Turning Managers into Owners
Equity Ventures is a venture capital and corporate finance firm. We
will help you raise money for expansion or a management buyout or even
a secondary buy-out (SBO) if you have already done an MBO and the
private equity firm is still invested in you.
We manage a regional venture capital fund in which HSBC and the
European investment Bank were investors (they have now exited having
achieved about 1.4x their investment); and we can co-invest with other
venture capital firms; but mostly we raise capital and arrange
management buyouts by working for management teams in companies with
annual sales of between £1 million and £100 million.
Whether we invest, co-invest or arrange a management buyout for you
depends on the circumstances of each transaction. But call for a brief
chat to see if we think we can help you.
We also work with managers in existing private equity companies who
are looking for an exit or secondary buyout opportunity. And we will
work with the shareholders of companies who are looking to make
acquisitions or sell all or part of their company - usually a
retirement type sale.
We are a small team so you always work with the same people.
What is your business worth to a venture capital firm?
Venture capitalists use detailed spreadsheet models in valuing and
structuring buyouts. Our model distills the essence of these and it is
a useful tool which has been used on many buyouts and has been
purchased by several institutions, companies and banks, including the
Bank of England. although this model is now no longer sold publicly
you can try it online.
The model shows how the future exit value of the company will be
shared between management and the venture capitalists. It is also
useful for managers of existing buyout and private equity deals who
are beginning to look at an exit by sale or secondary buy-out. You can
see our model here to try it out for your company:
MBO buyout business valuation You will need to spend a
little time putting in some financial information to get the best use
from this model, but we also have a quick "lite" model if you want -
just call us or try this link to it :
MBO quick valuation
Industrial sectors suitable for management buyouts
We are interested in most sectors. However, because of EU rules, we
are excluded from transactions involving oil & gas, and offshore
fishing. Apart from these exceptions, if it is legal and profitable,
we will look at it. Turnrounds are slightly more difficult to do but
we know some of the best practitioners in this field.
How does a small team buy a large company in a management buyout?
The way that a management team can fund and finance an MBO is now
well established. The existing business is known as the "Target" and
the MBO company is referred to as "Newco". Newco is funded by
money from the management team, venture capitalists, and banks.
Because the venture capitalists invest in shares as well as loans or
preference shares they get a lower precentage of the economic
ownership of the company than the MBO team for each pound invested. By
varying the investment proportions management can have a significant
financial stake in a large company for relatively little money -
provided the company increases in value after the deal is done.
What you should do to start the MBO process
The next step is to contact us by phone or email. You can approach
us with just an idea for a transaction, an executive summary, or a
full business plan.
If we think you have a potentially backable proposition we will
arrange to meet you. This can be at your premises or elsewhere; and we
are happy to meet outside normal office hours if that is more
convenient or you are worried about confidentiality issues.
Equity Ventures - a venture capital firm with experience of all
aspects of management buyouts
We prefer to invest alongside management and on similar terms to
them. This helps align our interests with yours. We won't encourage
management teams to produce profit forecasts that we don't believe in
or to pay more for a business than we think sensible. This approach
comes from our experienced background in banking, consultancy as well
as being venture capitalists for over 20 years. We also did our own
management buyout - so we have seen all sides of transactions.
Fees and costs
You can start on the management buyout process without worrying
about incurring costs on a transaction that doesn't happen. In fact,
you can get quite a long way through the process before having any
personal exposure to fees and other costs. Typically, a deal will
require about fifty days and our fee is usually paid by the acquiring
company (Newco) which is funded primarily by the venture capital firm,
not by the management team personally. Most deal fees, including ours,
are contingent upon a deal actually happening.
The one area where management do have a personal exposure to costs
is for professional advice on the terms of their employment contract
with Newco but these will only occur once there is near certainty of a
Is a buyout of your company possible?
A management buyout requires a seller, be they willing or
unwilling. A willing seller is typically the planned retirement sale
by the owner of a private business; or part of a corporate group being
sold for strategic reasons. Much of the time expended in dealing with
willing sellers involves finding financiers who are interested in the
company at a price that nears the vendor's expectations.
An unwilling seller is a typically company in distress or
administration because of losses or excessive borrowings. Even an
unwilling seller will only sell if the price is acceptable to them,
and distress deals often fail because the purchaser finds the problems
in a distressed company are often far worse than initially disclosed.
Presenting the right amount of information in the right manner is
At Equity Ventures we can help you establish at an early stage if
it is feasible to do a buyout of your company.
We have experience of making the first approaches and assessment of
buyout and acquisition possibilities and we can discuss and agree
these with you. But you won't know what can be done unless you start
the process - with a phone call to us.
Venture capital and private equity news and views:
The Equity Ventures Guide to Private Equity - this is probably the most
comprehensive guide to private equity online in HTML so you may want to bookmark
this page so you can return to it easily.
Private equity is medium to long-term finance provided in return
for an equity stake in potentially high growth unquoted companies.
Some commentators use the term “private equity” to refer only to the
buy-out and buy-in investment sector. Some others, in Europe but not
the USA, use the term “venture capital” to cover all stages, i.e.
synonymous with “private equity”. In the USA “venture capital” refers
only to investments in early stage and expanding companies. To avoid
confusion, the term “private equity” is used throughout this Guide to
describe the UK industry as a whole, encompassing both “venture
capital” (the seed to expansion stages of investment) and management
buy-outs and buy-ins.
How this Guide can help you
This Guide aims to encourage you to approach a source of private
equity early in your search for finance. It explains how the private
equity process works and what you need to do to improve your chances
of raising it. It gives guidance on what should be included in your
business plan, which is a vital tool in your search for funding. It
also demonstrates the positive advantages that private equity will
bring to your business.
The main sources of private equity in the UK are the private equity
firms (who may invest at all
stages – venture capital and buy-outs) and “business angels” (private
individuals who provide
smaller amounts of finance at an earlier stage than many private
equity firms are able to invest).
In this Guide we principally focus on private equity firms. The
attributes that both private equity
firms and business angels look for in potential investee companies are
often very similar and so
this Guide should help entrepreneurs and their advisers looking for
private equity from both these
sources. “Corporate venturers” which are industrial or service
companies that provide funds and/
or a partnering relationship to fledgling companies and may operate in
the same industry sector as
your business can also provide equity capital.
Throughout the 1990s the technology hype, internet boom and massive
capital investment propelled the New Economy revolution, but internet
mania in the late 1990s caused technology stocks to skyrocket until
the bubble burst in the year 2000. There was over-optimism, too much
easy money, proven ways of doing business were replaced by irrational
exuberance and private and public company market valuations were
driven to unsustainable levels. The mid 2000’s saw a substantial
increase in the later stages of private equity transactions with large
and mega buyouts fuelled by significant amounts of debt.
With the onset of the credit crunch in 2007/8 and the reduction in the
general availability of bank
loans, and tightening of the conditions required to obtain loan
finance, there is considerably less debt available for deals in the
current economic environment. Banks are reluctant to lend,
particularly if they have not had the experience of going through a
downturn in the leveraged, high risk market before.
There is however currently no shortage of private equity funds for
investment in the UK. Private equity deals going forward are likely to
involve much less leverage, and therefore perceived lower risk for the
banks. Excellent opportunities remain open to companies seeking
private equity with convincing business proposals.
Private equity firms are looking for investment opportunities where
the business has proven potential for realistic growth in an expanding
market, backed up by a well researched and documented business plan
and an experienced management team – ideally including individuals who
have started and run a successful business before. This Guide will
help you to understand what private equity firms are looking for in a
potential business investment and how to approach them.
What is private equity?
Private equity provides long-term, committed share capital, to help
unquoted companies grow and
succeed. If you are looking to start up, expand, buy into a business,
buy out a division of your parent
company, turnaround or revitalise a company, private equity could help
you to do this. Obtaining
private equity is very different from raising debt or a loan from a
lender, such as a bank. Lenders have a legal right to interest on a
loan and repayment of the capital, irrespective of your success or
Private equity is invested in exchange for a stake in your company
and, as shareholders, the investors’ returns are dependent on the
growth and profitability of your business.
Private equity in the UK originated in the late 18th century, when
entrepreneurs found wealthy individuals to back their projects on an
ad hoc basis. This informal method of financing became an industry in
the late 1970s and early 1980s when a number of private equity firms
were founded. Private equity is now a recognised asset class. There
are over 250 active UK private equity firms, which provide several
billions of pounds each year to unquoted companies.
Would my company be attractive to a private equity investor?
Many small companies are “life-style” businesses whose main purpose is
to provide a good standard
of living and job satisfaction for their owners. These businesses are
not generally suitable for private equity investment as they are
unlikely to provide the potential financial returns to make them of
interest to an external investor.
“Entrepreneurial” businesses can be distinguished from others by their
aspirations and potential for
growth, rather than by their current size. Such businesses are aiming
to grow rapidly to a significant
size. As a rule of thumb, unless a business can offer the prospect of
significant turnover growth
within five years, it is unlikely to be of interest to a private
equity firms. Private equity investors are only interested in
companies with high growth prospects, which are managed by experienced
ambitious teams who are capable of turning their business plan into
reality. However, provided there
is real growth potential the private equity industry is interested in
all stages, from start-up to buy-out.
Some of the benefits of private equity
Private equity backed companies have been shown to grow faster than
other types of companies.
This is made possible by the provision of a combination of capital and
experienced personal input from private equity executives, which sets
it apart from other forms of finance. Private equity can help you
achieve your ambitions for your company and provide a stable base for
strategic decision making. The private equity firms will seek to
increase a company’s value to its owners, without taking day-to-day
management control. Although you may have a smaller “slice of cake”,
within a few years your “slice” should be worth considerably more than
the whole “cake” was to you before.
Private equity firms often work in conjunction with other providers of
finance and may be able to help you to put a total funding package
together for your business.
Questions to ask yourself before reading further
- Does your company have high growth prospects and are you and your
team ambitious to grow
your company rapidly?
- Does your company have a product or service with a competitive edge
or unique selling point (USP)?
- Do you and/or your management team have relevant industry sector
- Do you have a clear team leader and a team with complementary areas
of expertise, such as management, marketing, finance, etc?
- Are you willing to sell some of your company’s shares to a private
- If your answers are “yes”, private equity is worth considering.
Internal and external financial resources
Before looking at new external sources of finance, make sure you are
making optimal use of your
internal financial resources.
- Ensure that you have good cash flow forecasting systems in place
- Give customers incentives to encourage prompt payment
- Adhere to rigorous credit control procedures
- Plan payments to suppliers
- Maximise sales revenues
- Carefully control overheads
- Consider sub-contracting to reduce initial capital requirements (if
- Assess inventory levels (if appropriate)
- Check quality control
Then think about the external options.
- Your own and your co-directors’ funds
- Friends’ or business associates’ funds
- The clearing banks – overdrafts, short or medium-term loans
- Factoring and invoice discounting
- Leasing, hire purchase
- Investment banks – medium to long-term larger loans
- Public sector grants, loans, regional assistance and advice
- Business angel finance
- Corporate venturing
- Private equity
But please don’t get the impression that private equity is a last
resort after you have exhausted your
own, your friends’, your business colleagues’ and your bank’s
resources. There are many advantages
to private equity over bank debt. Private equity firms can of course
work in conjunction with the other external sources as part of an
overall financing package.
