Preface

The investment process, from reviewing the business plan to actually investing in a proposition, can take a private equity firm anything from one month to one year but typically it takes between three and six months. There are always exceptions to the rule and deals can be done in extremely short time frames. Much depends on the quality of information provided and made available to the private equity firm.

Reaching your audience

When you have fully prepared the business plan and received input from your professional adviser, the next step is to arrange for it to be reviewed by a few private equity firms. You should select only those private equity firms whose investment preferences match the investment stage, industry, location of, and amount of equity financing required by your business proposition. For the initial approach, it is worth considering sending only a copy of the Executive Summary to potential investors. This has the advantage of saving costs and increasing the chances of receiving attention. Before communicating your plan to potential investors, read pages 51-55 concerning the FSMA requirements.

Confidentiality

All private equity firms who are members of the BVCA are bound by the BVCA’s “Code of Conduct” which states that they will respect confidential information supplied to them by companies looking for private equity capital (or indeed in which they have invested). There are safeguards you can take, however, if you are particularly concerned about confidentiality. These include:

• Seeking professional advice
  
• Checking whether the potential investor has any major conflicts of interest, such as a significant investment in a competitor
  
• Leaving out the more confidential data
  
• Sending only your Executive Summary
  
• Using the BVCA’s standard confidentiality letter
  

If you wish to use a confidentiality letter, an example of one can be obtained from the BVCA’s website. The general terms of this letter have been agreed by BVCA members and with your lawyer’s advice you can adapt it to meet your own requirements. You can then ask the private equity investor to sign it, before being sent the full business plan. We would recommend, however, that you only ask for a confidentiality letter when the potential investor has received your Executive Summary and has shown an interest in giving your proposal detailed consideration.

How quickly should I receive a response?

Generally you should receive an initial indication from the private equity firms that receive your business plan within a week or so. This will either be a prompt “no”, a request for further information, or a request for a meeting. If you receive a “no”, try to find out the reasons as you may have to consider incorporating revisions into your business plan, changing/strengthening the management team or carrying out further market research before approaching other potential investors.

How do private equity firms evaluate a business plan?

They will consider several principal aspects:

• Is the product or service commercially viable?
  
• Does the company have potential for sustained growth?
  
• Does management have the ability to exploit this potential and control the company through the growth phases?
  
• Does the possible reward justify the risk?
  
• Does the potential financial return on the investment meet their investment criteria?
  

Presenting your business plan and negotiations

If a private equity firm is interested in proceeding further, you will need to ensure that the key members of the management team are able to present the business plan convincingly and demonstrate a thorough knowledge and understanding of all aspects of the business, its market, operation and prospects.

Assuming a satisfactory outcome of the meeting and further enquiries, the private equity firm will commence discussions regarding the terms of the deal with you. The first step will be to establish the value of your business.

Valuing the business

There is no right or wrong way of valuing a business. There are several ways in which it can be done.

Calculate the value of the company in comparison with the values of similar companies quoted on the stock market.

The key to this calculation is to establish an appropriate price/earnings (P/E) ratio for your company. The P/E ratio is the multiple of profits after tax attributed to a company to establish its capital value. P/E ratios for quoted companies are listed in the back pages of the Financial Times, and are calculated by dividing the current share price by historic post-tax earnings per share. Quoted companies’ P/E ratios will vary according to industry sector (its popularity and prospects), company size, investors’ sentiments towards it, its management and its prospects, and can also be affected by the timing of year-end results announcements.

The private equity investment process

An unquoted company’s P/E ratio will tend to be lower than a quoted company’s due to the following reasons.

• Its shares are less marketable and shares cannot be bought and sold at will.
  
• It often has a higher risk profile, as there may be less diversification of products and services and a narrower geographical spread.
  
• It generally has a shorter track record and a less experienced management team.
  
• The cost of making and monitoring a private equity investment is much higher.
  

The following are factors that may raise an unquoted company’s P/E ratio compared with a quoted company.

• Substantially higher than normal projected turnover and profits growth.
• Inclusion in a fashionable sector, or ownership of unique intellectual property rights (IPR).
• Competition among private equity firms.

Calculate a value for your company that will give the private equity firms their required rate of return over the period they anticipate being shareholders.

Private equity firms usually think in terms of a target overall return from their investments. Generally “return” refers to the annual internal rate of return (IRR), and is calculated over the life of the investment. The overall return takes into account capital redemptions, possible capital gains (through a total “exit” or sale of shares), and income through fees and dividends. The returns required will depend on the perceived risk of the investment – the higher the risk, the higher the return that will be sought – and it will vary considerably according to the sector and stage of the business. As a rough guide, the average return required will exceed 20% per annum.

The required IRR will depend on the following factors.

