Why Private Equity Likes Founder and Family Owned Businesses

Read time: 3-4 minutes

“A big business starts small.” (Richard Branson)

Introduction

If you speak with a lower middle market private equity fund about what they look for in an investment, their comments will often include something like, “We like to invest in founder- or family-owned businesses.”  Others may introduce more complicated jargon and say, “We prefer to be the first institutional capital into a business.”  These statements essentially mean the same thing.  Why, though, does this matter?  It matters because there are actually a lot of different types of entities from which you can buy a business, founders and families being one of them, and making an investment in each scenario may require a nuanced approach to dealing with the seller in question.  For the sake of illustration, the table below highlights the common entities form which businesses are acquired.

Seller TypeDescription
 1. Founder or FamilyIndividuals or a collection of related shareholders that control a privately held company.
 2. Venture Capital FundA professional source of early stage capital for founder-led businesses that show strong upside potential.
 3. Private Equity FundAnother source of professional capital though for established, profitable businesses.
 4. Employee Stock
Ownership Plan
Often referred to as an “ESOP”, this is a benefit plan that gives workers an ownership interest in a company.  ESOPs are overseen by a trustee who acts as a fiduciary to protect the assets of the ESOP for the beneficiaries.
 5. Another BusinessOther corporate entities that may seek to sell (or, “divest”, or “carve out”) operating units that are non-core or underperforming.
 6. Public Company ShareholdersPublic companies can be acquired from shareholders and “taken private” if they are willing to pay a premium to entice the shareholders to sell.

So, given that many private equity funds pursue founder- or family-owned businesses as a strategy, they have clearly determined that acquiring from individuals as opposed to other investment groups or corporate entities is an attractive approach.  This article will explain why, but first let’s understand where all these family-owned businesses came from by learning about the origins of entrepreneurship in the U.S.

A Brief History of Entrepreneurship in the U.S.

Ever wonder from where the word entrepreneur originated?  Turns out it dates back to 1723, and we adapted it from the French word entreprendre which means “undertake”.  Today, we define entrepreneur as follows1:

  • Entrepreneur (än-trə-p(r)ə-‘nər): One who organizes, manages and assumes the risks of a business or enterprise

In the United States, entrepreneurship has a rich history that spans hundreds of years.  Famous Economist and Nobel Laureate Milton Friedman once wrote, “Ever since the first settlement of Europeans in the New World, America has been a magnet for people seeking adventure, fleeing from tyranny, or simply trying to make a better life for themselves and their children.”  One could even argue that America, as a nation, was in a sense built by investor-backed entrepreneurs.  For example, in 1607 the Virginia Company of England sent three ships on a four-and-a-half-month voyage to colonize American plantations.  The 100 or so passengers that disembarked settled and developed what became Jamestown, Virginia.  Relevant here is that the Virginia Company was a joint-stock company which allowed for investment in ventures with limited liability if the business failed, which was a good thing because it ultimately went broke.  You win some, you lose some.

While not often regarded for his entrepreneurial skills, Daniel Boone could be considered an early archetype of the American pioneer / entrepreneur who in 1799 departed Kentucky for a fresh start and settled along the Missouri River on a thousand or so acres of land then part of Spanish Louisiana. It was the Western migration of Boone and others that is credited with establishing the foundation for capitalism’s success in America.  During this period, a majority of these pioneers were farmers, eking out a living on small family farms, and it’s important to keep in mind that the cost of failure for such pio-preneurs was not merely financial, many paid with their lives.  In the early years, Westward migration proved challenging due to the limitations of undeveloped routes amidst the wilderness, but ultimately wagon-based travel became feasible followed by steam-powered locomotives which revolutionized human transportation.  It was the railroads that were both fueled by and facilitated future entrepreneurship.  Interestingly, some also cite the railroads as the origin of modern managerial systems given that the expanse of the railroads’ operations required new methods for managing organizations with a distributed geographic footprint.

It’s hard to believe, but prior to 1811 there had been a mere seven companies incorporated in North America.  This all changed when New York State permitted incorporation by law upon filing out the proper paperwork which freed the process from bureaucratic legislative acts and politics.  As a result, the number of corporations started in the U.S. increased dramatically, and the state of Pennsylvania alone incorporated more than 2,000 businesses between 1800 and 1860.  Consequently, the American dream of being in business for oneself expanded to include small merchants and independent craftsmen.

During the latter part of the 19th century, further Westward expansion and government incentives for industries such as the railroads, banking, and land acquisition led to tremendous opportunities for profit, which allowed entrepreneurship to flourish. During this period, entrepreneurship can also be credited with propagating capitalists, innovators, prospectors, financiers, and businessmen who created and expanded existing businesses.  It was this period that gave rise to big business and many household name companies within oil, steel, tobacco, shipping, railroads and banking.  These industries were largely unregulated, though, which led in some cases to monopolistic power and the inevitable ensuing regulation to establish a more stable business environment for companies of all sizes.

Continuing a trend that began in the latter part of the 19th century, the 20th century ushered in a dramatic increase to the scale and complexity of business in the U.S.  In many industries, small enterprises had trouble raising capital and operating at a scale large enough to efficiently produce goods for an increasingly sophisticated and affluent population. In this environment, the modern corporation, often employing hundreds or even thousands of workers, further rose in prominence. This period was responsible for the formation and success of such businesses as Ford Motor Company (1903), Hewlett Packard (1939), McDonald’s (1940), Wal-Mart (1945), Southwest Airlines (1967), Microsoft (1975) and Apple (1976).

Fueled by the internet, the 21st century has been marked by lower barriers to business formation and the creation of a new array of tech-enabled manufacturing and service-based companies both large and small.  We’ve come a long way from the pioneering ventures of early settlers and those who sought better fortunes in other parts of the U.S.  While the look, feel and focus of American entrepreneurs has changed over the years, the drive to undertake and build profitable businesses has endured paving the way for the successful family businesses of today so frequently sought after by private equity investors.

The Benefits of Investing in a Founder or Family Owned Business

Finally, and without further ado, here are some of the main reasons why lower middle market private equity funds like investing in founder or family-owned businesses:

  • There are a lot of them. One estimate is that there are 28.8 million small- and medium-sized businesses (SMBs) in the U.S. and that 19% of them are family owned.  So, 28.8M x 19% = ~5.5M family-owned businesses into which private equity can flow.
  • Aging Baby Boomer business owners are seeking liquidity. Of the ~5.5 million family-owned businesses in the U.S., nearly 4 million, or ~75% are controlled by Baby Boomers.  And, given that Baby Boomers are defined as those born between 1946-1964, that means that the Boomers are now aged between 55-73.  To that point, 47% of family business owners now report that they intend to retire within the next five years.  So, we are amidst a wave of estate planning-driven business sale activity that is buoying the population of target companies eligible for PE funds.
  • Most family-owned businesses do not survive generational transitions. Sad but true – only 30% of family businesses survive the transition from first to second generation ownership. Even worse is that only 12% survive the handoff from the 2nd to 3rd  It’s like the old saying, “Shirtsleeves to shirtsleeves in three generations.”  Most business owners are all-too familiar with these statistics and related adages, so they are looking for a safe set of hands to usher their life’s work into the future while creating a lasting home for their employees to continue their careers.  In many cases, private equity funds are the perfect acquiror insofar as they manage companies by profession and will increase the odds of a successful change in ownership.
  • Ability to develop a rapport with the founder and/or owners of the business. When you acquire a business from a corporate entity or institutional investor, the discussion is largely around price as the chief determining factor in whether the seller will transact.  However, deal discussions with a founder or family are much more nuanced.  Founders, rightfully so, want to know that what they’ve bled, sweat and cried for is going to endure into the future.  So, this creates an opportunity to build a meaningful relationship with the founder to ensure that there is a shared vision and a strong working chemistry insofar as they will continue to be involved after the deal closes.
  • The founder or family will often retain some ownership. I don’t know about you, but the notion of buying 100% of a company from a founder who has no intention of remaining involved with a company post-closing is scary to me.  This would be like someone throwing the keys at you after purchasing a car, wishing you well and then screeching off into the distance never to be seen again.  Not a good sign.  The best transactions are where the prior founder or family retains a meaningful amount of equity in the company and is aligned to help continue building the company with you.  After all, these are the people who architected the vision, strategy and culture to get the company to the point where a PE fund would want to invest in the first place.
  • Tangible growth opportunities. Once a company starts to generate substantial cash flow, the incentives to grow it can be at odds with the perceived risks of disrupting a comfortable lifestyle that a business owner has come to enjoy.  Said another way, if an owner is generating $5 million in EBITDA and is making more money than they ever dreamed they would, why undertake the investment and risk associated with growing the bottom line?  This dynamic is prevalent with many founder and family-owned businesses and creates the opportunity for a PE fund to execute on numerous “low hanging fruit” growth initiatives that have not yet been pursued.

How Private Equity Helps Founder and Family Owned Businesses

Explanation
1. Wealth DiversificationFor many entrepreneurs, their business represents their largest single financial asset.  This concentration of wealth created by the business creates an inherent risk to their net worth should something happen to adversely affect its valuation.  Therefore, a transaction with a private equity fund helps to diversify a business owner’s net worth by generating liquidity (i.e. cash) for the founder or family owner.
2. Team DevelopmentWhile many family or founder-owned businesses can generate strong growth and profitability for a time, they will ultimately stagnate if they haven’t invested in a team that can manage a larger organization with its new assortment and complexity of challenges.  And, we routinely see certain departments that have been under- or undeveloped such as Finance or Sales.  The good news is that private equity funds are in the common practice of helping companies supplement their teams with high quality talent who can help the business get to the next level.
3. Business BuildingBeyond team development, many founder and family-owned businesses have not fully embraced best practices regarding systems or process.  In order for small companies to become big companies, they need to be built upon a framework that will support the transition to a larger organization.  This applies to things like data capture & analysis, workflow management, compliance, and financial controls.  Given that private equity funds invest across a portfolio of companies, they have an excellent vantage point to identify and help implement the necessary systems and/or processes to help management teams drive their business forward.
4. Financial SophisticationPrivate equity funds have earned a reputation for taking an analytical eye to the businesses in which they invest.  Frequently, a founder or family-owned company’s prior reporting processes will evolve under new ownership to become both more strategic and granular.  Business owners will get a flavor of this during the due diligence process when an investor begins analyzing the business to better understand it.  A test of whether a fund is focused on the right things is if an owner gains new and valuable insight about their company that they had not previously considered.  The end goal is for a company’s investors and management team to know precisely where the key drivers of value exist and focus on the areas that really move the needle.
5. Capital For GrowthDon’t forget that private equity funds often reserve capital to support the growth of their partner companies beyond what it takes to close the deal.  For many businesses, growth via the acquisition of smaller businesses in the same industry can be an excellent way to increase scale and profitability.  So, if you aspire to acquire smaller businesses and fold them into your organization, make sure to ask any investors with whom you are speaking about their ability to fund future deals.
6. “Two Bites of the Apple”In many cases, a private equity fund will want the founder or family shareholders to retain some ownership following a transaction.  The helps ensure that the person or people that drove a company’s prior successes are aligned with the new investor’s goal of supporting future growth. The amount of retained ownership varies for each deal but generally ranges from 10-30%.  By holding onto some of the equity in the business, owners stand to benefit from the next exit if the business increases in value.  In some cases, we’ve seen the proceeds from an owner’s second transaction, or the “second bite of the apple” exceed proceeds from the initial transaction.

Conclusion

We hope this sheds some light on why private equity funds like investing in founder and family-owned businesses.  As always, we’re here to help, so give us a call to start a conversation.

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1Merriam Webster

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

This is Why Culture Eats Strategy for Breakfast

This is Why Culture Eats Strategy for Breakfast

Read time: 2-3 minutes

Culture is a hot topic these days. By now, you’re probably familiar with Netflix’s famous 100+ slide deck outlining their corporate values and have enjoyed Simon Sinek’s highly viewed Ted Talk musings on how good leaders make people feel safe.  However, it seems we’re hearing ever more about how this elusive dimension of organizational behavior is being embraced by top companies. Why it’s taking root so prominently now I can’t say, though Winston Churchill might have been onto something when he said, “Americans can always be counted on to do the right thing, after they’ve exhausted every other possibility.” That is to say, perhaps companies are now concluding that financial success is, after all, an ensuing result of creating a cultural framework that enables high-quality teams to achieve as opposed to something that is pursued without regard for the softer side of how you get there.

This is Why Culture Eats Strategy for Breakfast

To be clear, this blog is not about how to create a good company culture. There’s been plenty written about that, and I’m still not fully convinced that culture isn’t just a reflection of senior leadership’s behavior and how they reward the cardinal virtues they espouse. What I’d like to explore is why I think that Peter Drucker’s famous, “Culture eats strategy for breakfast” line has withstood the test of time and is presently top of mind for leaders at the helm of companies large and small. To do that, I’ll share the following ways that strong cultural dynamics have contributed to the success of organizations with which I’ve been affiliated. So, without further ado, strong cultures…

  • …encourage risk taking that leads to innovation. If the standard of performance is perfection, then people will simply talk themselves out of otherwise good ideas for fear of diminishing their internal status (or worse). However, when it’s OK to make mistakes in the name of progress, employees will take initiative and experiment with new ideas. More often than not, these ideas, while good, won’t move the needle and may even fail. However, without feeling safe enough to try something new, the truly game-changing ideas that allow you to stay ahead of your competition will not come to fruition.
  • …allow people to be vulnerable to promote problem solving. If people aren’t comfortable sharing challenges holding them back, then they’ll simply stew in frustration for fear of seeming like they aren’t up to the demands of their job. This will consequently hold the company back from progress it could otherwise be making. However, when people are willing to articulate problems and approach colleagues for advice, then the maxim of two heads being better than one will prevail. True success is when people can be vulnerable in front of a group of peers and/or superiors to access the best of their collective wisdom.
  • …reduce the energy wasted on fighting internal battles and focus on beating the competition. In many companies, an employee is forced to fight battles on two fronts – the external (i.e. against the competition), and the internal (i.e. against culture and the agendas of other employees). From my experience, external competitive forces are sufficiently formidable to require complete and undistracted focus. The challenge is that internal struggles are real and often result in a host of counterproductive emotions, most powerfully, worry. I’ll admit that of all the nights I’ve lost sleep in my career, the vast majority have been due to internal issues. Imagine how much stronger your organization would be if 100% of the team’s energy was focused on beating the competition.
  • …motivate people to show off their superpowers. This begins with the understanding that each person has a “genius” and that a universal yardstick of ability simply cannot be applied to everyone. If a culture singularly exalts a narrow skillset, then people won’t be energized to exhibit lesser-valued skills that a company may desperately need. There’s a reason it’s beautiful watching cheetahs sprint and dolphins jump acrobatically in the ocean – while different, those behaviors are what those animals are the best at, and they don’t hold anything back. What if observing your team was as fun as watching Blue Planet? Or, better yet, X-Men?
  • …speak to the person, not their position, to engender respect throughout the organization. There are hierarchies within every organization and roles that are more glamorous than others. And, usually, people are keenly aware of where their activities stack up in the pecking order of internal respect. One of the faster tactics I’ve seen to demotivate an employee is to engage with them as though their role deserves inferior treatment. Conversely, when a person is treated with respect, regardless of function, it has a way of helping that person find meaning and dignity in their activities which can compound to create unforeseen benefits to the business.
  • …recognize achievements that advance important goals. No better way to get a team to keep doing more of what works and less of what doesn’t than to acknowledge strong performance. If this praise comes from the top, you can all but guarantee that others will follow suit. I’ve had bosses make my entire week just by saying “good job” about something I didn’t think they had noticed. All things being equal, happy employees have got to outperform the alternative.