Some of the alternative sources of external finance are elaborated on
below for your information. These may particularly apply if you are
looking for finance at the lower end of the so-called ‘equity gap’,
say up to £250,000 or £500,000. The ‘equity gap’ is widely regarded as
being between £250,000 and £2 million where it can be difficult to
secure venture capital finance simply because of the amount of time
and effort required to appraise an investment proposition by a venture
capital firms. For smaller amounts of finance it is not simply worth
their while unless there will be further financing rounds required
later. More recently the UK has addressed the range of financing
towards the upper end of the equity gap with the Enterprise Capital
Funds (ECFs) – see below – that can provide up to £2 million of
Government sources of finance for SMEs and growing businesses
in the UK
These include the following:
Enterprise Finance Guarantee scheme (EFG)
The Enterprise Finance Guarantee (EFG) replaced the Small Firms Loan
Guarantee Scheme (SFLG)
and provides loans from £1,000 up to £1 million, repayable over 10
years, compared to an upper limit of £250,000 for the SFLG, and
supports businesses with a turnover of up to £25 million, compared to
£5.6 million under SFLG. The EFG can be used to support new loans,
refinance existing loans or to convert part or all of an existing
overdraft into a loan to release capacity to meet working capital
The Government will guarantee 75% of the loan. EFG is available to
viable businesses that in normal
circumstances would be able to secure lending from banks but who
cannot secure bank lending in
the current times. Most businesses in most sectors are eligible for
the scheme. However, the state aid rules exclude businesses in the
agriculture, coal and steel sectors.
Enterprise Capital Funds (ECFs)
Enterprise Capital Funds (ECFs) are a UK government initiative aimed
at bridging the equity gap by
improving access to growth capital for small and medium-sized
enterprises by applying a modified
US Small Business Investment Company (SBIC) model to the UK, a
difference being that with the UK
scheme the government has downside protection with a priority return
of 4.5% per annum plus a
minor profit share.
ECFs are privately managed and use a limited partnership model with
- a professional FSA authorised fund manager who acts on behalf of
- an active investor model (e.g. business angels) who invest and
manage their own funds through
ECFs (maybe without FSA authorisation).
There are now some 23 ECFs in operation and a further fund was
recently awarded ECF status. Responsibility for the management of ECFs
was transferred to Capital for Enterprise Limited (CfEL) in 2008 and
then in 2013 became part of the British Business Bank.
ECFs receive their funding from the UK government and private sources.
There is no maximum fund
size for an ECF, but the government will commit no more than £25
million to a single fund or no more
than twice the private capital, whichever is lower.
Equity investments of up to £2 million per deal can be made but to
avoid the problems of dilution experienced by many early stage
investors ECFs are allowed to invest more than £2 million in a single
company if not to do so as part of a subsequent funding round would
dilute their exiting stake in the company.
To access support from one of the Enterprise Capital Funds contact us
at Equity Ventures Limited on 0207 859 4106 of the British Business
Enterprise Investment Scheme
The Enterprise Investment Scheme which was set up by the UK government
to replace the Business
Expansion Scheme (BES) and to encourage business angels to invest in
certain types of smaller
unquoted UK companies. If a company meets the EIS criteria (See
may be more attractive to business angels, as tax incentives are
available on their investments.
Under the Enterprise Investment Scheme, individuals not previously
connected with a qualifying unlisted trading company (including shares
traded on the Alternative Investment Market (AIM)) can make
investments of up to £500,000 in a single tax year and receive tax
relief at 20 % on new subscriptions for ordinary shares in the
company, and relief from CGT on disposal, provided the investment is
held for three years.
Venture Capital Trusts (VCTs)
Venture Capital Trusts (VCTs) which are quoted vehicles to encourage
investment in smaller unlisted
(unquoted and AIM quoted) UK companies. Investors receive 30% income
tax relief on VCT investment on a maximum investment amount of
£200,000 in each tax year provided the investment is held forfive
years. Shares in VCTs acquired within the annual limit are also exempt
from capital gains tax on disposal at any time.
For further information on the above UK government grants and others
available visit the website
of the British Business Bank. In addition to providing advice on the
various grants available to SMEs and growth companies they provide
advice, help and an entrypoint to the various schemes run by the
Department for Business, Innovation and Skills (BIS) which renamed
itself to Department for Business Energy & Industrial Strategy.
New businesses (particularly those using new technology) can get help
with premises and management from the various Business Incubation
Centres in the UK or from one of the UK Science Parks. You may also be
eligible for EU grants if you are in an innovative business sector or
are planning to operate in a deprived area of the UK or a region zoned
for regeneration. Your local Chamber of Commerce and town hall should
have lists of grants and available property.
Business angels are private investors who invest directly in private
companies in return for an equity
stake and perhaps a seat on the company’s board. Research has shown
that business angels generally
invest smaller amounts of private equity in earlier stage companies
compared with private equity
firms. They typically invest between £20,000 and £200,000 at the seed,
start-up and early stages of
company development, or they may invest more than this as members of
syndicates, possibly up to
£1.5 million. Business angels will usually want a “hands-on” role with
the company that they invest in, maybe as an adviser and/or a
non-executive director or they may even take on an executive role.
Many companies find business angels through informal contacts, but for
others, finding a business angel may be more difficult, as the details
of individual business angels are not always available. The British
Business Angels Association (BBAA) lists its members on its website
(www.bbaa.org.uk) so this is a good place to start to help you find
business angel investor networks in the UK.
Corporate venturing has developed quite rapidly, albeit sporadically,
in recent years but still represents only a small fraction when
compared to private equity investment activity. Direct corporate
venturing occurs where a corporation takes a direct minority stake in
an unquoted company. Indirect corporate venturing is where a
corporation invests in private equity funds managed by an independent
private equity firms. Corporate venturers raise their funds from their
parent organisations and/or from external sources.
Investment forums and networking organisations
In addition to business angel networks you can also find angel
investors (and venture capitalists) at
various investment forums that are organized in the UK. Typically at
these events entrepreneurs seeking capital get to present their
propositions to an audience of VCs, angels, corporate investors and
Presenters have around 10 to 15 minutes to make their presentation (a
sort of extended ‘elevator pitch’).
Depending on the prestige and size of the event there may be a
selection process to decide which
companies get to make presentations and payment may or may not be
required. Some of these events are put on by the larger conference
organizers, others are organized by universities and business schools
and networking clubs. Usually, in addition to the company
presentations, there will be one or more plenary sessions from invited
guest speakers, including successful entrepreneurs on topical issues.
Do speak to friends, business contacts and advisers as well as your
local Local Enterprise Partnership. Do remember there are many
misconceptions about the various sources of finance and schemes vary
and get replaced by new initiatives, so obtain as much information as
possible to ensure that you can realistically assess the most suitable
finance for your needs and your company’s success.
Here are some well-known private equity backed companies:-
Birds Eye Iglo
Cambridge Silicon Radio
Earls Court & Olympia
Findus Group (Foodvest)
Merlin Entertainments Group
National Car Parks
Odeon & UCI Cinemas
Pizza Express/Zizzi/Ask – Gondola Group
Pret A Manger
UCI Cinemas/Odeon Cinemas
West Cornwall Pasty Co.
The advantages of private equity over senior debt
A provider of debt (generally a bank) is rewarded by interest and
capital repayment of the loan and it is usually secured either on
business assets or your own personal assets, such as your home. As a
last resort, if the company defaults on its repayments, the lender can
put your business into receivership, which may lead to the liquidation
of any assets. A bank may in extreme circumstances even bankrupt you,
if you have given personal guarantees. Debt which is secured in this
way and which has a higher priority for repayment than that of general
unsecured creditors is referred to as “senior debt”.
By contrast, private equity is not secured on any assets although part
of the non-equity funding package provided by the private equity firms
may seek some security. The private equity firms, therefore, often
faces the risk of failure just like the other shareholders. The
private equity firms is an equity business partner and is rewarded by
the company’s success, generally achieving its principal return
through realising a capital gain through an “exit” which may include:
- Selling their shares back to the management
- Selling the shares to another investor (such as another private
- A trade sale (the sale of a company shares to another company)
- The company achieving a stock market listing.
Although private equity is generally provided as part of a financing
package, to simplify comparison we compare private equity with senior
vs Senior debt
“exit”. Not likely
to be committed if the safety of the
loan is threatened. Overdrafts are payable
on demand; loan facilities can be payable on
demand if the covenants are not met.
Provides a solid, flexible, capital base to meet
your future growth and development plans.
A useful source of finance if the debt to equity
Ratio is conservatively balanced and the
company has good cash flow.
Good for cash flow, as capital repayment,
dividend and interest costs (if relevant) are
tailored to the company’s needs and to what it
Requires regular good cash flow to service
interest and capital repayments.
The returns to the private equity investor depend
on the business’ growth and success. The
more successful the company is, the better the
returns all investors will receive.
Depends on the company continuing to service
its interest costs and to maintain the value of the
assets on which the debt is secured.
If the business fails, private equity investors will
rank alongside other shareholders, after the
banks and other lenders, and stand to lose their
If the business fails, the lender generally has first
call on the company’s assets.
If the business runs into difficulties, the private
equity firms will work hard to ensure that the
company is turned around.
If the business appears likely to fail, the lender
could put your business into receivership in
order to safeguard its loan, and could make you
personally bankrupt if personal guarantees have
A true business partner, sharing in your risks and
rewards, with practical advice and expertise (as
required) to assist your business success.
Assistance available varies considerably.
Sources of private equity
There is a wide range of types and styles of private equity available
in the UK. The primary sources are private equity firms who may
provide finance at all investment stages and business angels who focus
on the start-up and early stages. In targeting prospective sources of
finance and business partners, as in any field, it works best if you
know something about how they operate, their structure, and their
Private equity firms
Private equity firms usually look to retain their investment for
between three and seven years or more. They have a range of investment
preferences and/or type of financing required. It is important that
you or your adviser only approach those private equity firms whose
preferences match your requirements.
Where do private equity firms obtain the money to invest in my
Just as you and your management team are competing for finance, so are
private equity firms, as they raise their funds from a number of
different sources. To obtain their funds, private equity firms have to
demonstrate a good track record and the prospect of producing returns
greater than can be achieved through fixed interest or quoted equity
Most UK private equity firms raise their funds for investment from
external sources, mainly institutional investors, such as pension
funds and insurance companies, and are known as independents. Private
equity firms that obtain their funds mainly from their parent
organisation are known as captives. Increasingly, former captives now
raise funds from external sources as well and are known as
semi-captives. These different terms for private equity firms now
overlap considerably and so are increasingly rarely used.
How may the source of a private equity firm’s money affect me?
Private equity firms’ investment preferences may be affected by the
source of their funds. Many funds raised from external sources are
structured as limited partnerships and usually have a fixed life of 10
years. Within this period the funds invest the money committed to them
and by the end of the 10 years they will have had to return the
investors’ original money, plus any additional returns made. This
generally requires the investments to be sold, or to be in the form of
quoted shares, before the end of the fund. Some funds are structured
as quoted private equity investment trusts, listed on the London Stock
Exchange and other major European stock markets and, as they have no
fixed lifespan, they may be able to offer companies a longer
Venture Capital Trusts (VCTs) (see above) are quoted vehicles that aim
to encourage investment in
smaller unlisted (unquoted and AIM quoted) UK companies by offering
private investors tax incentives in return for a five-year investment
commitment. If funds are obtained from a VCT, there may be some
restrictions regarding the company’s future development within the
first few years.
