Many venture capitalists have achieved celebrity-like status, but we don’t quite see the same among our private equity (PE) brethren. In fact, often the first thing the term “private equity” conjures up are ideas of cost-cutting and financial engineering. Founders, protective of the culture and team they’ve worked hard to cultivate, may in turn dismiss PE buyout firms as predatory players out to make a buck by chopping a company up for parts—and as a result, work hard to keep their distance.
Like any charged topic, the reality is more nuanced. Private equity, simply by definition, is an alternative asset class that is not listed on public exchanges. These firms primarily invest in private companies or buy out public ones. The investor base typically comprises institutional investors (pension plans, university endowments, foundations) and high-net worth individuals or family offices. PE firms’ investments range from billion-dollar buyouts of the brands we all know and love, all the way down to smaller, nimbler investments that often blur the lines with later-stage venture capital or growth equity investors.
Our team recently wrote about the range of exit options founders have when they stay disciplined in raising the right amount of capital and build methodically towards a $150 million exit. Founders may gravitate towards a strategic buyer (i.e. a larger adjacent software company) at this price point to avoid dealing with PE. But the reality is that the right PE firm can provide both growth-oriented capital and expertise, and facilitate founder liquidity along the way. No founder should discount it and in many cases, PE serves as the most logical (and lucrative) next-stage partner for growth.
Below we dig into the characteristics that can make for a good PE relationship for a company’s next phase, and how founders should approach developing relationships with these potential buyers.
The last few years have seen rapid growth and evolution of the private financial sponsor landscape at large, and PE is no exception. There is more capital available (or “dry powder”) now than ever. Buyout funds had an estimated $853 billion in dry powder as of Q3 2020 and the top six software-focused PE firms grew to $58 billion of committed capital in their latest funds – a 3X jump in just five years.
With growth comes diversity. On the high end, the firms with tens of billions of dollars in assets under management (AUM) are the ones making the big, splashy headlines for taking public companies private or acquiring chunks of equity in billion-dollar companies pre-IPO. There are a host of other funds that are active in SaaS growth investments, recaps, and buyouts have funds in the range of $500 million to low-single-digit billions. These firms add tremendous value and accelerate growth with management and governance strategies, operational playbooks, and industry leadership and expertise. Often, they can add on acquisitions of complementary companies that increase the original company’s revenue, growth rate, and total addressable market (TAM). Their goal is to put companies on the road to a strong, strategic exit, and IPO, or simply transact to a later-stage PE fund.
The profile of PE firm described above typically targets companies with annual revenues ranging from $10 million to $50 million as platform investments. Additional qualities they’ll look for are customer markets with a lot of upside and room for expansion, a competitive edge in delivering value to that customer and owning more of the market, stable recurring cash flow, and overall capital efficiency. This should sound familiar because we advocate bootstrapped startups focus on these things in the first place. These qualities are enhanced with the right amount of capital at the right time, paired with the right professional expertise.
We are so bullish on this model because many buyers (with lots of dry powder) will find companies of this profile attractive. Conversely, startups who have taken a more speculative approach, raising massive, early venture rounds will demand a higher acquisition price to appease their investors or have to keep their heads down on their way to an IPO.
Finding alignment is important at every stage of a startup’s growth and every round of institutional investment. And like any potential relationship, the best ones are developed over time and through trusted networks, rather than under pressure or out of the blue.
Finding the right PE partner goes back to your due diligence as a founder when you assess fit with any prospective investor. Many startups evaluate potential investors and board members through their ability to provide operational expertise and connections to critical partners. Given the likelihood (and attractiveness) of PE as a potential end buyer, startups should be equally eager to evaluate the strength of a potential investor’s relationships within the PE community.
This means looking for firms that see a high percentage of their portfolio go on to a viable PE exit, as well as firms that actively work to develop relationships with the right types of buyers. In other words, investors should be building relationships with PE firms to put the company on the path to further continued success.
Leveraging these trusted connections should help calm founders’ anxieties around PE stereotypes and make them more confident in selecting a firm as a long-term partner for growth. Investment firms that truly care about alignment with their founders will encourage them to take the exit path that fulfills their vision for the company, rather than solely benefitting the firm’s interest in securing a return on their investment.
Many advise startups to build relationships with potential strategic partners early and over the long haul—not simply when they are ready to exit or in need of a cash infusion. The same rule applies to how you approach PE. Connecting early and updating them of your progress often provides more latitude for assessing fit and finding alignment when the time for an exit comes.
The diversity and growth of the PE ecosystem should be reassuring to founders, rather than unnerving. Having optionality allows you to be selective in the right partner. As with many other big decisions, you should rely on your current investors to guide you through the process of vetting and brokering of PE relationships that work for your company and your vision.