While not an exhaustive list, I can say that I’ve experienced both the good and bad sides of these dynamics. Goes without saying that I’ve functioned at my best when I’ve felt safe enough to innovate, been comfortable asking for help, didn’t worry about internal frictions, knew that my skills were valued, felt respected and received recognition. Interested in your thoughts – how else do strong cultures make employees and companies better?

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

Franchisors vs. Franchisees: Why Private Equity Likes Both

Read time: 4 minutes

“Long-term consistency beats short-term intensity.” (Bruce Lee)

Introduction & Definitions

It’s official, private equity investors like franchises. This wasn’t always the case, but in recent years, there’s been a wave of private equity funds investing behind multi-unit concepts of all varieties. During 2018, significant franchisor acquisitions by private equity funds included Jamba Juice ($200 million), Sonic Drive-In ($2.3 billion) and Zoe’s Kitchen ($300 million) to name a few. In 2019, we’ve seen CorePower Yoga, Hooters and Whataburger attract new investors. What’s interesting is that a historical preference for franchisors has become more balanced in that private equity funds are starting to take material interest in franchisees as well. So, we thought it was worth exploring the nuances between the franchisor and franchisee model and explaining a few of the reasons why private equity sees strong investment returns potential in both strategies.

Introduction & Definitions

To start, let’s define the relevant terms1 :

  • Franchisor – The entity that establishes a brand’s trademark or tradename and a business system. Franchisors make money by charging its franchisees up-front fees and royalties as a percentage of revenue, typically around 5-6% (though there are exceptions to this rule of thumb).
  • Franchisee – Often a small business owner that pays a royalty and an initial fee for the right to do business under the franchisor’s name and system. Outside of royalties and, sometimes, marketing or other fees, the franchisee keeps whatever profits they generate from operating their business. When successful, it’s common for franchisees to own multiple units within a franchised system.

A Brief History of Franchising in the U.S.

A Brief History of Franchising in the U.S.

Not only was he one of the Founding Fathers of the United States but, you guessed it, Benjamin Franklin instituted the first franchise system in 1733. When he wasn’t busy inventing the lightning rod, bifocal glasses, swim fins, a stove bearing his name, and a much-needed update to a sadistically inflexible urinary catheter, Mr. Franklin evidently found time to strike a deal with one Thomas Whitmarsh to establish Whitmarsh as a printer in Charleston, SC. The deal was that Franklin would rent space for the printing operation and provide any equipment in exchange for one third of the profits over a six-year period. At the end of the term, Whitmarsh would be able to buy the equipment back from Franklin and work for himself free and clear. Whitmarsh went on to print such reads as the South-Carolina Gazette and local copies of Poor Richard’s Almanack. Franklin replicated this model in other cities that had either no printers or light competition by partnering with employees that demonstrated good work ethic.

Despite Franklin’s earlier claim, many sources credit Isaac Singer, the founder of sewing machine manufacturer Singer Corporation, with the creation of the modern franchising model in the mid 1800’s. Like Franklin, Singer used franchising as a means to quickly expand. Singer distributed his sewing machines throughout the U.S. via a network of licensees that paid both a licensing fee and were required to teach people how to use the sewing machines.

The bottom line is that franchising has been around for hundreds of years and has withstood the test of time. Thanks to these and other founding fathers2 of franchising, the U.S. is now home to over 700,000 franchised businesses. While there are not yet as many private equity firms in the U.S., perhaps 1-2 thousand depending on who you ask, the amount of capital they have raised should make it no surprise that they’ve discovered ways to generate strong investment returns in franchisors and franchisees alike.

 

What PE Firms Want to See in a Franchise System

Investment criteria across private equity firms for franchises may vary, but it’s safe to assume that most professional investors are going to look for one more of the following attributes when looking to back a franchisor or franchisee:

What a “Good” Franchise Looks Like to a PE Fund
Lender Product or Service that is Staightforward and Can be Consistently ReplicatedA system’s growth will usually be driven by franchisees, so the product or service needs to be something that can be quickly mastered by a small business owner and/or employees that may not have prior experience in the industry. Further, franchisees will need to consistently meet the brand standards set out by the franchisor such that the system upholds a consistently strong reputation across its network of operators.
Lender Product or Service that is Sustainably “On Trend”Systems that benefit from sustainable and easy to understand tailwinds are going to be more attractive to private equity investors. Most private equity funds are adept at discerning trends from fads, so if the shiny new product doesn’t appear to have staying power, then they may pass on making an investment.
Lender Universal Appeal Across Geographies3Some products or services may be relatively more embraced in certain geographies than others. A good example might be a food concept that is cherished in one part of the country but is not portable to other markets based on regional dietary preferences. So, investors will look for systems that are thriving within their original markets as well as new markets that they’ve entered. Example: Have you ever been to a part of the country that doesn’t have a McDonald’s?
Lender Sufficently Long Operating HistoryMuch like how investors evaluate non-franchised businesses, it’s comforting if a franchise has an operating history that suggests long-term viability. If a system is too young, investors may pause in favor of those with more longevity.
Lender Critical Mass of UnitsSystems that offer a critical mass of units, say 50 or more, tell investors a few things. First, they’ve been able to attract a good number of franchisees who were willing to incur the fees, development costs and risk associated with starting up a new location. Second, if the locations have been open for a while, then it suggests longer-term viability of the concept, though investors will also want to know how many locations have closed. Third, the larger the system, the more resources a franchisor will have to support their growing network in areas like marketing. Lastly, larger systems will have survived a lot of growing pains that smaller franchises experience and often emerge more ready to support future growth.
Lender Good Unit EconomicsUnit economics are the financial investment and results one might expect in opening and operating a single location. The basic ingredients to a good unit economic profile include return on investment (ROI) from build-out costs and same-store-sales growth, but there are a lot of metrics one can analyze within a franchised system. For more information on unit economics see “A Crash Course on Unit Economics” below.
Lender Successful FranchiseesGood franchisors want franchisees to be successful and happy. It’s a good sign if you see a high incidence of multi-unit franchisees – this suggests that a franchisee was sufficiently happy with the result of their first location to open additional locations. Systems with successful franchisees will be better at attracting new franchisees and have better prospects for growth.
Lender Runway for Future GrowthPE funds want to see that systems offer sufficient “white space” to permit growth during their ownership period and beyond such that they’ll be able to attract buyers when they seek to exit. In other words, there needs to be enough undeveloped territories to allow future investors to make a good return on their investment.