How do I select the right private equity firms?
Some private equity firms manage a range of funds (as described above)
including investment trusts, limited partnerships and venture capital
trusts, and the firms’ investment preferences are listed in the BVCA.
Equity ventures Limited or your existing advisers may be able to
introduce you to their private equity contacts and assist you in
selecting the right private equity firms. If they do not have suitable
contacts or cannot assist you in seeking private equity.
As far as a company looking to raise private equity is concerned, only
those whose investment
preferences match your requirements should be approached. Private
equity firms appreciate it when
they are obviously targeted after careful consideration.
You may find it interesting to obtain a copy of the BVCA’s Report on
Investment Activity which
analyses the aggregate annual investment activity of the UK private
equity industry. It looks at the
number of companies backed and the amounts they received by stage,
industry sector and region.
The next chapter will take you through the selection process in more
Selecting a private equity firms
Firstly, decide whether or not to hire an adviser (see the section on
‘The role of professional advisers’).
The most effective way of raising private equity is to select just a
few private equity firms to target with your business proposition. The
key considerations should be to assess:
1. The stage of your company’s development or the type of private
equity investment required.
2. The industry sector in which your business operates.
3. The amount of finance your company needs.
4. The geographical location of your business operations.
You should select only those private equity firms whose investment
preferences match these attributes.
1. Stage/type of investment
The terms that most private equity firms use to define the stage of a
company’s development are
determined by the purpose for which the financing is required.
To allow a business concept to be developed, perhaps involving the
production of a business plan, prototypes and additional research,
prior to bringing a product to market and commencing large-scale
Only a few seed financings are undertaken each year by private equity
firms. Many seed financings
are too small and require too much hands-on support from the private
equity firms to make them
economically viable as investments. There are, however, some
specialist private equity firms which are worth approaching, subject
to the company meeting their other investment preferences. Business
angel capital should also be considered, as with a business angel on a
company’s board, it may be more attractive to private equity firms
when later stage funds are required.
To develop the company’s products and fund their initial marketing.
Companies may be in the process of being set up or may have been
trading for a short time, but not have sold their product
Although many start-ups are typically smaller companies, there is an
increasing number of multimillion pound start-ups. Several BVCA
members will consider high quality and generally larger start-up
propositions as well as investing in the later stages. However, there
are those who specialise in the start up stage, subject to the company
seeking investment meeting the firm’s other investment preferences.
Other early stage
To initiate commercial manufacturing and sales in companies that have
completed the product
development stage, but may not yet be generating profits.
This is a stage that has been attracting an increasing amount of
private equity over the past few years.
To grow and expand an established company. For example, to finance
increased production capacity,
product development, marketing and to provide additional working
capital. Also known as “development” or “growth” capital.
Management buy-out (MBO)
To enable the current operating management and investors to acquire or
to purchase a significant
shareholding in the product line or business they manage. MBOs range
from the acquisition of relatively small formerly family owned
businesses to well over £100 million buy-outs. The amounts concerned
tend to be larger than other types of financing, as they involve the
acquisition of an entire business.
Management buy-in (MBI)
To enable a manager or group of managers from outside a company to buy
Buy-in management buy-out (BIMBO)
To enable a company’s management to acquire the business they manage
with the assistance of
some incoming management.
Institutional buy-out (IBO)
To enable a private equity firms to acquire a company, following which
the incumbent and/or incoming management will be given or acquire a
stake in the business.
This is a relatively new term and is an increasingly used method of
buy-out. It is a method often
preferred by vendors, as it reduces the number of parties with whom
they have to negotiate.
When a private equity firms acquires existing shares in a company from
another private equity firms or from another shareholder or
To allow existing non-private equity investors to buy back or redeem
part, or all, of another investor’s shareholding.
To finance a company in difficulties or to rescue it from
Refinancing bank debt
To reduce a company’s level of gearing.
Short-term private equity funding provided to a company generally
planning to flat within a year.
For recent information on the actual amounts invested at each stage of
investment, see the “BVCA
Report on Investment Activity.
2. Industry sector
Most private equity firms will consider investing in a range of
industry sectors – if your requirements
meet their other investment preferences. Some firms specialise in
specific industry sectors, such as
biotechnology, computer related, clean tech and other technology
areas. Others may actively avoid
sectors such as property or film production.
3. Amount of investment
The majority of UK private equity firms’ financings each year are for
amounts of well over £100,000 per company. There are, however, a
number of private equity firms who will consider investing amounts of
private equity under £100,000 and these tend to include specialist and
regionally orientated firms.
Companies initially seeking smaller amounts of private equity are more
attractive to private equity firms if there is an opportunity for
further rounds of private equity investment later on.
The process for investment is similar, whether the amount of capital
required is £100,000 or £10 million or more, in terms of the amount of
time and effort private equity firms have to spend in appraising the
business proposal prior to investment. This makes the medium to
larger-sized investments more attractive for private equity
investment, as the total size of the return (rather than the
percentage) is likely to be greater than for smaller investments, and
should more easily cover the initial appraisal costs.
Business angels are perhaps the largest source of smaller amounts of
equity finance, often investing
amounts ranging between £20,000 and £200,000 in early stage and
smaller expanding companies.
4. Geographical location
Several private equity firms have offices in the UK regions. Some
regions are better served with more local private equity firms than
others, but there are also many firms, particularly in London, who
look to invest UK-wide.
The business plan
A business plan’s main purpose when raising finance is to market your
business proposal. It should
show potential investors that if they invest in your business, you and
your team will give them a
unique opportunity to participate in making an excellent return.
A business plan should be considered an essential document for owners
and management to formally
assess market needs and the competition; review the business’
strengths and weaknesses; and to
identify its critical success factors and what must be done to achieve
profiable growth. It can be used to consider and re-organise internal
financing and to agree and set targets for you and your management
team. It should be reviewed regularly.
The company’s management should prepare the business plan. Its
production frequently takes far
longer than the management expects. The owner or the managing director
of the business should
be the one who takes responsibility for its production, but it should
be “owned” and accepted by
the management team as a whole and be seen to set challenging but
achievable goals that they
are committed to meeting. It should emphasise why you are convinced
that the business will be
successful and convey what is so unique about it. Private equity
investors will want to learn what you
and your management are planning to do, not see how well others can
write for you.
Professional advisers can provide a vital role in critically reviewing
the draft plan, acting as “devil’s
advocate” and helping to give the plan the appropriate focus. Several
of the larger accounting
firms publish their own detailed booklets on how to prepare business
plans. However, it is you who
must write the plan as private equity firms generally prefer
management driven plans, such as are
illustrated in this chapter.
Essential areas to cover in your business plan
Many businesses fail because their plans have not been properly
thought out, written down and
developed. A business plan should be prepared to a high standard and
be verifible. A business plan
covering the following areas should be prepared before a private
equity firms is approached.
This is the most important section and is often best written last. It
summarises your business plan
and is placed at the front of the document. It is vital to give this
summary significant thought and
time, as it may well determine the amount of consideration the private
equity investor will give to your detailed proposal. It should be
clearly written and powerfully persuasive, yet balance “sales talk”
with realism in order to be convincing.
It needs to be convincing in conveying your company’s growth and
profit potential and management’s
prior relevant experience. It needs to clearly encapsulate your
company’s USP (i.e. its unique selling
point – why people should buy your product or service as distinct from
The summary should be limited to no more than two to three pages (i.e.
around 1,000 to 1,500
words) and include the key elements from all the points below:
1. The market
2. The product or service
3. The management team
4. Business operations
5. Financial projections
6. Amount and use of finance required and exit opportunities
Other aspects that should be included in the Executive Summary are
your company’s “mission
statement” – a few sentences encapsulating what the business does for
what type of clients, the
management’s aims for the company and what gives it its competitive
edge. The mission statement
should combine the current situation with your aspirations. You should
also explain the current legal
status of your business in this section. You should include an overall
“SWOT” (strengths, weaknesses, opportunities and threats) analysis
that summarises the key strengths of your proposition and its
weaknesses and the opportunities for your business in the marketplace
and its competitive threats.
1. The market
You need to convince the private equity firms that there is a real
commercial opportunity for the
business and its products and services. This requires a careful
analysis of the market potential for
your products or services and how you plan to develop and penetrate
This section of the business plan will be scrutinised carefully;
market analysis should therefore be
as specific as possible, focusing on believable, verifiable data.
Include under market research a
thorough analysis of your company’s industry and potential customers.
Include data on the size
of the market, growth rates, recent technical advances, Government
regulations and trends – is
the market as a whole developing, growing, mature, or declining?
Include details on the number of
potential customers, the purchase rate per customer, and a profile of
the typical decision-maker who
will decide whether to purchase your product or service. This
information drives the sales forecast
and pricing strategy in your plan. Finally, comment on the percentage
of the target market your
company plans to capture, with justification in the marketing section
of the plan.
The primary purpose of the marketing section of the business plan is
for you to convince the private
equity firms that the market can be developed and penetrated. The
sales projections that you make
will drive the rest of the business plan by estimating the rate of
growth of operations and the financing required. Explain your plans
for the development of the business and how you are going to
achievethose goals. Avoid using generalised extrapolations from
overall market statistics.
The plan should include an outline of plans for pricing, distribution
channels and promotion.
How you plan to price a product or service provides an investor with
insight for evaluating your
overall strategy. Explain the key components of the pricing decision –
i.e. image, competitive issues,
gross margins, and the discount structure for each distribution
channel. Pricing strategy should also
involve consideration of future product releases.
If you are a manufacturer, your business plan should clearly identify
the distribution channels that
will get the product to the end-user. If you are a service provider,
the distribution channels are not
as important as are the means of promotion. Distribution options for a
manufacturer may include:
- Retailers (including on-line)
- Direct sales - such as mail order and ordering over the web, direct
contact through salespeople
- Original Equipment Manufacturers (OEM), integration of the product
into other manufacturers’ products.
Each of these methods has its own advantages, disadvantages and
financial impact, and these
should be clarified in the business plan. For example, assume your
company decides to use direct
sales because of the expertise required in selling the product. A
direct salesforce increases control,
but it requires a significant investment. An investor will look to
your expertise as a salesperson, or to the plans to hire, train and
compensate an expert salesforce. If more than one distribution channel
is used, they should all be compatible. For example, using both direct
sales and wholesalers can create channel conflict if not managed well.
Fully explain the reasons for selecting these distribution approaches
and the financial benefits they will provide. The explanation should
include a schedule of projected prices, with appropriate discounts and
commissions as part of the projected sales estimates. These estimates
of profit margin and pricing policy will provide support for the
The marketing promotion section of the business plan should include
plans for product sheets,
potential advertising plans, internet strategy, trade show schedules,
and any other promotional
materials. The private equity firms must be convinced that the company
has the expertise to move
the product to market. A well-thought-out promotional approach will
help to set your business plan
apart from your competitors.
It is important to explain the thought process behind the selected
sources of promotion and the
reasons for those not selected.
