Private Equity Strategies.

The life cycle of a successful company typically involves several stages of development. It begins as a startup, transitions into a phase of rapid expansion with increasing cash flows and profitability, then enters a more stable, mature development period, and finally, the company may enter a phase of decline as shown in the figure below.

Public stock exchanges have certain listing rules such as a minimum number of shareholders, asset size, and net worth. They also require the periodic release of audited financial reports. However, some companies, unable or unwilling to meet these public market requirements, opt to access private capital at different stages in their life cycle.

For many small- and medium-sized private firms, personal or family capital contributions are often sufficient to meet their business capital needs throughout their life cycles. However, institutional private equity investors can play a crucial role for companies at both earlier and later life cycle stages.

1. Venture Capital

Startup companies usually have little to no revenue, negative cash flow, and few assets. They are typically established with an equity contribution from a founding owner, friends, or family. As the company develops, founders often seek active institutional investors willing to assume very high risk. These venture capital investments typically involve minority equity positions held by more than one investor and often occur in stages.

Venture capital investors are highly selective, targeting firms with the highest growth potential and seeking some form of control, such as a board or advisory role in a new company. Many well-known, large global firms such as Apple, Starbucks, and Tesla were successful beneficiaries of venture capital funding at their earliest stage of development.

2. Growth Equity

Once a young company has a proven business model, initial customer relationships, and rising revenue, it enters an expansion phase. During this phase, it seeks to capitalize on the company’s total addressable market, a measure of the industry-wide revenue potential for the company’s product or service. In some cases, the firm is acquired or seeks public investors via an initial public offering (IPO). If the company chooses to remain private, private investors contribute what is referred to as growth equity during this life cycle phase.

Growth equity provides capital specifically targeting profitable expansion well above the rate of growth of a particular industry and the overall economy. This is achieved by increasing the company’s scale of production, marketing, and distribution. This growth may also occur via acquisition, new distribution channels, or new markets. In most cases, this new equity reduces the ownership concentration of founders and initial investors.

Private firms in the expansion phase usually rely primarily on a minority equity capital stake as a source of funding, avoiding the periodic interest expense associated with debt funding due to the uncertain trajectory of cash flow and profitability growth.

Mature public firms are typically those listed on global public equity exchanges and issue widely held fixed-income securities. These firms are more likely to use hybrid instruments such as preferred shares or convertible instruments. They offer investors more stability compared to startup or growth companies, and are more likely to pay periodic dividends to shareholders. They can also support debt service payments from steady cash flows.

However, mature companies operating in dynamic markets are also subject to structural changes that impact growth, contraction, and enhanced profitability. These changes are usually driven by company-specific factors, competitive industry pressures, or macroeconomic changes. In many cases, public company managers initiate such changes in response to declining market share or a falling share price.

3. Buyout Capital

Listed companies with widely dispersed ownership are often slower to restructure in response to competitive pressures or opportunities than closely held firms managed by private owners. This is largely due to the agency cost of equity, a type of principal-agent problem arising when company managers have more information about the firm than its shareholders, limiting the owners’ ability to assess performance and dismiss ineffective managers.

In contrast, private equity ownership and management allows for more direct control over strategic decisions. In the case of buyout equity investments, private equity firms acquire a controlling equity stake in underperforming public companies to transform, divest, or acquire businesses. These investors aim to improve cash flow and profitability with the intent to sell the reorganized firm at a higher price to a private investor, existing public company, or the public via an IPO. Such transactions are also referred to as leveraged buyouts due to the high proportion of debt financing used to make the acquisition.

4. Special Situations

The interaction between private and public sources of equity capital is typically not a one-time event but rather reflects a constant dynamic in many industries. At some point, most companies eventually enter a phase of decline as competitive pressures, technological change, or other factors cause a firm’s revenues and cash flow to fall, potentially resulting in financial distress. Private market investors often play a role in these so-called special situations—areas of investment that seek to generate return through investments in stressed, distressed, or event-driven opportunities.

Practice Questions

Question 1: A company in its early stages of development is seeking to expand its operations and capitalize on its total addressable market. The company has a proven business model, initial customer relationships, and rising revenue. However, it chooses to remain private and not go for an initial public offering (IPO). Which of the following best describes the type of investment the company is likely to seek and why?