• The risk associated with the business proposal.
• The length of time the private equity firm’s money will be tied up in the investment.
• How easily the private equity firm expects to realise its investment – i.e. through a trade sale, public flotation, etc.
• How many other private equity firms are interested in the deal (i.e. the competition involved).

Other methods
Private equity firms also use other ways of valuing businesses, such as those based on existing net assets or their realisable value.

Personal financial commitment

You and your team must have already invested, or be prepared to invest, some of your own capital in your company to demonstrate a personal financial commitment to the venture. After all, why should a private equity firm risk its money, and its investors’, if you are not prepared to risk your own! The proportion of money you and your team should invest depends on what is seen to be “material” to you, which is very subjective. This could mean re-mortgaging your house, for example.

Types of financing structure

If you use advisers experienced in the private equity field, they will help you to negotiate the terms of the equity deal. You must be prepared to give up a realistic portion of the equity in your business if you want to secure the financing. Whatever percentage of the shares you sell, the day-to-day operations will remain the responsibility of you and your management team. The level of a private equity firm’s involvement with your company depends on the general style of the firm and on what you have agreed with them.

There are various ways in which the deal can be financed and these are open to negotiation. The private equity firm will put forward a proposed structure for consideration by you and your advisers that will be tailored to meet the company’s needs. The private equity firm may also offer to provide more finance than just pure equity capital, such as debt or mezzanine finance. In any case, should additional capital be required, with private equity on board other forms of finance are often easier to raise. The structure proposed may include a package of some or all of the following elements.

Classes of capital used by private equity firms

The main classes of share and loan capital used to finance UK limited liability companies are shown below.

Share capital
The structure of share capital that will be developed involves the establishment of certain rights. The private equity firm through these rights will try to balance the risks they are taking with the rewards they are seeking. They will also be aiming to put together a package that best suits your company for future growth. These structures require the assistance of an experienced qualified legal adviser.

Ordinary shares
These are equity shares that are entitled to all income and capital after the rights of all other classes of capital and creditors have been satisfied. Ordinary shares have votes. In a private equity deal these are the shares typically held by the management and family shareholders rather than the private equity firm.

Preferred ordinary shares
These may also be known as “A” ordinary shares, cumulative convertible participating preferred ordinary shares or cumulative preferred ordinary shares. These are equity shares with preferred rights. Typically they will rank ahead of the ordinary shares for both income and capital. Once the preferred ordinary share capital has been repaid and then the ordinary share capital has been repaid, the two classes would then rank pari passu in sharing any surplus capital. Their income rights may be defined; they may be entitled to a fixed dividend (a percentage linked to the subscription price, e.g. 8% fixed) and/or they may have a right to a defined share of the company’s profits – known as a participating dividend (e.g. 5% of profits before tax). Preferred ordinary shares have votes.

Preference shares
These are non-equity shares. They rank ahead of all classes of ordinary shares for both income and capital. Their income rights are defined and they are usually entitled to a fixed dividend (e.g. 10% fixed). The shares may be redeemable on fixed dates or they may be irredeemable. Sometimes they may be redeemable at a fixed premium (e.g. at 120% of cost). They may be convertible into a class of ordinary shares.

Loan capital
Loan capital ranks ahead of share capital for both income and capital. Loans typically are entitled to interest and are usually, though not necessarily, repayable. Loans may be secured on the company’s assets or may be unsecured. A secured loan will rank ahead of unsecured loans and certain other creditors of the company. A loan may be convertible into equity shares. Alternatively, it may have a warrant attached that gives the loan holder the option to subscribe for new equity shares on terms fixed in the warrant. They typically carry a higher rate of interest than bank term loans and rank behind the bank for payment of interest and repayment of capital.

Other forms of finance provided in addition to equity

Clearing banks – principally provide overdrafts and short to medium-term loans at fixed or, more usually, variable rates of interest.

Investment banks – organise the provision of medium to longer-term loans, usually for larger amounts than clearing banks. Later they can play an important role in the process of “going public” by advising on the terms and price of public issues and by arranging underwriting when necessary.

Finance houses – provide various forms of instalment credit, ranging from hire purchase to leasing, often asset based and usually for a fixed term and at fixed interest rates.

Factoring companies – provide finance by buying trade debts at a discount, either on a recourse basis (you retain the credit risk on the debts) or on a non-recourse basis (the factoring company takes over the credit risk).

Government and European Commission sources – provide financial aid to UK companies, ranging from project grants (related to jobs created and safeguarded) to enterprise loans in selective areas. See pages 9-11.

Mezzanine firms – provide loan finance that is halfway between equity and secured debt. These facilities require either a second charge on the company’s assets or are unsecured. Because the risk is consequently higher than senior debt, the interest charged by the mezzanine debt provider will be higher than that from the principal lenders and sometimes a modest equity “up-side” will be required through options or warrants. It is generally most appropriate for larger transactions.