A discussion of the competition is an essential part of the business
plan. Every product or service
has competition; even if your company is first-to-market, you must
explain how the market’s need is
currently being met and how the new product will compete against the
existing solution. The investor
will be looking to see how and why your company can beat the
competition. The business plan
should analyse the competition (who are they, how many are there, what
proportion of the market
do they account for?). Give their strengths and weaknesses relative to
Attempt to anticipate likely competitive responses to your product.
Include, if possible, a direct
product comparison based on price, quality, warranties, product
updates, features, distribution
strategies, and other means of comparison. Document the sources used
in this analysis.
All the aspects included in the market section of your business plan
must be rigorously supported by
as much verifiable evidence as possible. In addition to carrying out
market research and discussions
with your management team, customers and potential customers, you may
need input from outside
2. The product or service
Explain the company’s product or service in plain English. If the
product or service is technically
orientated this is essential, as it has to be readily understood by
Emphasise the product or service’s competitive edge or USP. For
example, is it:
- A new product?
- Available at a lower price?
- Of higher quality?
- Of greater durability?
- Faster to operate?
- Smaller in size?
- Easier to maintain?
- Offering additional support products or services?
With technology companies where the product or service is new, there
has to be a clear “world class”
opportunity to balance the higher risks involved. Address whether it
is vulnerable to technological
advances made elsewhere.
- If relevant, explain what legal protection you have on the product,
such as patents attained,
pending or required. Assess the impact of legal protection on the
marketability of the product.
- You also need to cover of course the price and cost of the product
- If the product is still under development the plan should list all
the major achievements to date as
well as remaining milestones to demonstrate how you have tackled
various hurdles and that you
are aware of remaining hurdles and how to surmount them. Specific
mention should be made of
the results of alpha (internal) and beta (external) product testing.
- Single product companies can be a concern for investors. It is
beneficial to include ideas and
plans for a “second generation” product or even other viable products
or services to demonstrate
the opportunities for business growth.
3. The management team
Private equity firms invest in people – people who have run or who are
likely to run successful
operations. Potential investors will look closely at you and the
members of your management team.
This section of the plan should introduce the management team and what
you all bring to the
business. Include your experience, and success, in running businesses
before and how you have
learned from not so successful businesses. You need to demonstrate
that the company has the
quality of management to be able to turn the business plan into
The senior management team ideally should be experienced in
complementary areas, such as
management strategy, finance and marketing and their roles should be
specified. The special abilities each member brings to the venture
should be explained. This is particularly the case with technology
companies where it will be the combination of technological and
business skills that will be important to the backers. If some members
have particular flair and dynamism, this needs to be balanced by those
who can ensure this occurs in a controlled environment.
A concise curriculum vitae should be included for each team member,
highlighting their previous
track records in running, or being involved with successful
- Identify the current and potential skills’ gaps and explain how you
aim to fill them. Private equity
firms will sometimes assist in locating experienced managers where an
important post is unfilled
– provided they are convinced about the other aspects of your plan.
- Explain what controls and performance measures exist for management,
employees and others.
- List your auditors and other advisers.
- The appointment of a non-executive director (NED) should be
seriously considered. Many surveys
have shown that good NEDs add significant value to the companies with
which they are involved.
Many private equity firms at the time of their investment will wish to
appoint one of their own
executives or an independent expert to your board as an NED. Most
private equity executives
have previously worked in industry or in finance and all will have a
wide experience of companies
going through a rapid period of growth and development.
The BVCA’s Economic Impact Survey reveals that generally over
three-quarters of the private equity backed companies feel that the
private equity firms make a major contribution other than the
provision of money. Contributions cited by private equity backed
companies include private equity firms being used to provide financial
advice, guidance on strategic matters, for management recruitment
purposes as well as for their contacts and market information.
4. Business operations
This section of the business plan should explain how your business
operates, including how you make the products or provide the service.
It should also outline your company’s approach to research and
Include details on the location and size of your facilities. Factors
such as the availability of labour,
accessibility of materials, proximity to distribution channels, and
the availability of Government grants and tax incentives should be
mentioned. Describe the equipment used or planned. If more equipment
is required in response to production demands, include plans for
financing. If your company needs international distribution, mention
whether the operations facility will provide adequate support. If work
will be outsourced to subcontractors – eliminating the need to expand
facilities – state that too.
The investor will be looking to see if there are inconsistencies in
your business plan.
If a prototype has not been developed or there is other uncertainty
concerning production, include
a budget and timetable for product development. The private equity
firms will be looking to see how
flexible and efficient the facility plans are. The private equity
firms will also ask such questions as:
- If sales projections predict a growth rate of 25% per year, for
example, does the current site allow
- Are there suppliers who can provide the materials required?
- Is there an educated work force in the area?
These and any other operational factors that might be important to the
investor should be included.
5. Financial projections
Developing a detailed set of financial projections will help to
demonstrate to the investor that you
have properly thought out the financial implications of your company’s
growth plans. Private equity
firms will use these projections to determine if:
- Your company offers enough growth potential to deliver the type of
return on investment that the
investor is seeking.
- The projections are realistic enough to give the company a
reasonable chance of attaining them.
Investors will expect to see a full set of cohesive financial
statements – including a balance sheet,
income statement and cash-flow statement, for a period of three to
five years. It is usual to show
monthly income and cash flow statements until the breakeven point is
reached followed by yearly
data for the remaining time frame. Ensure that these are easy to
update and adjust. Do include notes that explain the major assumptions
used to develop the revenue and expense items and explain the research
you have undertaken to support these assumptions.
Preparation of the projections
- Realistically assess sales, costs (both fixed and variable), cash
flow and working capital. Assess yourpresent and prospective future
margins in detail, bearing in mind the potential impact of
- Assess the value attributed to the company’s net tangible assets.
- State the level of gearing (i.e. debt to shareholders’ funds ratio).
State how much debt is secured
on what assets and the current value of those assets.
- Include all costs associated with the business. Remember to split
sales costs (e.g. communications
to potential and current customers) and marketing costs (e.g. research
into potential sales areas).
What are the sale prices or fee charging structures?
- Provide budgets for each area of your company’s activities. What are
you doing to ensure that
you and your management keep within these or improve on these budgets?
- Present different scenarios for the financial projections of sales,
costs and cash flow for both the short
and long term. Ask “what if?” questions to ensure that key factors and
their impact on the financings required are carefully and
realistically assessed. For example, what if sales decline by 20%, or
supplier costs increase by 30%, or both? How does this impact on the
profit and cash flow projections?
- If it is envisioned that more than one round of financing will be
required (often the case with
technology-based businesses in particular), identify the likely timing
and any associated progress
“milestones” which need to be achieved.
- Keep the plan feasible. Avoid being over optimistic. Highlight
challenges and show how they will be met.
You might wish to consider using an external accountant to review the
financial projections and act
as “devil’s advocate” for this part of the plan.
6. Amount and use of finance required and exit opportunities
You need to determine how much finance is required by your venture as
detailed in your cash flow
projections. This needs to be the total financing requirement,
including fixed asset and working
capital requirements and the costs of doing the deal. Ascertain how
much of this can be taken as
debt as this is a cheaper form of finance than equity. This will
depend on the assets in the business
that can be used to secure the debt, the cash flow being generated to
pay interest and repay
amounts borrowed and the level of interest cover, ie. the safety
margin that the business has in terms of being able to meet its
banking interest obligations from its profits. Then determine how much
management can invest in the venture from your own resources and those
of family and friends.
Include any government sources of finance available to you also. The
balance is then the amount
you are seeking from the venture capitalist.
In this section of the business plan you need to:
- State how much finance is required by your business and from what
sources (i.e. management,
private equity firms, banks and others) and explain for what it will
- Include an implementation schedule, including, for example, capital
expenditure, orders and
- Consider how the private equity investors will make a return, i.e.
realise their investment. This
may only need outlining if you are considering flating your company on
a stock exchange within
the next few years. However, it is important that the options are
considered and discussed with
The presentation of your business plan
Bear the following points in mind when you are writing your business
Make the plan readable. Avoid jargon and general position statements.
Use plain English – especially
if you are explaining technical details. Aim it at non-specialists,
emphasising its financial viability.
Avoid including unnecessary detail and prevent the plan from becoming
too lengthy. Put detail into
appendices. Ask someone outside the company to check it for clarity
and “readability”. Remember
that the readers targeted will be potential investors. They will need
to be convinced of the company’s commercial viability and competitive
edge and will be particularly looking to see the potential for making
a good return.
The length of your business plan depends on individual circumstances.
It should be long enough
to cover the subject adequately and short enough to maintain interest.
For a multi-million pound
technology company with sophisticated research and manufacturing
elements, the business plan
could be well over 50 pages including appendices. By contrast, a
proposal for £500,000 to develop
an existing product may be too long at 10 pages. It is probably best
to err on the side of brevity
– for if investors are interested they can always call you to ask for
additional information. Unless
your business requires several million pounds of private equity and is
highly complex, we would
recommend the business plan should be no longer than 15 pages.
Use graphs and charts to illustrate and simplify complicated
information. Use titles and sub-titles
to divide different subject matters. Ensure it is neatly typed or
printed without spelling, typing or
grammar mistakes – these have a disproportionately negative impact.
Yet avoid very expensive
documentation, as this might suggest unnecessary waste and
Things to avoid!
On a lighter note, the following signs of extravagance and
non-productive company expenditure are
likely to discourage a private equity firms from investing and so are
- Flashy, expensive cars
- Company yacht/plane
- Personalised number plate
- Carpets woven with the company logo
- Fountain in the forecourt
- “International” in your name (unless you are!)
- Fish tank in the board room
- Founder’s statue in reception.
The above signs are common signs of a company about to go ‘bust’. As
one company liquidator
commented: ‘the common threads I look for in any administration or
liquidation are as you drive
up to the premises there’s a flagpole, when I’m in reception, a fish
tank and in between typically I
walk passed a lot of number plates that are personalized so if they’ve
got all three, there’s no hope
The investment process
The investment process, from reviewing the business plan to actually
investing in a proposition, can
take a private equity firms 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
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.
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
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
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
Presenting your business plan and negotiations
If a private equity firms 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 firms 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
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.
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
- It often has a higher risk profile, as there may be less
diversification of products and services and a narrower geographical
- It generally has a shorter track record and a less experienced
- The cost of making and monitoring a private equity investment is
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
- 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
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).
By way of illustration, assume an investor requires 30% IRR on an
equity investment of £1,175,000.
At end of: Year 1 plus 30% 1,527,500
Year 2 plus 30% 1,985,750
Year 3 plus 30% 2,581,475
Year 4 plus 30% 3,355,918
Year 5 plus 30% 4,362,693
Therefore, the investor needs to receive 3.7 times his money after 5
years to justify his investment risk, i.e. an IRR of 30% is equivalent
to a multiple of 3.7 times the original investment.
Pre-money and post money valuations
As the person seeking private equity finance you will be focused on
the value of the company at the
point in time that you are offering a stake in the company to the
private equity firms in return for its investment in your company.
