How Private Equity Deals Are Structured

For a private business owner looking to raise growth capital, or to sell the business and retire, private equity groups should not be overlooked. Collectively the hundreds of private equity groups in the United States control billions of dollars of business capital, with few strings attached.

The Fairy Tale

PEGs, as they are called, often seem like the knight in shining armor, galloping in to close a deal that would be too risky for banks and too mundane for venture capitalists. It’s a well-deserved reputation. PEGs make a living from investing in businesses, filling an important role in the business finance market. And with the proliferation of smaller “boutique PEGs” there is almost no deal too big or too small for these investors.

But the best part? Since PEGs are investment funds owned by professionals with operating experience, they will often help engineer rapid growth and enhance profitability.

The Dark Side

If all this sounds too good to be true, don’t forget that every investor wants its pound of flesh. In the case of PEGs, they often make money when they buy a company, not when they sell it. Primarily this means that they are looking to pay bottom dollar, or something close.

So if you are a small business owner looking for an exit, PEGs are reliable buyers but not necessarily the ideal buyers. Since they are finance professionals, they carefully calculate how much they can pay based on your past profits and current cash flow. They approach each deal with a very sharp pencil and must be convinced that your company can provide exceptional returns.

If your objective is to get top dollar for your company, forget PEGs. Look instead for a “strategic” buyer who will pay a higher price based on synergy and emotion. PEGs are classified as “financial buyers,” meaning they are looking only at the numbers.

A Hybrid Approach

Recognizing that not all business owners want to sell their stock for the bottom dollar, many PEGs offer an interesting alternative. A business owner can sell a part of the business to the PEG but stay on as chief executive to manage the growth. This accomplishes several things:

• The owner gets to take some cash out of the business. By selling a piece of the company to the PEG, the owner can lock in his or her own personal wealth and reduce the financial stress of owning a business.
• The business gets extra cash. Deep-pocketed PEGs will pledge growth capital to the business to assure it can execute its growth plans.
• The PEG management team can get involved but leave the day-to-day operations to the veteran. By not upsetting delicate office culture and staffing, the business is often better able to grow rapidly.

Over the few years following a private equity investment, as the business executes its growth plan and the value of the company increases, the owner’s share becomes worth more (as does the PEGs share, of course). That’s when the PEG can come back and buy the rest of the business from the owner, enriching him or her even further. Since the owner gets two paydays, and the combination is often richer than one single transaction, this approach is often called “taking two bites of the apple.”

The hybrid approach is a common deal structure, but it’s almost impossible to stereotype a PEG investment. Each PEG makes up its own rules, its own investment objectives, and its own style. For every $1 billion fund that does only pre-public-offering deals, there is a $10 million dollar fund that will help distressed businesses get through a rough patch, and everything in between.

Like every investor, a PEG wants to know how you are going to use its money to drive new profits. But unlike so many other investors, the right PEG will be there by your side.