Preface

Definition

Private equity is medium to long-term finance provided in return for an equity stake in potentially high growth unquoted companies. Some commentators use the term “private equity” to refer only to the buy-out and buy-in investment sector. Others, in Europe but not the USA, use the term “venture capital” to cover all stages, i.e. synonymous with “private equity”. In the USA “venture capital” refers only to investments in early stage and expanding companies. To avoid confusion, the term “private equity” is used throughout this Guide to describe the industry as a whole, encompassing both “venture capital” (the seed to expansion stages of investment) and management buy-outs and buy-ins.

How this Guide can help you

This Guide aims to encourage you to approach a source of private equity early in your search for finance. It explains how the private equity process works and what you need to do to improve your chances of raising it. It gives guidance on what should be included in your business plan, which is a vital tool in your search for funding. It also demonstrates the positive advantages that private equity will bring to your business.

The main sources of private equity in the UK are the private equity firms (who may invest at all stages – venture capital and buy-outs) and “business angels” (private individuals who provide smaller amounts of finance at an earlier stage than many private equity firms are able to invest). In this Guide we principally focus on private equity firms. The attributes that both private equity firms and business angels look for in potential investee companies are often very similar and so this Guide should help entrepreneurs and their advisers looking for private equity from both these sources. “Corporate venturers” which are industrial or service companies that provide funds and/or a partnering relationship to fledgling companies and may operate in the same industry sector as your business can also provide equity capital.

Throughout the 1990s the technology hype, internet boom and massive capital investment propelled the New Economy revolution, but internet mania in the late 1990s caused technology stocks to skyrocket until the bubble burst in March 2000. There was over-optimism, too much easy money, proven ways of doing business were replaced by irrational exuberance and private and public company market valuations were driven to unsustainable levels.

Post bubble, in the current economic environment, private equity firms are looking for investment opportunities where the business has proven potential for realistic growth in an expanding market, backed up by a wellresearched and documented business plan and an experienced management team – ideally including individuals who have started and run a successful business before. There is currently no shortage of funds for investment in the UK. Excellent opportunities remain open to companies seeking private equity with convincing business proposals. This Guide will help you to understand what private equity firms are looking for in a potential business investment and how to approach them.

What is private equity?

Private equity provides long-term, committed share capital, to help unquoted companies grow and succeed. If you are looking to start up, expand, buy into a business, buy out a division of your parent company, turnaround or revitalise a company, private equity could help you to do this. Obtaining private equity is very different from raising debt or a loan from a lender, such as a bank. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of your success or failure. Private equity is invested in exchange for a stake in your company and, as shareholders, the investors’ returns are dependent on the growth and profitability of your business.

Private equity in the UK originated in the late 18th century, when entrepreneurs found wealthy individuals to back their projects on an ad hoc basis. This informal method of financing became an industry in the late 1970s and early 1980s when a number of private equity firms were founded. Private equity is now a recognised asset class. There are over 170 active UK private equity firms, which provide several billion pounds each year to unquoted companies, around 80% of which are located in the UK.

Would my company be attractive to a private equity investor?

Many small companies are “life-style” businesses whose main purpose is to provide a good standard of living and job satisfaction for their owners. These businesses are not generally suitable for private equity investment, as they are unlikely to provide the potential financial returns to make them of interest to an external investor.

“Entrepreneurial” businesses can be distinguished from others by their aspirations and potential for growth, rather than by their current size. Such businesses are aiming to grow rapidly to a significant size. As a rule of thumb, unless a business can offer the prospect of significant turnover growth within five years, it is unlikely to be of interest to a private equity firm. Private equity investors are only interested in companies with high growth prospects, which are managed by experienced and ambitious teams who are capable of turning their business plan into reality. However, provided there is real growth potential the private equity industry is interested in all stages, from start-up to buy-out.