This is the pre-money valuation, i.e. the value of the business or
company before the particular finance raising round has been
The post-money valuation is the value of the business after the
finance raising round has been
completed, i.e. after the private equity firms has made its
investment. The private equity firms will be more focused on this than
the pre-money valuation, as it is the post-money valuation that will
be used as the benchmark for any subsequent rounds of financing or
indeed for the eventual exit. To achieve the required return the
private equity firms will be concerned at too high a post-money
As an example, consider an entrepreneur who owns 100% of a company and
is seeking an initial
investment of £5 million from a venture capital firm. The venture
capitalist reviews the proposition and offers to invest £5 million in
return for a 40% stake in the entrepreneur’s company. Based on what
the venture capitalist is prepared to invest in the company a 100%
shareholding must be worth £12.5 million post investment. This is the
The remaining 60% of the shares, held by the entrepreneur, are
therefore worth £7.5 million. But before the investment by the venture
capitalist the entrepreneur held 100% of the shares in the company.
The venture capitalist has therefore valued the business before he
makes his investment at £7.5 million.
This is the pre-money valuation.
If the venture capitalist is concerned that the post-money valuation
is too high, he will either put less money into the venture for the
same equity stake or indeed increase his equity stake.
Other valuation 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 firms 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, or foregoing the equivalent of one year’s salary.
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
firms 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 firms 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 firms 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.
The structure of share capital that will be developed involves the
establishment of certain rights.
The private equity firms 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.
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 firms.
Preferred ordinary shares
These may also be known as “A” ordinary shares, cumulative convertible
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 equally in sharing any surplus capital. Their
income rights may be defied;
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
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
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
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
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
ranging from project grants (related to jobs created and safeguarded)
to enterprise loans in selective areas – see above.
Mezzanine finance – 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 firms can usually
be negotiated. Other negotiating points are often:
- Whether the private equity firms 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
- 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?
Specific considerations relating to venture capital and
management buyout deals
1. How a venture capitalist arrives at his required equity
In the case of a venture capital investment, in order to illustrate
how a venture capitalist arrives at his required equity stake in a
company, assume that we have an early-stage investment proposition
that is looking for £10 million of investment and is projected to earn
£20 million in year 5 which is the year the venture capitalist wishes
to exit his investment. Similar quoted companies in the industry
sector have average P/E ratios of 15. The venture capitalist discounts
this by, say, 20% to allow for the fact that the company in which he
proposes to invest is private and is a relatively early stage company
and applies this discounted P/E to his investment’s earnings in year 5
to give a terminal value on exit of £240 million. The venture
capitalist needs to discount this to the present day value based on
his target IRR, using the formula:
Present value = Terminal value / ( 1 + Target IRR)* where * is the
number of years of the investment.
The venture capitalist sets the target IRR at 50%, commensurate with
the risk of investing in this
This therefore gives a present day, or discounted terminal value, of:
240 million / (1 + 50%)^5 = £31.6 million
The venture capitalist’s required stake in the venture is therefore
his investment of £10 million divided by the present day value of
£31.6 million, i.e nearly a third of the equity (31.6%).
The deficiencies in using this method to arrive at the investor’s
required equity stake are that the use of quoted company current P/E
ratios may not reflect the state of the market at the time of the
venture capitalist’s exit from the investment in a few years time and
that the discount factor applied to the P/E ratio to reflect that the
investee company is not quoted and different in other ways from the
larger company are quite subjective. Of course, the venture capitalist
can play around with different discount factors and required IRRs to
see how these affect the required equity stake.
2. Use of preference shares in structuring a venture capital
Venture capital finance is normally provided as a mixture or ordinary
and preference shares with
possibly debt hybrids and variations in classes of shares. How much of
the venture capitalist’s equity
is the form or ordinary shares or preference shares is open to
Preference shares rank ahead of ordinary shares for both income and
capital. The venture capitalist can attach various rights to the
preference shares and these are discussed under the term sheet
considerations below. These rights are not available to ordinary
shareholders and can include, for example, rights with regard to
liquidation preferences, or the right to receive cumulative or
non-cumulative dividends or the right to convert their shares into
ordinary shares, e.g., in the event of an IPO, as well as
anti-dilution provisions which protect the preferred shareholder from
dilution resulting from a later issues of shares in connection with a
subsequent financing round.
One of the most basic reasons for an investor wanting preference
shares in the venture, rather than
ordinary shares, is to protect his investment in the event of a
liquidation or sale soon after investment. If he holds just ordinary
shares along with the founder they will both receive any proceeds in
proportion to their ordinary shareholdings, even though the venture
capital investor is likely to have contributed substantially more to
the venture, in terms of finance provided, than the founder. By
holding preference shares the venture capital investor gets
substantially more of his original investment back out in the event of
a liquidation or a sale immediately post investment.
Whilst preference shares serve to protect the investor and can have
various rights attached to them they do not themselves allow the
investor to benefit from the growth and success of the investee
company. There the preference shares usually have the ability to be
converted into fully participating ordinary shares at any time at the
option of the venture capital investors. As an exit opportunity
approaches the venture capitalist will convert its preference shares
into ordinary shares at the appropriate point when its holding is more
valuable to the venture capitalist, in ordinary shares than in
preference shares and participate in the exit opportunity.
Through this combination of ordinary shares and preference shares the
venture capital investor can protect his downside exposure in the
event of a liquidation whilst benefiting from the upside potential of
the business. Also, by having different classes of share, the venture
capitalist does not have to wait for an exit to enjoy a return.
Shares with preferred or participating rights may improve the overall
rate of return to the investor by returning cash in the form of
dividends rather earlier and at a greater rate than the ordinary
shares are able to.
3. Management buyouts
In the case of a management buyout, whereby current operating
management and investors acquire
or purchase a significant shareholding in the company or subdivision
they manage, the private equity
firm often acts as overall sponsor, provides equity finance, leads
negotiations with the sellers of the
business or company, appraises the company’s ability to generate
profits and cash, and introduces a
syndicate of lenders to the deal such that the loans are tailored to
the forecast cash generating capacity of the company being acquired. A
key principle of management buyouts is the use of the target company’s
assets, and especially its future cashflow, as the basis on which to
fund the acquisition.
Value creation in a management buyout
The aim of the buyout is to rapidly increase the value of the company
in order to maximise the returns of the shareholders. There are three
main routes to creating value in a management buyout situation:
earnings enhancement, financial engineering and multiple arbitrage.
1. Under the earnings enhancement approach
management team is able to grow profits by increasing revenues and /
or cutting costs. This is particularly applicable in situations where
the company being acquired has been poorly managed, where it is
operating in a growth sector and the new management team’s skills can
be used to enhance profitability by streamlining and improving
operations and capitalising on growth opportunities. With even a
relatively small annual increase in profits the value of the company
will increase and, with increasing profitability, it is likely that
the company will generate more cash, allowing more debt to be paid off
than the debt that can be paid off under the financial engineering
approach (see (2) below), or perhaps allowing a dividend to be paid to
the equity holders.
2. The financial engineering approach
creation simply uses the cash generating ability
of the company to repay debt. This requires a tight focus on cash so
that cash flow can cover
the debt interest and principal repayments. Each debt repayment
enhances equity value even if
company itself does not grow in value through increasing its profits
for example (although without
projected profit growth a management team is unlikely to receive
backing from a private equity
firms). The financial engineering approach works well when there are
low interest rates, the company is relatively stable and is not
subject to significant competition.
. There is also scope to add value through skills in
buying and selling companies, i.e. by staging an
effective sale process whereby the investor and management team can
persuade a buyer that the
company is worth a larger multiple of its annual earnings than it
which it was acquired at the time of
the buyout. Buying and selling at different profit multiples is the
multiple arbitrage approach to value
creation in buyouts. It is not usually assumed in forecast return
models that a company will be sold at
a higher profit multiple than that paid on acquisition but it is a
reasonable assumption if you are buying in depressed markets and
selling into more upbeat markets, having achieved operational and
strategic improvements during the buyout period, and have the skills
to better positioning the company for sale.
Management buyouts in the 1980s, especially in the USA, relied heavily
on financial engineering
and use of leverage. The sustained rise in the stock markets in the
1990s allowed for exits at high
profit multiples. With the increase in acquisition prices for deals
(as a multiple of profit) and difficulties in repaying much higher
levels of debt, financial engineering and multiple arbitrage have
become less important. Buyouts are now much more dependent on
operational improvements and
earnings enhancement to generate value.
The financial structure of a management buyout deal is carefully
tailored to the cash and profit
generating characteristics of the company that is the subject of the
A special purpose vehicle (Newco), which is a separate legal entity
and usually a limited company with local or offshore incorporation, is
created to make the acquisition of the target company (the company
subject to the buyout). The equity capital is provided to Newco by the
private equity firms and the management team. Bank (loan) finance is
used to part fund the purchase of the target and to provide working
capital. The security for the bank finance is the target’s fixed
assets, operating assets, book debts plus usually a charge from Newco
over the capital it will hold in the target. The funding is only
committed once the acquisition actually takes place.
Simple buyout structure
The use of debt in the form of the bank loans helps maximise the
equity returns, e.g. a debt/equity ratio of 80/20 can double the
return on equity that would be achieved by a debt/equity ratio of
20/80. The debt element of the transaction has historically been
between 70% and 95% of the total finance required.
Debt finance in a management buyout transaction
Banks can produce a blend of debt instruments, matched to their
varying appetites for risk and
demands for return and tailored to the forecast cash generating
capacity of the target company. The
range of debt products include senior debt, including revolving loans,
term loans, capex term loans,
second lien debt, mezzanine finance and high yield bonds, all of which
rank behind the senior debt
in terms of security and repayment in the event of a liquidation.
There might also be the possibility of vendor financing from the
seller of the company being acquired or an earn-out arrangement
(deferred purchase consideration).
The return (usually in the form of interest) expected by the debt
provider increases as the risk increases.
Senior debt is secured on collateral, usually the assets of the target
being acquired pledged as security for the loan. In the event that the
borrower defaults on the terms of the loan, the assets may be sold,
with the proceeds used to satisfy any remaining obligations.
High-quality collateral reduces the risk to the lender and results in
a lower rate of interest on the loan. In the event of bankruptcy, the
senior debt provider is considered a secured creditor, which means the
creditor receives proceeds from the sale of the collateral to satisfy
the debt. Secured creditors, including the senior debt provider, must
have their debts satisfied before any unsecured creditors receive any
Other than straight cash, senior debt has the lowest risk financing,
has the highest priority for interest and principal repayments and
therefore requires less in terms of return (interest payments).
Interest also increases proportionate to the term of the loan.
Risk and reward on loan instruments
Senior debt A has the shortest maturity (e.g repaid over 7 years).
Senior debt B is repayable after all
the A debt has been repaid, usually in two semi-annual instalments,
followed by senior debt C which
will have a maturity of, say, 9 years. B and C debt carry higher
interest rates than A debt, as they have longer repayment terms.
A working capital facility is usually provided as part of the senior
debt. It can be structured as a
revolving credit facility or an overdraft. It will usually have a
fixed term arrangement and provided there is no default on the part of
the borrower, the lenders cannot withdraw the facility.
Second lien debt is also secured but ranks behind A,B and C debt. It
is usually repayable in a single
repayment after 10 years and carries a higher interest rate than the
A, B and C debt.
