Is the Risk of Private Equity Worth It? Should You Let Them "In the House"?
Imagine having someone like Shark Tank's Mark Cuban or Barbara Corcoran say "I believe in your company! Here's a fat check for $500,000. Just give me a 10 percent stake in the place. Do we have a deal?"
In this fantasy, you say "Where do I sign?" without even sleeping on it, because you already know you want to buy new equipment, lease a bigger space, or hire staff. And isn't this better than being saddled with a big loan to pay back?
However reality and entertainment television are two very different things.
Fewer deals have investors asking for greater stakes.
Private equity deals are coming with more strings attached than they did even a few years ago. Until recently, many equity investors were borrowing investment capital at low rates. Taking on increased risk was worth it; they could reasonably expect favorable returns on their investments.
But now that money is more expensive to borrow for these investors, every deal must be well worth the time and effort. So equity investors are being more selective and ensuring terms are favorable, which in turn can limit upside for sellers. Given these conditions, many business owners in need of capital are granting larger equity stakes than they'd wanted, because they have fewer investors to choose from.
What to consider before you sign.
While I'm not an equity advisor, I've worked with hundreds of dedicated entrepreneurs who've made the decision between short-term borrowing and seeking an equity stake in their business. I suggest two steps for any small business that's considering selling equity:
#1: Establish your business's worth — not just its current value, but what it would be worth after, say, 25 percent to 100 percent growth. You must know the value of the stake you may sell.
#2: Determine your current priorities for the business, as well as your goals for the next five to ten years. Will your equity investor support these objectives?
Once you take these steps, you can decide whether an equity infusion supports or hamstrings the plans you have for your business and your life.
How to determine — and maximize — your value.
Establish your business's value by understanding the market for equity in your industry, and the profile of your potential investor(s). Hubs such as BizBuySell.com, LoopNet, and BusinessesForSale.com function like the realtor.com or Zillow of business sales. In addition to listings and sales reports, they offer how-tos on everything from making valuations and screening potential investors to closing the deal.
The ultimate market value of your firm depends on many situational factors, though these are critical metrics:
Your business assets, including real estate, equipment, and contracts.
Key valuation metrics such as: EBITDA (Earnings before interest, taxes, and depreciation)
Comparative sale prices in your line of business
As a general rule of thumb, assessing business value is easier with a company posting $10 million or less in revenue, since there are so many comparative sales in this category. (When you're going much above $10 million, the criteria gets more complex, and you may want to get the help of a private-equity advisor.)
A little "home improvement" can go a long way.
Once you know the value of your business, you may opt to make a small investment to enhance its value. Think of it as investing in your house to get a better sale price. Do you want to list your now, with its leaky roof, and 1980s green kitchen cabinets, or take the time to renovate, so that you can draw even more value from it?
Likewise, taking a year or two to invest in your firm's sales and marketing may help you achieve your top-line revenue. With the resulting higher valuation, you may sign a better equity deal than you could without your careful investment.
Decide what you're willing to give up for an equity stake.
If, using the above example, you invested in your business and it's now worth more than ever, you may decide to retain full control of it. After all, your desire for autonomy is surely one of the reasons you started your business, so why not let it inform your equity decision?
At first blush, an equity deal may appear to come with freedom: You get a lump of cash without a designated payoff schedule. In contrast, you may see debt as a burden that requires you to pay up, on schedule, or face dire consequences.
But consider this: Once you've paid off that loan, you're free. Depending on the deal you've made, once you sell an equity piece you've ceded part of your decision-making process for the remainder of your time with your new business partner.
Vet your prospective equity partners with care.
In the best cases, some amazing equity investors can help you succeed. They may promise to handle operations like HR and Finance, while you focus on what you do best. A potential partner could also offer to introduce you to new clients and markets.
After they've made their offer, take a beat and think about it. What will be the three, four, or five biggest ways your business with change in this proposed partnership? And how many of these changes will support (or hamper) the goals you set when you were still running your business from the kitchen table?
Do you share the similar levels of risk tolerance?
Will the investor create a more aggressive timeline for certain levels of profit that you've planned?
What is their management style? Do you feel they understand yours — and your workplace culture?
Can they share their record of other small businesses they've invested in? Insist on talking with those partners.
You've got a plan for the future of your firm. What's theirs?
Smart questions like these can help to ensure you make a business decision that's right for you.
Look at equity as a debt position.
To aid your decision between an equity stake or debt, consider this example: You may be entertaining the idea of selling a 20 percent stake in your business for $1 million. If you take out a loan instead, and say you payback $1.4M or so, depending on the debt product, term and rate.
Meanwhile you've made some great business moves. Ten years on, that 20 percent stake is now worth $5 million. With a loan, you paid $400kto enjoy that greater equity for the long-term. With an equity investment, you've paid $5 million to sacrifice a piece of your autonomy for the long-term. You'll now be sharing the sweat equity you've accrued – 100-hour weeks and forsaken vacations — with your new equity partner.
Can you afford the time a PE deal requires?
The concept of time has come up a few times in this column, because equity deals are all about time; Be ready for a six-, a 12-, or even 18-month process, depending on many factors. This benefits both you and your potential investor. You'll want your legal and business advisors to make certain a deal addresses your business goals. At the same time, your investor must vet your financials and research your industry, to assess their risk exposure. Their careful consideration means you're more likely to get the value you deserve.
This all said, if you need cash fast, seeking an equity stake probably isn't for you.
With short-term, cash flow-based lending, you can establish the cost, estimate the ROI, and, most of all, know that once you're paid up, you're done — you're still head of the house.
Since 2008, Fora Financial has distributed $4 billion to 55,000 businesses. Click here or call (877) 419-3568 for more information on how Fora Financial's working capital solutions can help your business thrive.