A Crash Course on Unit Economics

Given what is often a large number of units operating within a franchise system, there is no shortage of data that can be analyzed. However, the essential metrics for most investors are relatively straightforward and relevant across franchised concepts. The good news is that some of these metrics will be profiled in the Franchise Disclosure Document (FDD). The graphic below summarizes how investors will usually look at and assess unit economics:

 

Common Unit Economics Analyzed by Private Equity Investors
Build-Out Costs Build-Out Costs
The initial fees and investment required to open a new location.
Should be examined in connection with how much EBITDA a mature location will generate, and how quickly. More modest build-out costs make systems accessible to more prospective franchisees, but build-out costs need to be taken in a broader context of return on investment.
Time to Profitability Time to Profitability
How quickly a unit becomes cash flow positive.
Will be important to franchisees with less liquidity to weather the cash burn phase. All else equal, a system where franchisees become cash flow positive faster will be more attractive.
Time to Recoup Build-Out Costs Time to Recoup Build-Out Costs
How quickly a franchisee earns back build-out costs from a unit’s profits.
A franchisee’s ability to quickly recoup build-out costs will allow them to open up new units to their benefit and the benefit of the franchisor.
Time to Maturity Time to Maturity
The length of time until a unit achieves steady-state Revenue and EBITDA.
Like other unit economics categories, faster is better. A good benchmark is under 3 years for a unit to achieve maturity, but this varies and needs to be taken into consideration alongside other unit economic categories.
Mature Revenue, or “Average Unit Volume” Mature Revenue, or “Average Unit Volume”
The point at which Revenue growth slows to a long-term rate.
As you might expect, bigger is better for AUV. The greater the Revenue potential, the better the opportunity to generate profits for franchisees. A good benchmark for AUV is $1MM+.
Mature EBITDA Mature EBITDA
The point at which EBITDA growth slows to a long-term rate.
The amount of EBITDA a location generates is critical for a franchisee. It’s the difference between the owner “buying themselves a job” vs. buying themselves a profitable business that generates cash flow that can be reinvested in new units or distributed to shareholders.
Build-Out Costs / Mature EBITDA Build-Out Costs / Mature EBITDA
A ratio that highlights how much upside exists between the cost for de novo units relative to an expected sale multiple.
This is as close to a golden ratio in franchise investing as you are likely to get. This simple calculation will tell you what it costs, in terms of an implied EBITDA multiple, to open new units. In this case, the lower the number, the better. Example: If build-out costs are $500k, and a mature location will produce $250k of EBITDA, then the ratio is 2x.
Same-Store Sales Growth Same-Store Sales Growth
The annual growth rate of a cohort of units that were opened for a full year or longer.
A unit’s growth rate will typically depend on how long it’s been open – younger units should grow at a faster rate than those that have been open for several years. So, it makes sense to look at growth rates by year of opening. However, same-store sales growth can also be analyzed across an entire portfolio of stores to give a sense for the general health of the system.

The Pros and Cons4 of Franchisors vs. Franchisees

Now that we’ve covered what franchising is, its history, what an investor looks for in a franchised business, and the ABCs of unit economics, we can finally share why investors like investing in both franchisors and franchisees. Like any sector, there are positives and negatives, but for many investors the pros far outweigh the cons in franchising. The following table highlights the respective merits and limitations of investing in franchisors and franchisees from an investor’s perspective:

The Pros and Cons 4 of Franchisors vs. Franchisees

Conclusion

We hope this sheds some light on how private equity funds evaluate franchises and why they have made substantial investments into both models. As always, we’re here to help, so give us a call to start a conversation.

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1Definitions from franchise.org.

2William Metzger (pictured above) purchased the first independent car dealership from General Motors in 1898. By working with franchisees in exclusive territories, OEMs like GM and Ford were able to bring their products to market more efficiently, and over longer distances. Famously, Ray Kroc (above) opened the first McDonald’s franchise restaurant in 1955. Shortly thereafter he set up the company that would become the McDonald’s we know today. By working with franchisees across the U.S., Kroc grew his system to over 100 restaurants by 1959.

3The exception to this rule is if a concept is more regional yet the region supports a sufficiently large addressable market.

4Believe it or not, Benjamin Franklin is also credited with developing the idea of a Pros and Cons list.

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle- market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

How to Value a Private Company

Read time: 3-4 minutes

“Strive not to be a success, but rather to be of value.” (Albert Einstein)

Introduction

As a business owner, you probably have a general sense for the range of value for your company based in formal or informal analysis. However, you never truly know what it’s worth until you see what a buyer is willing to put in writing. Therefore, it’s important to understand how investors are likely to approach the valuation exercise so that you can be grounded in reality and ask informed questions of suitors at the appropriate time. The following guide will walk you through the common valuation methods, some key financial information used as inputs to determine value, and some tips to increase your valuation.

Common Business Valuation Methods

A lot of terminology gets thrown around when people start talking about valuing private companies. However, at their core, regardless of what they are called, they are simply ways to put a present value on future cash flows. Here are some of the most common and practical approaches investors will take.

Description of Each Valuation Method
Lender 1. Public CompsWithin your industry, there are often comparable public companies whose business is similar to yours, though on a larger scale. These public peers, or “comps”, have valuations that are publicly available and can provide guidance around how your business will be valued. Most investors will look to EBITDA and/or Revenue multiples, though there are an array of other ratios that can be analyzed if so inclined. Please remember, though, that a public comp will often be valued at considerably more than a smaller, private peer due to the inherent value of larger scale and the ease with which you can buy and sell public shares. So, in order to determine the value of your smaller, private company, you will typically have to apply a discount to the public comps.
Lender 2. Precedent TransactionsThe specifics of private transactions in your industry can be hard to come by if they are not disclosed, but in many instances details around the purchase price and implied multiple of EBITDA find their way to the public domain. Further, various entities (e.g. investment banks) that focus on your industry will often publish industry reports that summarize information about comparable private transactions. These reports can give you a good idea what sort of multiple you might fetch for your business.
Lender 3. Returns ModelingIf you are speaking with a private equity fund or other “financial buyer”, it’s likely that they will do some returns modeling around various growth assumptions for your business. Typically, private equity funds are shooting to double or triple their money over their investment period, and this will impact what they can pay. The most common returns modeling is called an “LBO Model” which forecasts out 5 or so years of performance with certain assumptions regarding the amount and type of debt the buyer would intend to put on the business.
Lender 4. Perception of ValueExperienced investors will often have an intuitive feel for a company’s worth if provided with sufficient information about historical / projected performance. It’s probably discounting the value of this intuition to call it “gut feel”, but veteran investors can often come extremely close to an accurate EBITDA multiple without traditional analysis. Whether they will admit it or not, many investors consult their intuition before other more analytical methodologies.