Some of the benefits of private equity

Private equity backed companies have been shown to grow faster than other types of companies. This is made possible by the provision of a combination of capital and experienced personal input from private equity executives, which sets it apart from other forms of finance. Private equity can help you achieve your ambitions for your company and provide a stable base for strategic decision making. The private equity firms will seek to increase a company’s value to its owners, without taking day-to-day management control. Although you may have a smaller “slice of cake”, within a few years your “slice” should be worth considerably more than the whole “cake” was to you before.

Private equity firms often work in conjunction with other providers of finance and may be able to help you to put a total funding package together for your business.

Questions to ask yourself before reading further...

• Does your company have high growth prospects and are you and your team ambitious to grow your company rapidly?
  
• Does your company have a product or service with a competitive edge or unique selling point (USP)?
  
• Do you and/or your management team have relevant industry sector experience? Do you have a clear team leader and a team with complementary areas of expertise, such as management, marketing, finance, etc?
  
• Are you willing to sell some of your company’s shares to a private equity investor?

If your answers are “yes”, private equity is worth considering. If “no”, for other sources of capital and advice call your local Business Link (see Appendix).

Internal and external financial resources

Before looking at new external sources of finance, make sure you are making optimal use of your internal financial resources.

• Ensure that you have good cash flow forecasting systems in place
• Give customers incentives to encourage prompt payment
• Adhere to rigorous credit control procedures
• Plan payments to suppliers
• Maximise sales revenues
• Carefully control overheads
• Consider sub-contracting to reduce initial capital requirements (if appropriate)
• Assess inventory levels (if appropriate)
• Check quality control

Then think about the external options.

• Your own and your co-directors’ funds
• Friends’ or business associates’ funds
• The clearing banks – overdrafts, short or medium-term loans
• Factoring and invoice discounting
• Leasing, hire purchase
• Merchant banks – medium to long-term larger loans
• Public sector grants, loans, regional assistance and advice
• Business angel finance
• Corporate venturing
• Private equity

But please don’t get the impression that private equity is a last resort after you have exhausted your own, your friends’, your business colleagues’ and your bank’s resources. There are many advantages to private equity over bank debt. Private equity firms can of course work in conjunction with the other external sources as part of an overall financing package.

Some of the alternative sources of external finance are elaborated on below for your information.

The Small Firms Loan Guarantee Scheme allows businesses without sufficient security for commercial bank lending to obtain loans from participating banks that are guaranteed by the Government. The Small Business Service (SBS) guarantees 75% of the loan. Borrowers pay a 2% premium on the outstanding balance. The maximum loan for businesses trading for more than two years is £250,000 or £100,000 for newer businesses.

The scheme is available to UK businesses with an annual turnover of up to £3 million – for manufacturers up to £5 million.

Business Links are part of the SBS and can provide advice on the various grants available to small businesses as well as practical advice, help and entry to the various schemes run by the Department of Trade and Industry (DTI). Grant opportunities include grants for research and development, Local Regional Development Agency grants and the Phoenix Fund for disadvantaged communities and groups. New businesses (particularly those using new technology) can get help with premises and management from the various Business Incubation Centres in the UK or from one of the UK Science Parks. You may also be eligible for EU grants if you are in an innovative business sector or are planning to operate in a deprived area of the UK or a region zoned for regeneration. Apart from Business Links your local Chamber of Commerce and town hall should have lists of grants and available property.

A new product Selective Finance for Investment in England has replaced the former Regional Selective Assistance Scheme and is provided by the Regional Development Agencies. Funding of up to 10-15% of a project’s total eligible capital expenditure may be obtained.

The Regional Venture Capital Funds (RVCFs) are one element of the £180 million Enterprise Fund that was created in 1998 through the SBS to stimulate more finance for small businesses and address market weakness in the provision of that finance. The RVCFs were set up to address small to medium enterprises (SMEs) seeking small-scale investment (i.e. £500,000 and below). The funds cover the North East, North West, London, Yorkshire and the Humber, South East and South West, East Midlands, West Midlands and East of England.

