture Capital and Private Equity Country Attractiveness Index - 2011
PITCH BOOK: The materials prepared by a company to attract an investor. Usually includes the business plan, financial model and the offer statement; how much investment you seek and how much of your company you are offering in exchange.
RISK: Equity investors are less concerned about your balance sheet, and more about your ability to generate future cash flows. Risk determines how much they want (returns) in exchange for how much they invest. Main risks are liquidity (can’t sell shares), country (instability), regulatory (changes impact business), market (inflation), tax (impacts net income), operating (poor management). Generally, the sum of these risks (usually a %) equals the discount rate.
DISCOUNT RATE: The rate investors discount future cash flows based on the risk of the investment. The more risk the higher the discount rate. The higher the discount rate, the lower the “valuation.”
VALUATION: The value “someone” gives to a company. There are many different valuation techniques. Main ones are discount cash flow (DCF) and price multiples. For venture capital there is pre-money (PRE) and post-money valuation (POST). PRE = POST – investments (INV). A VC fund calculates POST using a discounting, then PRE, % ownership, new shares issues, and price per share.
PAYBACK PERIOD: The time it takes for an investor to recoup their initial investment amount.
TIME VALUE OF MONEY: Money today is worth more than the same amount tomorrow.
QUESTION: WHAT ARE THE INVESTORS LOOKING FOR?
TERM: The length of time an investor expects to invest in a company before they exit (years).
ANSWER: A GREAT ENTREPRENEUR THEY TRUST.
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IRR: Internal rate of return. It is the discount rate that makes the future cash flows equal to the investment or gives a net present value of zero. You may hear investors say “target IRR,” which is their way of saying their desired rate of return, or “discount rate.”
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TERM SHEET: A document that contains the results of the negotiations between the investor and company. Also known as a letter of intent (LOI). Usually happens before due diligence, which is costly, so investors want to make sure the company generally agrees to their terms. Key sections include management compensation, and rights (tag along, drag along, board representation, non-compete, priority in claims, required approvals)
STAGE 0: “GETTING READY” – Understand what PE is and what it is not! It is not free money or debt.
STAGE 2: “DATING” – Sign an NDA and begin sharing information.
For companies: Prepare ahead of time. Have someone in your company get a pitch book prepared with your business plan, financial model, audited financial statements, corporate records, etc. Do not “go silent” during this stage. The investor will lose interest.
STAGE 1: “FLIRTING” – The first meeting. They either approach you, or you approach them. Goal is to see if there is attraction.
For companies: Almost there, but there may be unforeseen delays with getting approvals from the government. You may have to make changes, or they may block the investment for reasons not known to the investor or the company. To prevent this, make sure (back
STAGE 3: “ENGAGEMENT” – Negotiate and sign a term sheet.
COMPANY: (1) Owner/manager – your Trust score; (2) Management team – their background, skill, experience, presence; (3) Market potential – meet with experts, your competitors, your suppliers, your customers; (4) Track record/past performance – sales mainly, and trends (shrinking sales, shrinking margin?); (5) Projected returns – your financial model; (6) Financial health – balance sheet; (7) Payback period
For companies: Put on a good showing: clean up! Show them around, have a PPT briefing ready (10 slides). Avoid being late, too optimistic, too “sales-y”. Focus on being honest.
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TRUST EQUATION: Trust = (Reliability + Credibility + Intimacy)/Self-interest. The higher the trust you have with each other, the higher chance you are to get them as an investor.
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ANSWER: IT’S LIKE GETTING MARRIED!
For companies: Be prepared to negotiate – don’t take it personal. If you are confident about what your business can do over the next five years, it will be easier to negotiate.
For companies: By this point you both should each know what you are getting into, but even so, new things may get uncovered that change the terms of the relationship or end it all together. To prevent this, share information often and early.
STAGE 5: “GETTING MARRIED” – Closing.
QUESTION: HOW DOES THE PE PROCESS WORK?
For companies: One of the biggest frustrations investors have is when an owner isn’t ready. Investors assume when a company meets with them they understand what they are getting into. If you are not ready to give up some control, or you don’t like sharing, DON’T approach equity investors. Get debt!
STAGE 4: “ENGAGEMENT PERIOD” – Due diligence.
For companies: This is when the investors sell their shares. You can either buy them back, or they sell to someone else. This ends the relationship with the equity investors.
ANSWER: PRACTICE AND KNOW YOUR NUMBERS.
Articulate the investment you need, what it will be used for, the impact it will have on your business. Know how the investment will improve your financial performance!
For companies: This is not just “take the money and run” time. The immediate weeks after the investment closes (money transfers to your account) can be fun or scary. You have to use the money how you said you would, otherwise there can be consequences.
STAGE 6: “GROW YOUR FAMILY” – Growth.
STAGE 7: “DIVORCE?” (Bad analogy – not really like this.) – Exit.
Be realistic about your market and be able to articulate the trends and opportunities you see. Know your numbers!! Be ready to share your sales, gross profit, new profit, and your margins for the last two years. Know your unit costs!
QUESTION: WHAT ELSE SHOULD I DO TO LEARN ABOUT PE?
Do your homework. Research the investor. Know their investment criteria. Find out as much information about them as you can.
Prepare a 10-slide pitch briefing. Practice, practice, practice!! Follow up: Be responsive, and make sure to do what you said you would do. If you don’t hear back after 2-3 emails, don’t be too pushy; they are probably not interested. Maybe follow up in a month or two. Move on and do it again!
QUESTION: HOW DO I “PITCH” MY BUSINESS TO INVESTORS?
7 PIPELINE MANAGEMENT TOOL | in Stage 0) that you know whether a (foreign) investor can invest in your company or not. Stay alert to any changes that may occur in the regulations. Be proactive and check in with the government approving offices before you get to this stage.
NOTE: Be careful – if an outside consultant prepared your business plan/feasibility study you should read it carefully. If you say something that is different from the plan, your “trust score” will go down.
Know their culture. Don’t be late, be confident but humble, be prepared to negotiate, and be honest. Be prepared to describe your business, your business model, your market and your competition.
ANSWER: READ, WATCH OR LISTEN TO THESE THINGS... Readings: E-Myth, Shark Tank Jump Start Your Business
You should also realize things will have to change (go back to Stage 0), such as how you are paid, how decisions are made and your reporting. Also, you should reread the legal agreements you signed with the investors to ensure you know what they expect.
Websites: Investopedia.com, Emerging Market Private Equity Association (EMPEA), Africa Private Equity and Venture Capital Association (AVCA), Africa Venture Philanthropy Alliance (AVPA), PitchBook or the Lighter Capital’s Start Up Finance Blog
Multimedia: Shark Tank (all seasons), Robert Schillers Econ 252 “OpenYale” on iTunes. It’s free!
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