Key Financial Information Used to Value a Private Company

If you decide to sell your company, there’s no question that it will ultimately entail the provision of a large amount of data to a potential buyer. However, in the early stages of courtship, the items below are typically sufficient for an investor to arrive at a preliminary valuation range. If you decide to explore discussions with investors, you should make sure you at least have the following items readily available and well organized for when they ask:

Key Financial Information Used to Value a Private Company

  • Last Twelve Months (LTM) Adjusted EBITDA. Businesses are most commonly valued on a multiple of LTM Adjusted EBITDA. Therefore, this number is the single most important input to determining your valuation. Note that we’ve incorporated the term, “Adjusted” here. It’s important to present an EBITDA figure that reflects your company’s profitability if it were to be owned by another entity. In other words, if there are non-recurring or inflated expenses (e.g. Country club memberships, vehicles, etc.) that would not be incurred under new ownership, it is customary to add these expenses back to arrive at a normalized, or Adjusted EBITDA figure. Just don’t get too creative here lest you lose credibility with an investor. Last Twelve Months (LTM)
  • 5-Year Historical P&L. A 5-year snapshot of your income statement will give an investor a good idea of how Revenue, Gross Profit and EBITDA have been trending along with your various expense line items. This is important because if Revenue and profitability have been steadily increasing, that will give an investor comfort that your trajectory is relatively more likely to continue than if the alternative were true. These days, we sometimes even ask for a 10+ year history to see how a business performed during the Great Recession as a proxy for how it might weather a future downturn. A longer operating history becomes more important if a business or industry is inherently cyclical (e.g. Building products).
  • Most Recent Balance Sheet. Balance sheets illuminate a few things of relevance to investors. One of the more important items is the degree to which your business consumes capital, or is “working capital intensive”. In other words, is a lot of cash trapped in receivables and inventory, or is the company efficient at converting P&L results into cash? This matters because as a business grows, a company that is more working capital intensive will consume more cash flow as it builds inventory, increases its receivables balance and funds various other asset line items. Here’s how most investors will assess your level of working capital intensity:

    Net Working Capital = Current Assets (Excluding Cash) – Current Liabilities (Excluding Debt)

    Net Working Capital

  • Capital Expenditures (“CapEx”). Investors care about CapEx because it represents cash that has to be reinvested into a business to maintain and grow its profitability. Varying levels of CapEx across businesses and industries means that not all EBITDA is created equal. To that end, a common metric that buyers will evaluate is Adjusted EBITDA minus CapEx as an approximation for the true profitability of a business, or “free cash flow”. Take a look at the following example that highlights how CapEx can sway the amount of free cash flow a business is generating:

    Free Cash Flow = Adjusted EBITDA – CapEx

    Capital Expenditures (“CapEx”).

  • Top Customer Summary. Most investors are allergic to customer concentration, so they’re going to want to know early in your discussions whether you have exposure to any single or small group of accounts. When requesting this item, investors will usually tell you that it’s OK to share your customer information on a no-names basis in recognition of its sensitivity. Ideally, you will have a few years of historical data regarding revenue by customer for each account to highlight any year-over-year variations in revenue, but a top 10 summary will usually suffice. Here’s an example of what such a summary may look like:
    Top Customer Summary.

Tips to Increase Your Valuation

You’ve probably heard many of these before, but it never hurts to refamiliarize yourself with some essential business attributes that will attract investors and support a stronger valuation for your company. You can also download our guide to maximizing your exit valuation here.

Tips to Increase Your Valuation

  • Reduce Customer Concentration. A dependence on large customers is a primary reason why an investor will pass or reduce valuation. Your goal should be to have your top customer generating less than 20% of total revenue. Above that level you will lose interest from a lot of suitors due to the risk of that customer going away. Many tenured investors have learned this lesson the hard way and are not likely to make the same mistake twice.
  • Create the “Dream Team”. An overdependence on a company’s founder or CEO can scare investors that are leery of “key man risk”. A new investment partner will want to see that your company’s customer relationships have been institutionalized and that you have a talented supporting cast of executives ready to drive the business forward.
  • Target High Growth End Markets. We’ve all heard that “a rising tide lifts all boats”, and most investors will agree that the tailwinds behind a good industry can be a powerful driver of good financial returns. So, if your product or service is supporting a sector with lackluster growth, it might be worth entering, or seeking help entering, some more attractive market segments.
  • Embrace Financial Sophistication. This is where a talented CFO or operator can really move the needle. You cannot underestimate the value investors place on seeing accurate, timely and strategically insightful financial information. In general, financial reporting that reflects a professionally managed organization will help an investor get comfortable that you have a good grasp of the operations. Audited financials are another indicator the business has been managed to build long-term value. At a minimum, make sure any information provided to investors ties out across the various reports you send over.
  • “Culture Eats Strategy for Breakfast”. A strong culture is palpable to an investor and is an important dimension in understanding a company’s prior successes and prospects for future growth. All else being equal, a passionate, energized team is always going to be more encouraging. Some easy indicators of this are demonstrated by Mission, Vision, Values driven organizations with leadership that walks the walk and employees that like coming into work every day.
  • Consistency is Key. Historical ups and downs in revenue or profitability will make investors pause. If you can show sustained upward trajectory in both revenues and profit, then you are on your way to a better valuation. With that in mind, make sure to grow the right way with higher margin, recurring revenue when possible.

Conclusion

We hope you found this guide useful in gaining a better understanding for how professional investors will approach valuing your company. We’ve been investing in privately held companies for nearly 20 years now and would be happy to walk you through our proven process that has resulted in over 20 closed transactions with business owners. We’re here to help, so give us a call to start a conversation.

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

How to Find an Investor for Your Business

How to Find an Investor for Your Business

Read time: 3-4 minutes

Introduction & Definitions of the Different Types of Investors

Raising capital is often cited as one of the more difficult exercises in business which is a fascinating paradox given how much of it is available to business owners. Globally, there is over $1 trillion of uninvested capital at the ready to be deployed, so why then is the process of finding an investor so challenging? To start, investors come in a variety of shapes and sizes, and there are a LOT of them to choose from.

Not to worry, we’re here to help. Like any good journey of understanding, it’s important to start by defining key terms to make sure you are clear on the characters you may encounter on your quest to find the right investor for you. Here are the most common categories of investors from which you can choose (no particular order):

