Private equity investors majorly invest in mature well-established companies and do not fund startups and small businesses. But lately, some institutional investors and wealthy individuals started investing in high-growth small businesses that have maintained a consistent growth track record and looking to expand.
These firms provide funding to SMEs they need to grow in exchange for a significant equity stake in the company. Let’s navigate what is private equity funding, how it works, whether PE funding is good for small businesses, how SME owners and promoters can raise capital from private equity investors along with key challenges or risks.
What is Private Equity Funding?
Before securing PE funding, SME owners must know what it means.
Private equity investors pool money from several investors and invest it in high-growth-fueled companies. PE funding usually comes from big institutional investors who can provide substantial capital to small and medium businesses for high growth, business expansion, and other growth initiatives. These investors inject capital and get an equity ownership stake in return.
The primary goal of private equity investors is to get high returns at exit in the event of an IPO, acquisition, or sale of the business to another strategic investor.
How Does Private Equity Funding Work for Small Businesses?
Though Private Equity Funding is a great financing method to get the required amount of capital you need to grow your business it’s not always a good option for all SMEs. So before you as a small business owner approach investors, you must understand how PE financing works to decide whether it’s the right time to get funding from them.
When you pitch PE investors and if they are convinced about your business traction, they will negotiate on valuation and other terms and finalize a deal. In return for the capital invested, they usually demand a sizeable stake in your company and thus, will have a say in major business decisions.
Along with capital investment, PE investors also offer strategic insights, access to valuable networks, and expert oversight. PE firms have experienced professionals who help small business owners create solid business strategies in all operational areas.
Types of Private Equity Funding
Large institutional investors mainly invest in well-established businesses with promising growth prospectus. Private Equity financing comes from a variety of sources including;
1. Venture Capital Funding: VC Funding is the widely accepted method of raising private equity funding for small businesses. Venture Capitalists usually invest in small and early-stage growth businesses that have a compelling growth trajectory but have limited access to capital. Thus, VC provides them with the required capital to help them grow and expand their business to get high returns.
VC usually provides different types of funding;
- Seed Capital: This is the initial round of funding offered to entrepreneurs to validate their business concept.
- Early-Stage funding: This is the funding provided to startups to commercialize their operations to generate initial revenues.
- Expansion Stage: This type of financing is provided to grow and expand small business operations.
2. Growth Equity Capital: SMEs that have reached maturity and are generating good profits but are looking for expansion can seek growth capital. Private Equity investors provide growth capital to small businesses to tap newer markets and expand rapidly.
3. Buyouts: PE buyouts come in two forms – management buyouts and leveraged buyouts. When investors acquire existing management, known as a management buyout. However, when the acquisition is financed through a large amount of debt capital. This type of funding is generally done for matured businesses and investors get a majority stake in the company. Hence, buyout financing is not suitable for small businesses.
Why Private Equity Funding is Good for Small Businesses?
Today, PE funding has become a popular fundraising option for small businesses for plenty of reasons, explained below;
- Access to larger capital: The most important reason private equity is a good funding option is these investors provide larger access to capital to help you grow and scale. As a small business owner, you may struggle to access the required money, but if private equity investors, be it venture capitalists or growth equity investors, have a strong belief in the high growth of your business, they will inject the required sum of capital.
- Strategic guidance and support: PE investors are professional experts who bring diversified experience, strategic insights, operational expertise, and industry experience to help SME owners grow.
- Their oversight helps companies formulate suitable strategies, identify key challenges, and follow the right risk mitigation strategies to strengthen competitive positioning.
- Networking Opportunities: PE investors have long-standing experience so they bring access to a broad industry network for small businesses. They help SME owners get connected with potential partners, investors, and customers.
- Access to resources: SMEs when got funding from private equity investors, get access to all the resources they need to expand. PE firms provide resources to companies to grow or scale up their operations, enter into new markets, new product development, and more. They offer valuable advice, mentorship, and professional guidance to help SMEs grow and succeed.
- Increase business credibility: Financing through reputed institutional investors adds to your business credibility. As you get more attention from the media, it boosts your image in the public eye.
- Long-term focus: PE investors have a longer investment horizon, so they provide enough time to owners to take their SMEs to the next level. Entrepreneurs have the flexibility to take strategic initiatives to drive huge growth.
How to Secure Private Equity Funding?
1. Assess Your Readiness
Not all companies can secure funding from PE investors and only those who have high growth potential can succeed. Small businesses must assess their readiness to know the right time for PE funding. SMEs who meet the following criteria are ready to approach private equity financing;
- Emerging Small businesses that are generating increasing revenues at a fast pace
- Companies with strong competitive moat, unique selling propositions, and business model
- SMEs who have good financial track record and have strong growth outlook
- Fast-growing SMEs who want to expand or enter into new market segments
2. Prepare comprehensive documentations
Get ready with all the documents including your operational performance track record, financial statements, market analysis & industry research, business model, competitive positioning, strategic initiatives, and an impressive growth strategy with a clear path to profitability.
Prepare an impactful pitch deck highlighting all key numbers, your financial health & future projections for successful funding.
3. Find the right PE Firms
Just like all the companies are not viable for PE investment, all the investors are not good for you. So, as a promoter, you must research to find the right PE firm. Factors to be checked to find the right PE investor are;
- Look for private equity investors who have invested in other companies in your industry so they will be aware of your industry
- Search PE investors specialized in investing in companies at a similar growth stage
- Analyze their track record or performance by examining how well their portfolio companies have performed after obtaining PE capital
4. Pitch potential investors
Once you find potential investors, present a strong pitch deck to introduce your business.
While approaching them, you should be clear and concise to show all the business facts, strengths, and challenges you may face. Also, why you need funding and how you will capitalize on it to drive growth should be disclosed.
For successful funding, your pitch deck must be impactful to convince and attract them for investment. You should also leverage your network to introduce your business to them.
5. Due Diligence
PE firms conduct a thorough due diligence assessment to identify key risks involved.
They assess the company’s financial health and performance and analyze market potential and the viability of the growth prospectus. SMEs who show impressive operational track records and visible growth in the future encourage PE investors to provide capital.
6. Negotiate with investors
At this stage, SME owners seek expert guidance by hiring legal and financial advisors to negotiate with investors.
They generally negotiate on terms, including valuation, equity stake percentage, investor rights, and exit provisions.
7. Close the deal
Finally, the investment deal is finalized and legal documentation is done to receive funding. And now, the company must update investors about the business growth, financial performance, and other important events.
Disadvantages in Securing PE Funding for Small Businesses
- Equity Dilution: Dilution of stake is the most important challenge associated with private equity financing. SME owners seeking PE financing must be willing to give up a portion of business ownership to investors.
- Impact on business decisions: As the stake gets diluted PE investors may seek a board seat and thus, significantly influence major business decisions.
- High return expectation: PE firms target high-growth companies to get high returns when they sell their stake. Due to high return expectations, they can pressure the managing team for aggressive growth.
- Exit Pressure: PE investors may also put pressure on companies to exit their investments and may force you to go public even if you are not ready.
Tips to Secure Funding From Private Equity Investors
- Foster strong relationships with PE investors to take advantage of their guidance and expertise
- Align your interest and strategic goals with PE investors
- Be transparent while communicating with investors on your business performance, challenges & risks, and other aspects
- Showcase how you will use the money raised to drive strategic growth – developing new markets, operational improvements, or market expansion
- Be clear on exit opportunities to maximize the value for all stakeholders