1. The company is likely to seek venture capital investments as they are willing to assume very high risk and often occur in stages.
2. The company is likely to seek growth equity as it provides capital specifically targeting profitable expansion well above the rate of growth of a particular industry and the overall economy.
3. The company is likely to rely primarily on a minority equity capital stake as a source of funding, avoiding the periodic interest expense associated with debt funding due to the uncertain trajectory of cash flow and profitability growth.

Answer: Choice B is correct.

The company described in the question is likely to seek growth equity investments. Growth equity is a type of private equity investment, usually a minority investment, in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a significant acquisition without a change of control of the business. These companies are likely to be more mature than venture capital funded companies, able to generate revenue and profit but unable to generate sufficient cash to fund major expansions, acquisitions or other investments. Because of this lack of scale these companies generally can find few alternative conduits to secure capital for growth, so access to growth equity can be critical. Growth equity investments are also usually done in conjunction with a strategic plan that requires capital, such as entering a new market, acquiring a competitor, or launching a new product line.

Choice A is incorrect. Venture capital investments are typically made in early-stage companies with high growth potential, but the company described in the question is not in its early stages. It has a proven business model, initial customer relationships, and rising revenue, which suggests it is beyond the stage where venture capital would be the most appropriate form of investment.

Choice C is incorrect. While a minority equity capital stake could provide some funding for the company’s expansion, it is not the best description of the type of investment the company is likely to seek. The company is seeking to capitalize on its total addressable market and expand its operations, which suggests it needs a significant amount of capital. A minority equity capital stake may not provide sufficient funding for this purpose. Furthermore, the company’s decision to remain private and not go for an IPO suggests it is looking for a type of investment that allows it to maintain control, which is more characteristic of growth equity investments.

Question 2: A startup company with little to no revenue, negative cash flow, and few assets is looking for investors. The founders are seeking active institutional investors willing to assume very high risk. Which type of investors are the founders likely to approach and why?

1. The founders are likely to approach public stock exchanges as they require the periodic release of audited financial reports.
2. The founders are likely to approach institutional private equity investors as they can play a crucial role for companies at both earlier and later life cycle stages.
3. The founders are likely to approach venture capital investors as they are highly selective, targeting firms with the highest growth potential and seeking some form of control, such as a board or advisory role in a new company.

Answer: Choice C is correct.

The founders of a startup company with little to no revenue, negative cash flow, and few assets are likely to approach venture capital investors. Venture capitalists are investors who provide capital to startups and small companies with the potential for long-term growth. They are known for taking on high-risk investments in exchange for significant returns. In this scenario, the founders are seeking active institutional investors willing to assume very high risk, which is a characteristic of venture capitalists. Venture capitalists are highly selective, targeting firms with the highest growth potential and seeking some form of control, such as a board or advisory role in a new company. This allows them to actively participate in the company’s decision-making process and guide the company towards success. Therefore, venture capitalists are the most suitable type of investors for the founders to approach in this scenario.

Choice A is incorrect. Public stock exchanges are not suitable for a startup company with little to no revenue, negative cash flow, and few assets. Listing on a public stock exchange requires the company to meet certain financial and regulatory requirements, including the periodic release of audited financial reports. Given the company’s financial situation, it is unlikely to meet these requirements. Furthermore, public stock exchanges are not active investors and do not provide the hands-on guidance and support that the founders are seeking.

Choice B is incorrect. While institutional private equity investors can play a crucial role for companies at both earlier and later life cycle stages, they are not the most suitable type of investors for the founders to approach in this scenario. Private equity investors typically invest in established companies with stable cash flows and assets, which the startup company does not have. Furthermore, private equity investors often seek to take control of the company and implement their own strategies, which may not align with the founders’ vision for the company.

Glossary:

• Startup: A newly established business.
• Expansion phase: The stage in a company’s life cycle where it experiences rapid growth in revenues and profitability.
• Mature public firms: Companies that are listed on public equity exchanges and have stable revenues and profitability.
• Agency cost of equity: A type of principal-agent problem arising when company managers have more information about the firm than its shareholders.
• Leveraged buyouts: A transaction where a company is acquired using a significant amount of borrowed money.

Private Markets Pathway Volume 1: Learning Module 3: Private Equity; LOS 3(a): Discuss private equity strategies over the company life cycle