 Description of Each Investor Type
Lender 1. LenderPassive investors offering debt in exchange for scheduled principal and interest repayments. This is the most risk averse category of investor who will want to see tangible collateral protecting their investment in the form of assets (e.g. Receivables, inventory, real estate) and/or personal guarantees. Capital from lenders can be used to fund growth / expansion, satisfy short-term cash needs and sometimes allow you to take money out of the business in the form of a dividend.
Angel Investor 2. Angel InvestorHigh net worth individuals who have both the personal liquidity and risk appetite to make non-control investments into early stage companies. Alongside a founder, angels will often be some of the earliest equity capital into a business. Angels will come from various walks of life – in some cases they will have generated their wealth from entrepreneurial or other business pursuits, though they are likely to be passive investors. Angels are frequently part of angel networks that periodically congregate to source and evaluate early-stage investment opportunities.
Venture Capital 3. Venture CapitalA professional source of early stage capital for founder-led businesses that show strong upside potential. Venture capital firms (or, VCs) raise committed capital from Limited Partners and focus on businesses that are frequently pre-profitability (in some cases, pre-revenue). VCs typically invest in a larger portfolio of 20-40+ companies from their fund with the understanding that a mere 20% of their investments will produce 80% of their targeted returns. VCs are usually non-control investors, though many hail from entrepreneurial backgrounds and may be a good source of guidance given analogous experiences.
Growth Equity 4. Growth EquitySimilar to how this definition is situated in this chart, growth equity investors exist somewhere between venture capital and private equity. Growth equity investors may pursue more traditional VC and/or PE-style deals, but the name generally implies that they are making non-control investments into later stage businesses. Because growth equity deals traditionally have less upside potential than VC deals, a growth equity investor will be less tolerant of investment losses and may seek more downside protection than some of the earlier stage investors profiled above. It would be common for a growth equity investment to be “structured”, meaning that their investment would be in the form of a preferred class of stock possessing features not offered to other shareholders (e.g. accruing dividends, liquidation preference, etc.).
Private Equity 5. Private EquityAnother source of professional capital though for established, profitable businesses. Private equity (or, PE) investors raise funds from institutions (e.g. pension funds, endowments, insurance companies) to take controlling (51%+) ownership positions in companies generating positive EBITDA and with strong growth potential. In many cases, PE funds will encourage businesses owners to retain equity (or “rollover”) in the company to create shared interests in supporting future growth. PE investors will usually target a 2-3x return on their capital over a 3-5+ year investment period before seeking an exit. PE funds invest across a wide range of company sizes, though many “middle market” firms pursue founder or family-owned businesses valued at $100MM or less.
Family Office 6. Family OfficeEntities established by high net worth families to manage the wealth and investing activities of that family. Family offices are not mandated to deploy capital in the same way, say, a VC or PE fund might be and may be more selective in the investments they choose to make. This is especially true given that they are investing their own capital as opposed to capital raised from other sources. Further, family offices will often have longer investment horizons, meaning that they can invest in perpetuity in a business given that they won’t have external constituencies looking to generate near-term returns. Family offices can differ in their approach to managing investments in private companies but reputationally skew more passive in their approach.
Search Fund 7. Search FundThese firms are typically led by 1-2 newly minted MBAs that raise funding from high net worth individuals to identify a single acquisition target that they intend to run as CEO post-closing. Search funds frequently elevate recurring revenue services businesses in their list of acquisition criteria and prioritize finding a founder / owner seeking to transition out of the business to create room for the “search funders” to take control of the day-to-day operations. Note that search funds do not have authority over their investors’ capital in the way that a PE or VC fund might as General Partners. Rather, search funds need to present investment opportunities to their backers who then can approve or deny an acquisition.
Independent Sponsor 8. Independent SponsorThese groups will look and feel like private equity investors in many ways, though the primary distinction is that they do not have the capital to invest. Independent sponsors are frequently professionals that were previously affiliated with private equity funds and decided to set off on their own to source and structure deals to be funded by a third party. There are over 300 or so independent sponsor groups across the country, so it is an established population, but it’s important to know that if you agree on a deal, the next step will be for the independent sponsor to find someone to fund the transaction. Often times, independent sponsors shine in helping to identify hidden value in an opportunity where other investors passed.

The many nuances of each investor type can be tough to commit to memory, so here’s a chart that visually summarizes the key distinctions between the various groups:

Step 1: Determine the Type of Investor You Need

Step 1: Determine the Type of Investor You Need

They say a picture is worth a thousand words, so I figured the flow chart below would be a more efficient way to help you determine the type of investor that is appropriate for your business. Once you know what you’re looking for, you can proceed to “Step 2” for instructions on how to build your contact list.

Step 2: Build a Contact List

Step 2: Build a Contact List

So, now you know the type of investor you’re looking for. Here are the information resources you will want to check out to build a list of firms to reach out to:

 Information Resource
GoogleIt may seem a little too obvious, but Google can be an excellent way to find the type of investor you’re looking for. This is because the more sophisticated investors in each category will have invested in developing a digital presence such that they are easy to find. Give it a shot, you’d be surprised with how many firms you can identify this way.
Linked inWhile the majority of LinkedIn connectivity is person to person, you can search for keywords that may help highlight potential investors for your business. An added benefit is that you’ll also be able to quickly identify any connections (1st, 2nd, 3rd degree) to groups that pop up in your search.
Pitch BookPitchbook is a subscription information platform frequently used by investors and companies alike. The user interface is highly intuitive, and they frequently make feature updates that make it ever more powerful as a search tool. Start by requesting a free trial – this may be enough to build your initial list or you may find value in becoming a subscriber.
CrunchbaseThis is another business information platform centered around companies and investors. It offers a searching tool that allows you to filter their database of thousands of contacts and home in on the types of groups and people you are looking for. Similar to Pitchbook, certain features require a subscription, but you can access a free trial.

Step 3: Reach Out to Your List of Contacts

Each category of investor has their own distinctions in terms of the types of companies / situations in which they invest and, similarly, the way you get in touch with each of them is also nuanced. So, once you have your contact list in hand, here’s how to get in touch with each type of investor directly. Please note, though, that a warm intro into someone at a firm in which you are interested will always be preferable to a cold outreach. This guide is simply to point you in the right direction if you can’t get such an intro.

 How to Get in Touch with Each Type of Investor
Lender 1. LenderLenders will frequently employ business development officers (BDOs) whose primary job is to identify commercial lending opportunities. These professionals are compensated based on their ability to surface leads, so they should respond ASAP to any inbound inquiries. Look for titles on their websites that sound like “business development” or “relationship manager”.
2. Angel Investor 2. Angel InvestorMost angel networks have a website that will tell you how to contact their members or the broader organization. One option is to apply for funding through a general submission form, the other is to identify higher ranking members of the network and reach out to them directly via email or LinkedIn.
3. Venture Capita 3. Venture CapitalVCs tend to have fairly aggressive investment sourcing processes, so they should be relatively easy to get a hold of if you have a promising business. Like banks, many VCs have professionals solely focused on deal origination, so those professionals may be a good starting point. Shoot them an email and see what you hear back. However, make sure the firm’s sector focus areas align with what your business does to improve your response hit rate and reduce any wasted time. If that doesn’t work, review their team’s bios to see whose entrepreneurial experiences may align with yours – if they deem you to be a kindred spirit, that should yield a response.
4. Growth Equity 4. Growth EquityMany growth equity investors have dedicated deal sourcing teams, so this is a good place to start. Scan through the bios and look for language that references “sourcing” or “business development”. If not, start at the top of the org chart and work your way down until you get a response. Persistence should pay off even if it takes a few followup attempts.
5. Private Equity 5. Private EquitySame as growth equity & VCs, it’s common for PE funds to have dedicated deal sourcing professionals. Insofar as it’s these individuals’ jobs to identify new investment opportunities, they will be happy to hear from you. Look for titles with the words “Investment Development”, “Business Development”, “Deal Sourcing”, or “Origination” in them. As with other professional investment firms, make sure their investment criteria aligns with your business in terms of industry and the amount of EBITDA you are generating.
6. Family Office 6. Family OfficeGood luck. There’s a saying, “If you’ve met one family office, you’ve met one family office.” All that means is that “family office” can mean a lot of different things and getting through to the decision maker can be a real challenge. To improve your odds, look for family offices that advertise investment activity of the variety that your business presents. In other words, if a family office has made all of their money in real estate and seems to focus within that asset class, it may not be worth approaching them about your manufacturing business. Your best bet is to start at the top and work your way down. If you can’t get a response from the head of the office, many of these groups have a Chief Investment Officer or CFO that may be a good starting point.
7. Search Fund 7. Search FundThe good news about search funds is that they are run by 1-2 people whose sole purpose is to find a business to buy, so they will be highly motivated to respond to your call email. Of every investor type profiled here, a search fund will be relatively more likely to respond to a cold call or email. Plus, they spend most of their time sending out emails and letters to prospective targets, so someone seeking to have a conversation about a deal will be most welcomed.
8. Independent Sponsor 8. Independent SponsorSimilar to search funds, independent sponsors spend most of their time hunting for new investment opportunities. In the rare instance that a business owner actually calls them, they will be highly likely to return the call. Your best bet is to reach out to the founder directly. Just make sure to probe on their network of capital sources because they won’t directly control the capital needed to close on a transaction with you.