Additional points to be considered

By discussing a mixture of the above forms of finance, a deal acceptable to both management and the private equity firm can usually be negotiated. Other negotiating points are often:

• Whether the private equity firm requires a seat on the company’s board of directors or wishes to appoint an independent director.
• What happens if agreed targets are not met and payments are not made by your company?
• How many votes are to be ascribed to the private equity firm’s shares?
• The level of warranties and indemnities provided by the directors.
• Whether there is to be a one-off fee for completing the deal and how much this will be?
• Who will bear the costs of the external due diligence process?

The Offer Letter

At this point, the private equity firm will send you an Offer Letter, which sets out the general terms of the proposal, subject to the outcome of the due diligence process and other enquiries and the conclusion of the negotiations. The Offer Letter, without being legally binding on either party, demonstrates the investor’s commitment to management's business plan and shows that serious consideration is being given to making an investment.

The due diligence process

To support an initial positive assessment of your business proposition, the private equity firm will want to assess the technical and financial feasibility in detail.

External consultants are often used to assess market prospects and the technical feasibility of the proposition, unless the private equity firm has the appropriately qualified people in-house.

Chartered accountants are often called on to do much of the due diligence, such as to report on the financial projections and other financial aspects of the plan. These reports often follow a detailed study, or a one or two day overview may be all that is required by the private equity firm. They will assess and review the following points concerning the company and its management:

• Management information systems
• Forecasting techniques and accuracy of past forecasting
• Assumptions on which financial assumptions are based
• The latest available management accounts, including the company’s cash/debtor positions
• Bank facilities and leasing agreements
• Pensions funding
• Employee contracts, etc

This review aims to support or contradict the private equity firm’s own initial impressions of the business plan formed during the initial stage. References may also be taken up on the company (e.g. with suppliers, customers, and bankers) and on the individual members of the management team (e.g. previous employers). The chartered accountancy firm may also be able to provide advice on the key commercial and structural risks facing the business and to carry out assessments on the company’s technology base and intellectual property.

If the private equity firm commissions external advisers, it usually means that they are seriously considering investing in your business. The due diligence process is used to sift out any skeletons or fundamental problems that may exist. Make the process easier (and therefore less costly) for you and the private equity firm by not keeping back any information of which you think they should be aware in arriving at a decision. In any event, you will have to warrant this in due course.

Syndication

When the amount of funding required is particularly large, or when the investment is considered to be relatively high risk, the private equity firm may consider syndicating the deal.

Syndication is where several private equity firms participate in the deal, each putting in part of the total equity package for proportionate amounts of equity, usually with one private equity firm acting as lead investor. Whilst syndication is of benefit to the private equity firm in limiting risk in the venture, it can also have advantages for the entrepreneur as syndication:

• Avoids any one investor having a major equity share and significant unilateral control over the business.
• Makes available the combined business experience of all the private equity partners to the benefit of the company.
• Permits a relatively greater amount of financing than with a single investor.
• Can offer more sources of additional future financing.

And finally, completion

Once the due diligence is complete, the terms of the deal can be finally negotiated and, once agreed by all parties, the lawyers will draw up Heads of Agreement or Agreement in Principle and then the legally binding completion documents. Management should ensure that they both take legal advice and have a firm grasp themselves of all the legalities within the documents. The legal documentation is described in the next chapter.

Additional private equity definitions

Burn rate
The rate at which a company requires additional cash to keep going.

Chinese walls
Arrangements that prevent sensitive information being passed between different parts of the same organisation, to prevent a conflict of interest or breach of confidentiality.

Dividend cover
Calculated by dividing earnings after tax by the net dividend and expressed as a multiple. It shows how many times a company’s dividends are covered by posttax earnings.

Earn-out
Part of the price of a transaction, which is conditional on the performance of the company following the deal.

Gearing, debt/equity ratio or leverage
The total borrowings of a company expressed as a percentage of shareholders’ funds.

IPO
Initial Public Offering, “flotation”, “float”, “going public”, “listing” are just some of the terms used when a company obtains a quotation on a stock market. Stock markets include the Official List of the London Stock Exchange (where around 40% of trading company flotations are venture backed), the Alternative Investment Market (AIM), NASDAQ Europe, NASDAQ (USA) and other overseas exchanges.

Ratchets
A structure whereby the eventual equity allocations between the groups of shareholders depend on either the future performance of the company or the rate of return achieved by the private equity firm. This allows management shareholders to increase their stake if the company performs particularly well.

Yield
Calculated by dividing the gross dividend by the share price and expressed as percentage. It shows the annual return on an investment from interest and dividends, excluding any capital gain element.

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