Written By: Andrew Gelfand
Read By: Nora Mahoney
For business owners that are seeking liquidity but are not quite ready to sell control of their company and retire, one option is to sell a minority interest in the company to a professional investor such as a private equity group (“PEG”). The sale of the entire company can then be pursued three to five years into the future. This approach is called a “two-step process.”
In the first phase, a PEG that specializes in making minority investments in privately-held companies acquires a stake in the company directly from the owner. The PEG may also concurrently make a direct investment in the company to facilitate a growth strategy. This “first institutional capital” is so named because it is typically the first capital invested in the company by “professional investors.”
In these situations, the owner “takes some money off the table,” but continues to own more than 50% of the economics, retains voting control of the company, and retains operational control of the company. The PEG may also provide the owner with specific expertise to grow the company and to help take it to the next level of its life cycle. The ultimate goal is to support a higher, more lucrative exit valuation three to five years into the future. In case it was not obvious, that is the second phase — selling the company.
It is worth noting, however, that partnering with a private equity investor is not for everyone. It is a relationship that takes careful consideration and perhaps some soul-searching. However, for owners who want to realize the benefits & partner with a professional investor that can help take the company to the next level, the advantages of partnering with a minority investor can go far beyond the partial liquidity event.
First, for many owners, their company represents the vast majority of their net worth. In addition, this asset is illiquid. Step one creates partial liquidity for the owner and de-risks their personal financial statement while they continue to control the company and benefit from its appreciation.
Second, PEGs typically have specific expertise in areas such as operations, technology, accounting, sales and marketing, that can be applied to the company. They can bring a fresh perspective to the company and the owner can tap into this expertise to address challenges in these areas. In a private equity partnership, the company gains access to expert advice from parties that have a vested interest in helping the company succeed.
Finally, it is critical for owners to consider their total financial picture when thinking about a private equity partnership, and eventually, a sale. The significance of financial planning at the beginning of the sale process becomes an integral factor in preparing for the sale of a business. To recap: Owners should understand the amount they need to realize from a sale to maintain their current lifestyle and achieve their financial goals, and why that is the “magic” number. A PEG can help the owner determine how to achieve that financial goal, perhaps even faster than the owner might on their own, if at all.
One caveat to partnering with a private equity group is that the owner must be committed to a sale in three to five years, otherwise they can end up in what we call “private equity hell.” If the owner and investor do a great job increasing the company’s value, the PEG wants to sell its interest, and the owner changes their mind about selling the company, the owner can end up in the never-ending cycle of having to replace the current PEG with a new PEG, never being able to own the company outright again.
In conclusion, owners seeking partial liquidity now, together with a complete exit in three to five years, may be able to benefit from a private equity group partnership. As described above, the two-step process can be the best of both worlds: the owner achieves partial liquidity now while retaining control of the company, benefits from the resources of the PEG, and may achieve an even higher exit valuation down the road. With that said though, owners should not consider partnering with a private equity group in this fashion unless they are considering a sale of the entire company three to five years into the future.