Conclusion

I realize that was a lot of information, but hopefully you’re now armed with knowledge about the type of investor your need, how to build a list of contacts and best practices in reaching out to each type of investor directly. As always, we’re here to help, so please reach out to start a conversation.

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

Private Equity vs. Venture Capital: Similar but Mostly Different

Read time: 3-4 Minutes

“The beginning of wisdom is the definition of terms” (Socrates)

Introduction & Definitions of Private Equity and Venture Capital

At 60+ years since the birth of the Private Equity (PE) and Venture Capital (VC) industries, it’s easy to marvel at what they’ve become from their humble beginnings in the 1950’s.  While both sectors are now fairly mature, it remains surprisingly commonplace for business owners to use the terms PE and VC interchangeably.  Yes, in concept, both are vehicles for capital to flow into private companies with the expectation of returns that beat the public markets, but the differences between these asset classes far outnumber the similarities.  So, it seemed time to lay out the primary differentiating factors to eliminate any confusion.

Per Socrates’ advice above, let’s start by providing some basic definitions of PE and VC:

  • Private Equity. At its core, private equity is investing into (typically) established private companies to help them grow.  To do this, private equity fund managers, or General Partners, will raise capital from Limited Partners that often consist of pension funds, endowments, high net worth individuals or other entities seeking to invest through this asset class.  Using this capital, PE funds will source investment opportunities relevant to their investment criteria, negotiate transactions, and work with their acquired companies to improve profitability over what usually amounts to a 3-5 year (or more) investment period. 
  •  Venture Capital.  Similar to PE funds, venture capital firms also invest as General Partners on behalf of institutions and other accredited investors.  However, they generally focus on emerging companies or technologies that are earlier in their lifecycle and show greater upside potential (described further below).

The Key Differences Between Private Equity and Venture Capital

Based on the definitions above, PE and VC may seem relatively similar at this point, but a closer look will reveal some important distinctions.  So, without further ado, here are the main differences between PE and VC.  Just remember that the guide below will apply in most cases, but there are exceptions to every rule:

  1. Stage of company in which they invest. Perhaps the most universally applicable differentiator between VC and PE funds is the stage of company in which they invest.  “Stage” can mean a lot of things but can generally be defined in terms of (i) length of time in operation and (ii) EBITDA – you either have it, or you don’t. 
  1. Not to oversimplify things, but if your business falls somewhere between start-up and 5 years in operation, you are most likely a better target for venture capital.  Said another way, if you are still raising capital in “rounds”, then you are squarely a target for the VC community.  Further, if your company is producing revenue and growing quickly, yet you are not generating positive EBITDA because you have been investing heavily to support your growth and acquire new customers, then you are also a better fit for a VC fund.  Of course, the inverse of these examples is true in that more time in operation and more profitability generally makes you a more relevant candidate for PE.  See the table below to summarize these points:
  1. How they approach valuing your company. A common PE methodology to valuing a business is to simply apply a multiple to last twelve months (or, “LTM”) EBITDA to arrive at an Enterprise Value.  However, as noted above, not all businesses are generating EBITDA, so VC investors have developed methodologies to ascribe value to other metrics that can be indicative of a company’s worth.  For instance, for fast growing companies that have revenue but no profits, one way to arrive at a valuation is to apply a multiple of revenue.  This approach has become commonplace in sectors like the software industry (case in point, if you want to make a SaaS entrepreneur give you a funny look, then start talking about EBITDA multiples).  It’s a strange paradox that, as the owner of a high growth business, it can be advantageous to not have EBITDA, because as soon as you generate profits investors will change their thinking from revenue multiples to EBITDA multiples.  The exercise is even further complicated when a business is pre-revenue – I’ve spoken with one VC who humorously suggests that in this case you apply a “multiple of dreams”.  The table below outlines this basic idea:
  1. Amount of capital invested per deal / number of investments made. While the total amount of capital under management between a PE and VC firm may be similar, it’s often the case that the amount invested per deal is higher for PE firms than VC firms.  As a result, a PE firm will typically have a more concentrated portfolio of companies, say 10 or fewer investments in a given fund, as compared to a VC that may have 20-40 (or more) per fund.  The chart below provides an illustrative visual example of this dynamic.  
  1. Ownership position taken. In short, PE funds usually need control and VC funds don’t.  For a PE fund, though, control doesn’t always mean 100% ownership.  This is a common misconception.  For example, many private equity funds insist that a company’s existing shareholders retain equity alongside them (or, “rollover”) such that the executive team has “skin in the game” as well.  But, why do PE funds prefer control in the first place?  There are various reasons for this, but an important one is that many successful PE funds have a proven track record of adding value to their portfolio companies by actively helping to guide strategy.  All things equal, it’s much easier to influence an investment if you are the final decision maker – if you are a business owner reading this, you can appreciate the concept.  PE funds also seek control given that they are typically writing relatively large checks into each deal as a percentage of their total fund size, and one way to offset the risk of such exposure is to have more say regarding how a business is managed (though most funds would freely admit that they would prefer to leave day-to-day management to their executive teams).  Note also that in a private equity deal the number of investors is usually limited to the PE fund, a small group of prior controlling shareholders and the company’s management team.   
  1. Conversely, VC funds are more comfortable with non-control, or “minority” investments because they are making far more bets than a PE fund (i.e. less of their fund is at risk per investment) and are not often set up for the requisite oversight of such a large portfolio of companies.  Further, VCs are inclined to let a visionary founder retain control and continue to rapidly grow his/her business in advance of an IPO or sale once they’ve achieved critical mass.  At this stage of investing, it’s important that the founder remains highly motivated with the accompanying entrepreneurial freedoms necessary to continue their growth trajectory.  Finally, another departure from PE is that the ownership group in a VC-backed company will often include additional parties such as other VC funds, angel investors and early employees who knowingly traded lower compensation for equity upside.   
  1. Here’s a chart that will help you think about the composition of shareholders in PE- and VC-funded deals:
  1. How they’ll seek to exit their investments. Once a PE fund has increased profitability to a point where an exit will likely produce an acceptable return, they will explore a sale to return capital to their investors. Today, private equity funds are exiting to two primary categories of buyers: (i) other private equity funds, and (ii) strategic buyers (i.e. larger corporate entities in the same or similar industry as the target company).  While IPOs are a possibility if a PE firm’s portfolio companies achieve a suitable size, a sale to another PE fund or strategic buyer is often a more familiar path, results in fewer transactional intricacies and allows for a more complete exit.
  1. While VC funds have the same exit options as PE funds in the form of sales to PE funds and strategic buyers (and frequently utilize them), they are relatively more inclined to tap the public markets for exits via an IPO.  VCs have historically gravitated to IPOs due to the ability to achieve premium valuations relative to other exit alternatives and their effectiveness in raising a large amount of capital at one time.  IPOs also offer an ancillary, marketing-related benefit of raising awareness of the target company in connection with its public offering.     
  1. In case you’re interested, here’s a chart that shows the “Top 25 VC-Backed Exits of All Time”.  Are you familiar with the term “Unicorn”?  In a business context, it refers to any VC-backed company that achieves a $1BN or more valuation.  So, consider these success stories best in breed:
  1. Returns expectations. This is an area where we see a big divide in how PE and VC firms approach investing.  PE funds are generally targeting a 2-3x return on each deal whereas VC investors have grown to accept that a mere 20% of their investments will produce 80% of their targeted returns.  In other words, VCs know that many of their investments will not return anything, though a select few will be huge homeruns, on the order of 10, 50 or even 100x+ returns.  Interestingly, though, that while the respective loss tolerances and upside potential for both strategies may differ, the expectations for a minimally acceptable return for the fund as a whole are not that far apart.  Here’s a chart that puts this in perspective:
  1. Team backgrounds. Given the difference in the stage at which PE and VC firms get involved with their companies, the approach to staffing these firms can be different as well.  For instance, it’s common for VC fund investment professionals to have significant entrepreneurial and operating experience with tech-related businesses.  This experience can be important to position themselves as value-added investors and in their ability to relate to the founders of companies in which they are investing. 
  1. In private equity funds, professionals will often come from the ranks of management consulting and/or investment banks, though certain PE firms do have a more operationally focused orientation which can result in them attracting talent with operating experience as well.  For private equity funds, having investors with an operating background can result in more empathetic interactions with the executives running their portfolio companies and the ability to add value beyond financial engineering.  Regardless of background, any investor with whom you’ll be working will be highly focused on helping you increase the value of your business.