The concept of Enterprise Capital Funds (ECFs) is a proposed new UK Government initiative following a consultation process instigated at the 2003 Budget. This aims to improve access to growth capital for small and medium-sized enterprises by applying a modified US Small Business Investment Company (SBIC) model to the UK by:

• Bringing more entrepreneurial investors into the management of funds aimed at smaller, early stage deals.
  
• Offering incentives to investors to make these investments.
  
• Enhancing the impact of business angel networks in providing sources of risk capital and expertise to SMEs.
  

ECFs will be privately managed and invest up to £2 million of equity into an enterprise. A pathfinder round of ECFs is to be launched, subject to European state aids clearance. ECFs will use a limited partnership model with two variants.

• A professional FSA-authorised fund manager who acts on behalf of passive investors.
  
• An active investor model (e.g. business angels) who invest and manage own funds through ECFs (maybe without authorisation).

Business angels are private investors who invest directly in private companies in return for an equity stake and perhaps a seat on the company’s board. Research has shown that business angels generally invest smaller amounts of private equity in earlier stage companies compared with private equity firms. They typically invest less than £100,000 at the seed, start-up and early stage of company development. Many companies find business angels through informal contacts, but for others, finding a business angel may be more difficult, as the details of individual business angels are not always available.

The Enterprise Investment Scheme was set up by the Government to replace the Business Expansion Scheme (BES) and to encourage business angels to invest in certain types of smaller unquoted UK companies. If a company meets the EIS criteria, it may be more attractive to business angels, as tax incentives are available on their investments.

The aim of the UK Government’s University Challenge Seed Fund Scheme is to fill a funding gap in the UK in the provision of finance for bringing university research initiatives in science and engineering to the point where their commercial viability can be demonstrated. Certain charities and the Government have contributed around £50 million to the scheme. These funds are divided into 15 University Challenge Seed Funds that have been donated to individual universities or consortia and each one of these has to provide 25% of the total fund from its own resources. If you are looking into the commercialisation of research at a UK university which is in receipt of a fund, contact your university administration to enquire about the application process. Follow-on finance may be provided by business angels, corporate venturers and private equity firms.

Corporate venturing which had developed quite rapidly in recent years still represents only a small fraction when compared to private equity investment activity. Direct corporate venturing occurs where a corporation takes a direct minority stake in an unquoted company. Indirect corporate venturing is where a corporation invests in private equity funds managed by an independent private equity firm. Corporate venturers raise their funds from their parent organisations and/or from external sources.

Do speak to friends, business contacts and advisers as well as your local Business Link. Do remember there are many misconceptions about the various sources of finance, so obtain as much information as possible to ensure that you can realistically assess the most suitable finance for your needs and your company’s success.

The advantages of private equity over senior debt

A provider of debt (generally a bank) is rewarded by interest and capital repayment of the loan and it is usually secured either on business assets or your own personal assets, such as your home. As a last resort, if the company defaults on its repayments, the lender can put your business into receivership, which may lead to the liquidation of any assets. A bank may in extreme circumstances even bankrupt you, if you have given personal guarantees. Debt which is secured in this way and which has a higher priority for repayment than that of general unsecured creditors is referred to as “senior debt”.

By contrast, private equity is not secured on any assets although part of the non-equity funding package provided by the private equity firm may seek some security. The private equity firm, therefore, often faces the risk of failure just like the other shareholders. The private equity firm is an equity business partner and is rewarded by the company’s success, generally achieving its principle return through realising a capital gain through an “exit” which may include:

• Selling their shares back to the management
• Selling the shares to another investor (such as another private equity firm)
• A trade sale (the sale of company shares to another)
• The company achieving a stock market listing

Although private equity is generally provided as part of a financing package, to simplify comparison we compare private equity with senior debt.

Private equity compared to senior debt

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