Mezzanine debt is subordinated to senior debt, part of the interest is
usually paid in cash and part
rolled up into principal (known as a payment in kind or PIK). It often
includes warrants or options to
purchase equity shares in the borrower at a nominal price (equity
kicker) which provides additional
return to lender without a further fixed burden on borrower (but could
have a higher interest rate in lieu of the equity kicker).
High yield debt is bonds or notes sold to investors through the
publicly-traded debt markets. Interest
is paid semi-annually at a fixed rate several basis rates above the
rate for government bonds. The
bonds or notes are repayable after 8 to 12 years. They are unsecured,
ranking behind senior and
Institutional debt (or unsecured loan stock) is an integral part of
the equity investment but in practice it is structured as debt rather
than shares so that on exit (or liquidation) the bulk of the equity
investor’s funds are repayable first before the management team
receive any proceeds. If cash flows permit a running yield can be paid
to the investor as interest payments on the debt without the need for
retained profits needed to pay a dividend. Institutional debt is
subordinated to all other debt, is unsecured and although it carries
much higher risk than debt this is not reflected by higher interest
rates. It looks like equity except to the management team (for whom it
is effectively debt as it has to be repaid before management receive
any share in the exit proceeds) and to the company’s unsecured
creditors with whom it ranks equally.
The Offer Letter (Term Sheet)
Following the review and discussion of the business plan, initial
investigation and enquiries, and
negotiations on capital structure and other terms, and provided that
the private equity firm is keen to do a deal with you, the private
equity firm will send you an offer letter or term sheet. This sets out
the general terms of the proposal, subject to the outcome of the
formal due diligence process (see below) and other enquiries and the
conclusion of the negotiations. The term sheet, 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 term sheet represents the
private equity firm’s preferred terms and not necessarily and indeed,
unlikely at this early stage in negotiations, your preferred terms.
The private equity firm may change the terms as the due diligence
process and negotiations progress,for example adjustments to the
overall valuation, refinement of ratchets etc.
The terms in the term sheet will be incorporated into the
shareholders’ agreement at the end of the
negotiation process. It is better for the term sheet to be as detailed
and unambiguous as possible
so that there are no surprises when the eventual shareholders
agreement has been drafted for you
You can obtain an example of an indicative term sheet from the BVCA.
Whilst there are no standard
term sheets you can expect that the term sheet will cover the
following areas all of which are briefly
- amount to be invested, instruments (e.g. convertible preferred
shares), valuation, capital structure;
- liquidation preferences, dividend rights, conversion rights,
anti-dilution protection, redemption
rights, lock-ups, pre-emption rights;
- board composition, consent rights, information rights;
- warranties, vesting, option pool, milestones;
- confidentiality, exclusivity, fees, conditions precedent.
Areas covered by term sheet
Amount to be invested and instruments
The term sheet will set out the amount that the private equity firms
is to invest in the company, the
format in which the investment is to be made, e.g. convertible
preference shares, and the number and price of the shares.
The valuation (pre-money) should be firmly buttoned down in the term
sheet. The pre-money valuation is the value of the business or company
before the particular finance raising round has been completed.
The capital structure should be shown in the final term sheet both
before and after the private equity firm’s investment, on a fully
diluted basis, including all share options.
These are the right of the preference shareholder to receive before
any other shareholders cash that is available in the event of the
company being liquidated or indeed sold, as in a trade sale, or
achieving an IPO. The private equity investor may express that he
requires a multiple of his original investment in these situations.
The right to receive dividends may be cumulative or non-cumulative. If
cumulative the dividend due
to the preference shareholder accrues even if the company does not
have adequate distributable
reserves to be able to pay a dividend when it is due. The accumulated
dividends then become payable to the private equity firms in the event
of a liquidation occurrence as above. Non-cumulative dividends are not
accrued if the company does not have distributable reserves to pay
Preference shareholders usually have the right to convert their shares
into ordinary shares, for example in the event of an IPO. They will do
this only if it is a ‘qualifying’ IPO where above a certain minimum
amount of capital is raised at above a minimum stock price. This
protects preferred shareholders converting from preferred shares to
ordinary shares in connection with an IPO that is too small or has no
meaningful public market or liquidity for the shareholder.
Anti-dilution provisions protect the preferred shareholder from
dilution resulting from later issues of
shares, in connection with a subsequent financing round, at a lower
price than the private equity
investor originally paid (known as a ‘down round’). Anti-dilution
provisions in their most aggressive form are set up such that the
lower share price of the later share issue is applied to the original,
higher priced shares and the investor’s share holding adjusted as if
he had invested at this lower price.
Redemption rights require the founder or management team to buy back
the private equity investor’s shares by a specific date. These rights
are used if the business does not generate the growth required by the
investor to give him his required capital gain. A multiple of what the
private equity firms invested may be required to be paid back to the
Lock-ups specify how soon after a flotation the management team and
the private equity investor can sell their shares, which is important
in making the shares attractive to public investors at the time of the
Pre-emption rights apply when a company proposes to issue new shares
and existing shareholders,
such as the private equity investor, have the right to be offered a
pro-rata part of the new shares
before they are offered to a new shareholder in a way that does not
dilute the original private equity
shareholder. In relation to sales of existing shares, similar rights
require a shareholder wishing to sell shares to offer them first to
existing shareholders before being able to transfer them to outsiders.
The private equity firm has the right to have a seat on the board of
Consent rights give the private equity firms the right of veto over a
whole range of areas even though the private equity firms may not have
a majority of the shares with voting rights. Such areas could include
the recruitment of new members of the management team, purchase of new
equipment, corporate mergers and acquisitions, expansion overseas or
into new markets, future finance raisings, issue of stock options,
borrowing levels and the sale or flotation of the company. The private
equity investor may set limits over which he wants the right of veto,
for example new equipment purchases greater than £100,000 or borrowing
limits greater than £50,000.
Information rights will require the company to provide the private
equity firms with copies of the monthly management accounts (including
budget versus actual comparisons and explanation of variances),
updated monthly cash flow forecasts, audited annual accounts, annual
strategic plan and budget etc.
The term sheet may require the management team to warrant certain
information which the private
equity firms is relying on in arriving at his investment decision. You
will need to negotiate, with your
lawyer involved, the nature, extent and limit of these warranties and
what happens if they are breached in terms of indemnification (if the
value of the company is reduced in the event of breach of warranty you
may have to compensate the investor for the reduction in value) or
contractual damages (if it can be argued that the shareholders have
suffered no loss you might not have to pay the private equity firms in
connection with the breach).
The private equity firms may require the shareholder founders or
management or other key employees to remain working with the company
for a minimum term before they can realise the rights over all the
options or all the shares ascribed to them. The shares are considered
vested when an employee can leave his job, yet maintain ownership of
the shares or exercise his options to obtain the shares with no
The percentage of equity shares reserved for new options for existing
and future employees should
also be set out in the term sheet. This will affect the valuation of
Milestones are often used to set goals that the management team have
to reach before additional
tranches of capital are put into the company by the investor, or
management salaries reviewed or
share options granted.
The term sheet will contain a clause on confidentiality, i.e. that
both the investor and the founder /
management team will keep the fact that discussions are progressing
between them confidential as
well as agreeing not to divulge any information supplied.
The private equity firms may want to include an exclusivity clause in
the term sheet preventing you from
talking with other private equity firms about investing in your
proposition for a specified period of time,
usually the period that the various due diligence exercises are
The term sheet will set out the basis on which the professional fees
of the investor’s accountants,
lawyers and other due diligence providers are to be paid. In addition,
some private equity firms may
charge a fee for doing the transaction (deal fee) and,
post-investment, some private equity firms may charge the company for
monitoring their own investment by taking a fee for the provision of
non executive directors appointed to the board.
Conditions precedent included in the term sheet include details on
what has to happen between
the term sheet being signed and the completion of the investment. This
will include the satisfactory
completion of the due diligence process and the completion of the
various legal agreements, including the shareholders agreement and the
warranties and indemnities documentation. Conditions precedent may
also specify that you must do certain other things during this period,
such as securing the contract with the major customer that you have
informed the private equity firms is in process.
All of the above areas included in the term sheet are negotiable. The
term sheet is only binding as
regards exclusivity, confidentiality and fees. The term sheet will go
on to form the basis of the final
legally binding investment agreements (see below).
The due diligence process
To support an initial positive assessment of your business
proposition, the private equity firms will want to assess the
technical and financial feasibility in detail.
External consultants are often used to assess the commercial and
market prospects and the technical
feasibility of the proposition, unless the private equity firms has
the appropriately qualified people in house.
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). Advice may also
be sought on the key commercial and structural risks facing the
business in addition to assessments
on the company’s technology base and intellectual property rights.
Chartered accountants are often called on to do much of the financial,
and sometimes other, due
diligence. This will include reporting on the financial projections
and other financial aspects of the
business 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 firms. They will assess and
review areas such as the following
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
- Bank facilities and leasing agreements
- Pensions funding
- Employee contracts.
These due diligence reviews aim to support or contradict the private
equity firm’s own initial impressions of the business plan formed
during the initial stage. 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 firms 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.
When the amount of funding required is particularly large, or when the
investment is considered to be relatively high risk, the private
equity firms 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 firms 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
- 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
- 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
The rate at which a company requires additional cash to keep going.
Arrangements that prevent sensitive information being passed between
different parts of the same organisation, to prevent a conflict of
interest or breach of confidentiality.
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 post tax earnings.
Part of the price of a transaction, which is conditional on the
performance of the company following the deal.
The ratio between the effective price paid by management and that paid
by the private equity firms for their equity stakes in the company.
The higher the envy ratio the better the deal is for management. The
ratio depends on how keen the private equity firms is to do the
transaction, what competition they are facing and the general economic
conditions at the time of doing the deal.
Gearing, debt/equity ratio or leverage
The total borrowings of a company expressed as a percentage of
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, the Alternative Investment Market (AIM),
NASDAQ (USA) and other overseas exchanges.
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 firms.
This allows management shareholders to increase their stake if the
company performs particularly well.
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.
The role of professional advisers
The financial adviser, accountant and lawyer have important roles to
play in the private equity process, both for the management team
seeking finance and the private equity firms. It is often the case
that the financial advisory role and the role of the accountant
performing investigatory due diligence are performed by different
teams within the same organisation. Your accountant may therefore be
able to act as your financial adviser.
The financial adviser’s role
The primary role of the financial adviser, for example in an MBO
transaction, is to provide corporate
finance advice to either the management team or the private equity
firms sponsoring the transaction. Your financial adviser will provide
you with impartial financial advice, independent of the private equity
firms and its own advisers. The precise nature of the role varies from
situation to situation but typically includes:
- Undertaking an initial appraisal of management’s financing
- Advice on your business plan – critically reviewing and appraising
your plan to ensure that it includes all the areas referred to in the
business plan section of this Guide and that the business plan is
framed and presented in accordance with the requirements of the
private equity firms.
- Advice on valuation of the business and planning for the ultimate
sale of the business and realisation of management and the private
equity firm’s investment.
- Undertaking financial modelling – carrying out sensitivity analysis
on the financial projections to establish that the forecasts make
accounting and commercial sense. Checking that they have been prepared
in accordance with reasonable accounting policies and with due regard
to publicly available information.