Summary

I realize I just threw a lot at you, so here’s a side-by-side comparison of they key differences between PE and VC.  Please get in touch if you’d like to discuss anything in this piece further, and consider us a resource to you and your business.

About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects.  Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value.  For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

Don’t Stay Past Midnight – Reflections on Knowing When to Sell Your Business (Part 6)

If you’ve been with us for the preceding weeks, you know that we’ve been walking through a list of six ways to objectively determine if it might be a good time to consider the sale of your private business.  Last week’s blog addressed the concept of making sure there is enough future value remaining in the business to attract investors.  In short, if you wouldn’t invest in your company today, then why would someone else?

This week, we’re going to explore the 6th and final point below which suggests that if your competitors are deciding to sell, then they have likely thoughtfully considered one or more of the items on our list and concluded that the timing was right.

  1. Valuations are Historically High
  2. You’ve Experienced Multi-Year Growth in Revenue and Profits
  3. Expected Proceeds from an Exit Exceed Your Previously Defined Goals (i.e. You’ll Hit Your “Number”)
  4. The Industry is Experiencing Tailwinds from Positive Trends
  5. Value Remains for the Next Buyer
  6. You See Your Competitors Deciding to Sell

Remember when your mom said, “If your friends jumped off of a cliff, then would you do it too?”  Well, maybe you would if the cliff was a metaphor for selling your business and valuations in your industry were historically high, you’d experienced consistent growth in Revenue and Profits, a sale would allow you to live in a manner consistent with your goals, your industry was benefitting from an upswing, and the business would make for a good investment by an investor’s standards.  Here are some more reflections on the topic:

  • You See Your Competitors Deciding to Sell. If you assume that (i) an entrepreneur’s business is their most valuable financial asset and (ii) that they are not likely to part ways with it unless one or more compelling factors drove them to the conclusion to sell, then news of a competitor deciding to exit should result in some real introspection on your own exit timing.  And, an ancillary benefit of a competitor proceeding with a transaction is that you can often triangulate around the purchase multiple once the gossip mill starts humming about the deal.  It goes without saying that just because your peers in the industry decide to sell, it doesn’t mean that you have to.  Perhaps you have a higher risk tolerance than they do and your patience will pay off.  Just recognize that forces could be at work that are creating a good window for an exit.

Well, this completes our blog series, and we hope you’ve benefitted from some of these perspectives.  As always, we’re interested in your feedback.  To start a conversation, please reach out to Joe Schmidt (jjs@clearlightpartners.com) or Mark Gartner (mpg@clearlightpartners.com).  We want to hear from you!

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About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects.  Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value.  For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.

Don’t Stay Past Midnight – Reflections on Knowing When to Sell Your Business (Part 5)

If you’ve been with us for one of the preceding weeks, you know that we’ve been walking through a list of six ways to objectively determine if it might be a good time to consider the sale of your private business.  Our prior blog highlighted why investors respond well to an industry that is benefitting from positive trends that are likely to continue for the foreseeable future.  In short, good industries often support good investments, and if your business is operating in a sector with tailwinds at its back, this could be another factor contributing to a decision to explore an exit. 

This week, we’re going to explore #5 below which is a good reminder that in order to drive a good exit, buyers have to believe that your business has strong growth prospects for the foreseeable future.  This is important because whoever buys your business has to also believe that they will be able to sell the growth story to another investor down the road. 

  1. Valuations are Historically High
  2. You’ve Experienced Multi-Year Growth in Revenue and Profits
  3. Expected Proceeds from an Exit Exceed Your Previously Defined Goals (i.e. You’ll Hit Your “Number”)
  4. The Industry is Experiencing Tailwinds from Positive Trends
  5. Value Remains for the Next Buyer
  6. You See Your Competitors Deciding to Sell

Think of it this way, nobody would purchase a lemon with all of the juice squeezed out of it, right?  Perhaps a lemon is not the best example here, but you get the point.  Here are some more reflections on the topic:

  • Value Remains for the Next Buyer. Sometimes, an owner’s decision to exit is driven by the threat of looming headwinds to the business or industry.  Conceptually, getting out before these challenges arrive makes sense, but it’s likely that investors are already, or will be, attuned to those same issues, and it may then be too late to drive an optimal outcome from a sale.  At a minimum, investors are going to need to know that the prospects for growth will remain strong for the next 5-10 years.  Otherwise, they may encounter challenges when they ultimately seek an exit.  Said another way, if you are considering an exit, reflect on whether you would want to invest in your business today
  • To drive home the point visually, take a look at the following chart that illustrates how an investor may assess the relative attractiveness of your business based on the expected growth in profitability over time.  The punchline is that your prospects for an exit are substantially improved if investors see a sustainably bright future for the company.

Stay tuned for our final blog where we’re going to address point #6 above, You See Your Competitors Deciding to Sell.  As always, we’re interested in your feedback.  To start a conversation, please reach out to Joe Schmidt (jjs@clearlightpartners.com) or Mark Gartner (mpg@clearlightpartners.com).

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About ClearLight Partners

ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects.  Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value.  For more information, visit www.clearlightpartners.com.

Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.