- Advice on the most appropriate capital structure to be used to fund
- Making introductions to appropriate sources of private equity with
investment criteria that match
your business proposition and a business style that should be right
for you. If your business is a
highly attractive investment opportunity for private equity firms,
this may include organising an
“auction” or a “beauty parade” of private equity firms to compete for
the right to finance your
company. The financial adviser will need to ensure that the terms of
the FSMA are properly complied
with in providing this service.
- Making introductions to appropriate sources of debt and other
finance to help to fund the proposal.
- Reviewing offers of finance – reviewing the terms of the deal
offered by the private equity firms and other finance providers and
assisting in negotiating the most advantageous terms from those on
- Assisting in negotiating the terms of the deal with the private
equity firms and banks and with the vendor.
- Project managing the transaction to minimise calls on management
time and disruption to the business.
- Providing other advice, at a later stage if required, on the
flotation of your shares on a stock
exchange, or their sale to another organisation, or other such
The accountant’s role
The primary role of the accountant acting on behalf of the private
equity firms, in an MBO transaction for example, is to undertake
investigatory due diligence. The precise scope of the accountant’s
role varies from situation to situation but typically includes:
- Reporting formally on projections.
- Undertaking financial and commercial due diligence – often a
prerequisite to private equity
investment. The accountant will also be able to make informal
judgmental opinions on aspects of
the plan to the benefit of both management and the private equity
- Undertaking pensions, IT or environmental investigatory work and due
- Providing audit, accounting and other advisory services.
- Planning your tax efficiently – help management obtain the maximum
benefit from the tax system,
whether the aim is for a public flotation or to remain independent,
and to minimise tax liability on any ultimate sale of equity.
- Valuing your company’s shares – for tax planning and Inland Revenue
The tax adviser will also help to ensure that, where possible:
- Tax relief is available for interest paid on personal borrowings to
finance management’s equity
- Potential gains on the sale of equity are taxed as a capital gain
and not treated as earned income.
- Capital gains tax (CGT) is deferred on the sale of equity.
- Exposure to Inheritance Tax is minimised.
- Tax indemnities provided by the company directors and shareholders
to the private equity firms are reviewed.
- Tax relief on professional costs in connection with an MBO,
flotation or other exit is maximised.
- Share option plans are properly set up.- Advantage is taken of
appropriate plant and machinery, industrial buildings and research &
development capital allowances.
- Corporate funding is structured to maximise tax relief.
- Tax due diligence procedures are properly carried out.
Your tax adviser can also explain the qualifying criteria under which
personal investments can be made through the Enterprise Investment
Scheme and in Venture Capital Trusts (both of which are described
The lawyer’s role
Usually there are at least three sets of lawyers involved in the
private equity process; one representing the management team and one
representing the private equity firms. Other parties, such as bankers
and other private equity firms, if acting as a syndicate, will each
want their own lawyer involved.
The private equity firm’s lawyer
The lawyer is mainly concerned with ensuring that the private
equity firm’s investment is adequately
protected from a legal standpoint. The lawyer will draw up the various
investment agreements, usually including the following:
Shareholders’ or subscription agreements
Documents detailing the terms of the investment, including any
continuing obligations of management required by the private equity
firms, the warranties and indemnities given by the existing
shareholders, penalty clauses and the definition of shareholder
Investors’ rights agreement
Specifies the rights of the private equity firms with regards to the
Warranties and indemnities
Documents that confirms specific information provided by the directors
and/or shareholders to the
private equity firms. If this information turns out later to be
inaccurate, the private equity firms can claim against the providers
of the information for any resulting loss incurred. An indemnity is as
a promise to indemnify, i.e. to reimburse the investors in respect of
a designated type of liability if it arises.
Loan stock or debenture agreements
A statement of the terms under which these forms of finance are
Documents that formalise the conditions of employment of key members
of the management team.
Contains all the key information disclosed to the private equity firms
on which the investment decision has been based. It is essential that
the directors do not omit anything that could have an impact on that
decision. The disclosure letter serves to limit the warranties and
The management team’s lawyer
The management team’s lawyer will review the Offer Letter (the heads
of agreement or Term Sheet) from the private equity firms and,
together with your financial adviser, will help you to negotiate
acceptable terms. The management team’s lawyer will also, in due
course, negotiate the investment agreements with the private equity
firm’s lawyer and produce the disclosure letter, as well as
negotiating any loan documents with the banker’s lawyer.
In the case of a new company, your lawyer can incorporate the company
and draw up the Memorandum and Articles of Association, which govern
the constitution of the company, its permitted activities (which under
the Companies Act 2006 can now be unrestricted unless the articles
express otherwise) and the powers of its shareholders and directors.
Under the CA 2006 when a new company is registered it must supply to
Companies House a memorandum of association, but this is a simple form
containing only the names and addresses of the subscribers and (in the
case of a company limited by shares) the number of shares taken by
each. The company must also have articles of association which can be
based on the CA 2006 new Model Articles (one for private companies and
one for public companies) although private equity investment articles
will need to be fairly bespoke. Even in the case of an existing
company, a new Memorandum may be required and new Articles almost
certainly will be needed to document the dividend and other rights
attaching to the company’s shares following the private equity
In many cases, the costs of all the professional advisers will be
borne by the company receiving
the investment. The private equity firms will usually increase the
funding provided to allow for these
costs, so you and your team should not be “out of pocket” as a result,
although you may be left with
a slightly smaller equity stake. However, there are circumstances
where this might not be possible,
due to contravention of Company Law, or where itis agreed that each
party bears its own costs.
Ensure that you agree the basis of costs before any work commences. In
particular, ensure that you have firm agreement as to who is to bear
the costs in the event of the negotiations being aborted.
Usually in this case the private equity firms will bear the cost of
work commissioned by them and you
will pay the costs of your own professional advisers.
Professional costs incurred by the financial advisors, accountants and
lawyers employed by
the management team and the private equity firms, like any service,
need to be carefully controlled.
There is a range of costs that will depend on the complexity of the
transaction, but will typically be
around 5% of the money being raised.
Private equity for growth and success
Private equity investment has been demonstrated to contribute
significantly to companies’ growth.
Private equity backed companies outperform leading UK businesses.
The “2007 Economic Impact of Private Equity in the UK” shows that the
vast majority of companies
receiving private equity believe that without private equity they
would not exist at all or would have
developed less rapidly. Furthermore, the report consistently
demonstrates that private equity-backed
companies increase their sales, exports, investments and people
employed at a considerably higher
rate that the national average.
While the growth and success of these companies owes much to private
equity investment, enabling
them to achieve their full potential, the non-financial input by the
private equity firms is also a very
important contributor. The private equity firm’s involvement generally
does not end following the initial investment. Of the private equity
backed companies analysed in this survey, annually over three quarters
say that their private equity firms make a major contribution other
than the provision of money.
Contributions cited by private equity-backed companies often include
private equity firms being used
to provide financial advice, guidance on strategic matters, for
management recruitment purposes as
well as with their contacts and market information.
Most private equity firms’ executives have a wide range of experience.
Many have worked in industry and others have a financial background,
but what is more important, all have the specialist experience of
funding and assisting companies at a time of rapid development and
growth. Levels of support vary, however, ranging from “hands-on” to
- A “hands-on” or active approach aims to add value to your company.
In addition to advising on
strategy and development, including in such areas as entering new
markets, overseas expansion,
acquisitions and hiring new management, the private equity firms will
have many useful business
connections to share with you, possibly including introductions to
potential customers, suppliers,
headhunters, acquisition candidates and even to other private equity
firms in connection with
syndicating financing rounds.
- The private equity firm aims to be your business partner, someone
you can approach for helpful
ideas and discussion. The investor can act as a coach or mentor to you
and your management team. Backing from a private equity firm can
provide credibility and status in dealing with third parties. A
hands-on investor is particularly suited to a company embarking on a
period of rapid expansion. However, day-to-day operational control is
rarely sought. In order to provide this support, some private equity
firms will expect to participate through a seat on your board. The
director may be an executive from the private equity firms or an
external consultant and fees will need to be paid for the director’s
- The private equity firms will expect to:
- Receive copies of your management accounts, promptly after each
- Receive copies of the minutes of the board of directors’ meetings.
- Be consulted and involved in, and sometimes have the right to veto,
any important decisions
affecting the company’s business. This will include major capital
purchases, changes in strategic
direction, business acquisitions and disposals, appointment of
directors and auditors, obtaining
additional borrowings, etc.
Some investors will have a less active role in the business, a
“hands-off” or passive approach, essentially leaving management to run
the business without involvement from the private equity firms, until
it is time to exit. They will still expect to receive regular
financial information. If your company defaults on payments, does not
meet agreed targets or runs into other types of difficulties, a
typically hands-off investor is likely to become more closely involved
with the management of the company to ensure its prospects are turned
Most private equity firms in reality tend to operate
somewhere between these two extremes.
Help to avoid the pitfalls
One of the private equity firm’s positive contributions to your
business might be to help you avoid
receivership or liquidation. They can help you spot the danger signs
of troubled times ahead and avoid business pitfalls.
Examples of danger signs
- Lack of response to changing environments
- Fixed price contracts
- Increasing level of fied costs
- Cash flow problems
- Breaches in bank covenants
- Failing to meet capital interest or dividend payments
- Increasing overseas competition
- Deteriorating credit control
- Uncontrolled capital expansion
- Inaccurate and/or untimely management information
- Autocratic management
- Financial impropriety
- Early success, but no staying power
- Over expansion and loss of control
- High turnover of key employees
- Extravagant executive lifestyle
- Dependence on too few customers/suppliers
Tips for working with your private equity investor
Here are some practical tips for a successful working relationship
with your private equity investor:
- Work in a true partnership with your investor: share your issues and
views as often as possible. Be
completely transparent, disclose all news, including bad news! Don’t
hide things from your investor.
The private equity investor will find out anyway and he hates
- Listen carefully to the private equity firm’s advice and validate
it; private equity and venture capital investors have typically seen
many cases of developing and growth companies. They can help you in
identifying issues ahead of time.
- Hire the right talent at the right time for your company together
with your investor. Never compromise on the quality of management.
- Be open to advice from your investor to bringing in outside
expertise where necessary
- Have a clear plan about how to achieve sustainable earnings growth
in the medium to longer term
– don’t just focus on short-term targets
- Demonstrate a strong focus on cash management to your investor and
actively restrain cash spend
- Prepare your exit strategy early in order to create maximum value
- Remember that once you have an external investor on board you have
started the process of
eventually selling your business, be it through a trade sale or
- Remember that the aim is to achieve maximum long-term value not only
for the management
team’s own reward (and the private equity firm’s) but with an ultimate
purchaser in mind.
As a company director you have onerous responsibilities to your
shareholders and your creditors.
Many of the duties and obligations of a director are mandated by the
Companies Act 2006. Others
are governed by the Insolvency Act 1986 (you should be particularly
aware of the “wrongful trading”
provisions contained therein) and the Company Directors’
Disqualification Act 1986. Under the wrongful trading provisions a
director may, by court order, be made personally liable for a
company’s debts if it is allowed to continue trading at a time when it
was known, or should have been concluded, to be insolvent. Discuss any
concerns with your private equity firms and other professional
advisers before they become real problems and help to ensure success
for you, your management team and your investors.
You should also have recourse to the Combined Code on Corporate
Governance (2008) which is aimed
at enhancing board effectiveness and improving investor confidence by
raising standards of corporate governance. The code sets out standards
of good practice in relation to issues such as board composition and
development, remuneration, accountability and audit and relations with
shareholders. The Financial Reporting Council has recently undertaken
a review of the Combined Code.
Guidelines for success
The following guidelines apply to most successful business situations:
- Stick to what you know – avoid industries in which you are not
- Encourage a common philosophy of shared business goals and quality
standards so that you meet
and even exceed the expectations of your customers. Communicate the
objectives and results
throughout your organisation.
- Avoid information overload – concentrate your management information
systems on what is critical
- Build your team – as your business grows, recognise the need to
direct the company and to not be
personally involved in each day-to-day decision, which should be
delegated to senior managers.
- Cash flow – remember “cash is king”, take care to manage your cash
resources with the
- Anticipate problems – know what is going to be critical as your
company moves through its various growth stages.
- Keep your investors, bankers and advisers informed – they are there
to help and do not like surprises.
- Watch your costs – ensure that the market price of your products
gives a profit contribution in excess of the costs you incur. This may
sound facile, but it is amazing how often this is not assessed
regularly, resulting in unexpected losses.
- Do not anticipate sales – the costs can grow by themselves, but the
sales will not.
- Use the network – a well-developed set of business contacts is one
of the keys to business success. These could include customers,
suppliers, trade associations, Government agencies and professional
- Look for opportunities – the business plan is the agreed route
forward for the business, but other opportunities will arise. Assess
them, discuss them with your investors and pursue them if it makes
sense for the business. Adapt your business plan as your company
develops and new opportunities are considered.
Realising the investment
Many business owners and shareholder management teams are looking at
some point to sell their
investment or seek a stock market listing in order to realise a
capital gain. Private equity firms usually also require an exit route
in order to realise a return on their investments. The time frame from
investment to exit can be as little as two years or as much as ten or
more years. At the time of exit, the private equity firms may not sell
all the shares it holds. In the case of a flotation, private equity
firms are likely to continue to hold the newly quoted shares for a
year or more.
The five main exit options are listed below. If you are considering
any of these, you will need the
specialist advice of experienced professional advisers.
The sale of your company’s shares to another company, perhaps in the
same industry sector.
Since the dotcom crash, the majority of venture capital exits have
been achieved through trade sales. This can bring a higher valuation
to the company being sold than a full stock market quotation, if the
acquirer actually needs the company to supplement its own business
area. But depending on the type of company seeking a listing on a
stock exchange this may bring a higher valuation if it is creating a
Private equity firms tend to favour the trade sale exit route over an
IPO because they can realize their investment in cash or cash and
shares where the shares can be sold for cash. With an IPO the private
equity firms may not be able to actually sell their shares for some
time (the so-called “lock up” period).
This also applies to the entrepreneur, founder or shareholder
The repurchase of the private equity investors’ shares by the company
and/or its management.
To repurchase shares you and your advisers will need to consult the
Companies Act, which governs the conditions of this exit option.
Advance clearance from the Inland Revenue and professional accounting
and tax advice is essential before choosing this route.
The purchase of the private equity investors’ or others’ shareholdings
by another investment institution. This type of exit may be most
suitable for a company that is not yet willing or ready for flotation
or trade sale, but whose private equity investors may need an exit.
To obtain a quotation or IPO on a stock exchange, such as the Official
List of the London Stock
Exchange, AIM or NASDAQ (USA).
Going for an IPO or flotation has various attractions for the
entrepreneur or shareholder management team, particularly when they
are wanting to carry on with their involvement in the business, but
there are also several disadvantages to be aware of. The various
advantages and disadvantages of going public are summarised in the
Also, do not underestimate the amount of time that it takes to go
through the flotation process. Whilst you are dealing with the
investment bankers, the private equity firms, various sets of lawyers
and accountants, endless prospectus drafting meetings, warranties and
indemnities etc you also have to continue to run and grow your
business. It is important not to take your eye off the ball during the
arduous process. Expect to spend more of your time and that of your
management team on the flotation than you did in raising private
equity or venture capital. Following flotation you will also need to
take the time to deal with investor relations including spending time
with the press.
Where the company goes into receivership or liquidation.
- Realisation of some or all of the owner’s capital.
- Finance available for expansion.
- Marketable shares available for acquisitions.
- Enhanced status and public awareness.
- Increased employee motivation via share incentive schemes.
- Possible loss of control.
- Requirement to reveal all price sensitive information which may also
be of interest to your
- Unwelcome bids.
- Continuing obligations – costs and management time incurred.
- Increased scrutiny from shareholders and media.
- Perceived emphasis on short-term profits and dividend performance.
- The cost.
Valuing the investment on exit
For partial disposals and certain exits it is often necessary to
arrive at a mutually acceptable valuation of the company. The
“International Private Equity and Venture Capital Valuation
Guidelines”, jointly prepared and endorsed by the BVCA and many other
national private equity and venture capital associations, address the
bases and methodologies to be used for valuing private equity and
venture capital investments. These guidelines are aimed principally at
private equity fund managers, to provide consistency and commonality
of valuation standards amongst funds, largely for fund performance
Before you do anything – read this!
Legal and regulatory issues you must comply with in raising finance
Raising finance is a complex legal and regulatory area and you should
be aware of the need to take
legal advice during the process. In particular, sending a business
plan to, or discussing it with, potential investors, is a financial
promotion and this may require you or other persons involved in the
process to be authorised or regulated here in the UK. In some cases,
if you are not authorised by the Financial Services Authority, you may
be committing a criminal offence or agreements entered into may not be
enforceable against the other parties. Whilst financial promotions
sent by those seeking funds to private equity houses will, in most
cases, be exempt from restrictions in the Financial Services and
Markets Act 2000 (FSMA), we recommend that you seek professional/legal
advice before communicating your plans to anyone.
The Financial Services and Markets Act (“FSMA”)
The FSMA provides that “a person must not, in the course of business,
communicate an invitation
or inducement to engage in investment activity”. This does not apply
if the person is an authorised
person under the FSMA or the contents of the communication are
approved by an authorised
person. As you are likely to be raising finance to start-up or to
expand your business it is unlikely
that you will be authorised. The general prohibition is set out in
section 21 of the FSMA, but the
details of exemptions from this restriction are contained in the
secondary legislation, mainly
the FSMA 2000 (Financial Promotion) Order 2005 (Financial Promotion
Order). There are over
65 exemptions in the Financial Promotion Order. You are recommended to
take legal advice
before applying any of these exemptions which need to be carefully
considered in each case.
The Financial Promotion Order differentiates between real-time and non
real-time communications. A real-time communication is one that is a
communication made in the course of a personal visit, telephone
conversation or other interactive dialogue. A non real-time
communication is one that does not fall within the definition of a
real-time communication and includes letters, emails and publications
(including TV and teletext). The Financial Promotion Order also sets
out indicators to look for when determining if a communication is a
non real-time communication. The indicators include if the
communication is directed to more than one recipient in identical
terms or if the communication is made in a way that the recipient
cannot or is not required to reply immediately or can refer to it at a
The Financial Promotion Order also distinguishes between solicited and
unsolicited real-time calls,
solicited calls being ones which are initiated by the recipient or
take place following an express request (which is more than mere
acquiescence) from the recipient.
Some relevant exemptions to individuals or companies communicating
business plans to potential
investors include the following. There are various requirements and
conditions that must be observed in taking advantage of these
exemptions, all of which have not been included below, and you are
recommended to take legal advice before applying any of these, or
indeed the many other, exemptions.
This exemption applies to financial promotions made only to recipients
whom the person making the
communication believes on reasonable grounds to be investment
professionals. These are:
- Authorised persons
- Governments and local authorities
- Exempt persons (where the financial promotion relates to a
controlled activity which is a regulated
activity for which a person is exempt).
- Persons whose ordinary business involves carrying on a controlled
activity of the kind to which the
financial promotion relates (i.e. private equity and venture capital
firms, investment trust companies,
large companies which have a corporate treasury function).
Also exempted are persons acting in their capacity as directors,
officers or employees of such entities such as directors, officers or
employees of authorised private equity and venture capital firms.
There are exemptions for one-off non real-time communications and
solicited real-time communications which are made to (rather than
directed at) recipients. To benefit from this exemption, the
communication must be tailored and individual in nature and should not
form part of an overall organized marketing campaign.
Certified high net worth individuals and self-certified
Non-real time or solicited real time communications, relating only to
investments in unlisted companies, are exempt if made to an individual
who the communicator reasonably believes to be a certified high net
worth individual or a self-certified sophisticated investor. The
individual must have signed an appropriate statement within the period
of 12 months prior to receiving the communication. High net worth
individuals must have an annual income of not less than £100,000 or
net assets to the value of not less than £250,000 (excluding primary
residence, life assurance policies and pension). Self-certified
sophisticated investors must be (1) a member of a network or syndicate
of business angels and have been so for six months before the date of
the statement, (2) he has made more than one investment in an unlisted
company in the two years before the date of the statement, (3) he is
working or has worked in the two years before the date of the
statement in a professional capacity in the private equity sector or
in the provision of finance for small and medium enterprises, or (4)
he is currently or has been in the two years before the date of the
statement, a director of a company with an annual turnover of at least
£1 million, and (5) he accepts that he can lose his property and other
assets from making investment decisions based on financial promotions.
The FSMA generally prohibits the inclusion of misleading statements in
documents that are designed to induce or persuade people to enter into
investment agreements or to buy or sell shares in companies. This
would therefore apply to your business plan. Any person who makes a
statement, promise or forecast or dishonestly conceals any material
facts, or who recklessly makes (dishonestly or otherwise) a statement,
promise or forecast which is misleading, false or deceptive, is guilty
of an offence if he makes the statement, etc. for the purpose of
inducing (or is reckless as to whether it will induce) another person
to enter or offer to enter into an investment agreement. Sanctions for
a contravention of these provisions includes imprisonment up to seven
years or a fine or both.
It is therefore essential that, irrespective of whether or not any of
the exemptions in relation to financial promotions apply, any
statement, promise or forecast contained in any communication,
document, including a business plan, private placement memorandum,
information memorandum, etc., made available to potential investors is
verified in order to ascertain whether by itself, or taken in the
context in which it appears, it could possibly be misleading or false
or deceptive. This verification could be carried out by an authorised
person such as an investment bank, corporate finance boutique or
authorised professional services firms. If however you are sending
your plan to a UK private equity house which is itself authorised then
you do not have to have this verification process undertaken. You
should, nevertheless, ensure that the plan does not contain misleading
In case of any doubt, if you are seeking equity or debt finance, other
than ordinary banking facilities, you are recommended to obtain legal
advice before making any communications (whether written or oral) with
potential investors, including the circulation of your business plan.
This guide was based on the “Guide to Private Equity” written by Keith
Arundale for the British Venture Capital Association. Certain edits
and updates have been done by David Tallboys of Equity Ventures Ltd.
It is important to note that information and regulations change and
that parts of this guide may no longer be relevant. Ensure you take
proper legal advice before entering on a transaction.
David Tallboys of Equity Ventures Ltd can be contacted at 0207 859