When to Consider Private Equity

The decision to take on private equity is a difficult decision for most business owners. Why bother with the effort and risk?
There are a variety of reasons but in my career working with business owners, I have found it generally comes down to these four reasons to look at private equity partners:
1) The founders' increased need to shore up their personal financial security, 
2) To finance further growth, or  
3) To help prepare a company for a future IPO within 3 years 
4) To prepare for partial or full sale within the next 5 years.

Becoming a Millionaire requires out-thinking the majority of people

At my finance club, I was startled to learn from one of the top fund managers of Canda that it is a small percentage of Canadians who play the stock market with over $500,000 of investment money.  To have one million of net worth is still rare. Here is a fun article from Yahoo finance on how to be a millionaire:

There's no real practical reason to ask "who wants to be a millionaire?" because the only people who won't put their hand up are religious types who've taken vows of poverty and those who are already multi-millionaires. Unfortunately, there's a big gulf between those who want it and those who do the things to make it happen. 
 Based on recent statistics on U.S. household income, millionaire-dom is not something that's going to happen for most people, even with the dubious benefits of inflation.   
A household earning the median level of income (approximately 50K) and saving an impressive 20% of that would need almost 100 years to save $1 million (excluding taxes and investment gains). It's pretty clear, then, that a would-be millionaire has to think outside the boundaries of "median" experience.

Start a Business
There are certainly people who can become millionaires by working for other people, but this is not an especially good route to choose. The trouble with trying to become a millionaire by working for other people is that there are always other people siphoning off the value of whatever you produce. Say you're a hotshot salesman – although you're going to get your cut, a lot of the value you create is going to get split among a broader pool of workers, managers and the owner(s) of the business.

Start your own business, though, and you get to decide how to divide that pie. Better still, your ownership stake can become more and more valuable over time as that business becomes larger and larger. While a good employee may get raises and promotions as his or her employer grows, they'll never see the same benefits (including the tax-free appreciation in the value of the ownership interest) as the owners.

Use Other People's Money
One of the remarkably consistent features of stories about people who go from relatively no wealth to major wealth is the role of other people's money in making it happen. Sometimes it's start-up capital from a generous relative, or maybe it's a small business loan or venture capital.

Borrowed money can be a major force multiplier. Behind virtually every real estate empire is borrowed money and the use of leverage in investing (whether through buying stocks on margin, buying options or buying futures) can rapidly magnify a skillful investor's success. Of course, this cuts both ways – just as borrowed money can create a large business (or portfolio) quickly, just one mistake in an over-leveraged enterprise can bring the whole thing crashing down.

It comes down, then, to risk tolerance. Those who really want to build large wealth (and do so quickly) through business or investment will have to do so in part with other people's money.

Cultivate a Valued Skill
Wages respond to supply and demand just like everything else, so it is very important to cultivate a skill that is not only in demand, but scarce enough to be valuable. Architecture and law, for instance, are both specialized skills, but not necessarily rare enough to make their practitioners wealthy unless they are at the high end of their profession.

Sports is an obvious example, but most people know in their teens whether they have the rare physical gifts (and perhaps the even rarer mental discipline and dedication) to open the doors to a professional sports career, and it's not really a door that can be opened in college or later. Medicine and engineering, though, are both open to college-aged people who have the requisite abilities and the willingness to put in the effort. The services of these professionals is not only almost always in demand, but the supply is small enough that professionals here can fairly expect to become millionaires on the basis of their labors.

This is also true for unconventional skills as well. Pursuing a career as a writer, actor or professional gambler is a virtual guarantee of poverty for most people. For those who actually have the skills necessary to succeed, though, it can be their best chance of building real wealth.

Out-Think or Out-Hustle
Lazy and self-made millionaire just don't go together. Hearkening back to that supply-demand equation, anything that's relatively easy, convenient and accessible is going to have ample supply and relatively low payouts. Since most people don't actually want to work that hard, though, there are real wealth-creation opportunities out there for those willing to think and/or work just a little harder than average.

One option for building exceptional wealth is to out-think the majority of people out there. While endeavors like writing, investing and inventing all involve a tremendous amount of effort and dedication, there is at least some aspect of out-thinking to them all. Steve Jobs of Apple , Herb Kelleher of Southwest a nd Alfred Mann of MannKind all clearly worked hard to achieve success, but a lot of that success was predicated on seeing things that others didn't see and figuring out how to do them even better.

Out-hustling is an undervalued aspect of wealth creation. Success in business is often about the hustle – the willingness to make one more call or work an extra hour later. The field of "hustle" is wide, rich and fertile. You can make good money visiting estate sales and reselling undervalued items, just as you can make good money from a variety of multi-level marketing programs. The question is whether you want to spend the hours it takes to drive the process forward.

Rental real estate is a good example. It is actually not all that difficult to find rental properties, buy them and rent them out. Do this well and it's fairly easy to earn an annual return of 8-15%. The problem is that there are a myriad of small annoyances that go with it – hassles in haggling over the purchase price, hassles in getting mortgages, hassles in getting tenants, hassles in dealing with tenants and so on. Some people just don't want to be bothered with this, but those who don't mind the annoyances can reap the rewards.

The Bottom Line
Having $1 million or more in net worth is still uncommon enough to be special and significant, and it doesn't often come as a byproduct of luck or chance. Hard work is a virtual requisite, but so too is a willingness to take on some risk (such as starting a business or using leverage) or cultivate a rare gift (like writing or inventing). Although simple living and sound investing will help anyone build more wealth, a special level of success requires a special person who is willing to do more and risk more than most people. 

Cash was one of the last things that his company was looking for from private equity

Selling a company used to be the only choice for a business owner. Unfortunately. this myopic view still lingers on even though there are many more options for those founders wanting to get some money for their hard work. Companies may consider taking on a private equity even if they don't need the money, simply as a way of making the transition from a private to a public company. 
Other companies, like Bermingham Construction, had a balance sheet ill suited for the public market because it was lumpy due to large contracts. The public market just would not bear the irregular cash infusions. Their option was not the public markets but to take on private equity partners.
A private equity partner can generally help companies in a number of ways, including:

• Upgrading the board of directors with seasoned industry professionals
• Forcing a strategy process and financial reporting on a more frequent basis
• Recruiting senior management, if necessary
• Implementing more sophisticated systems and financial controls
• Introducing entrepreneurs to investment bankers or potential buyers in preparation for an eventual IPO or sale

The Facebook story is well known to the point of exhaustion but it worthwhile to note how quickly Zuckerman got involved with private equity. Not just any private equity either - the best.

Another case study that reached the media was told by David Kalt, CEO of optionsXpress. David says cash was one of the last things that his company was looking for from a private equity partner. OptionsXpress, an online broker based in Chicago, Ill., specializes in the fast-growing market for online options trading for retail investors. The company expanded rapidly over the first three years of its existence, reaching 70,000 accounts and $50 million in revenue by the end of 2003. "Because we were very capital-efficient and profitable, we didn't need an outside investment to grow the business," said Kalt, "Instead, we viewed a private equity relationship as a way to navigate very rapid expansion and prepare for an IPO."

What helped get optionsXpress to the IPO stage? A $90 million equicty investment provided liquidity to early shareholders, allowing the firm time to fully consider its IPO strategy. Additionally, its equity partner helped them understand the process and introduced the optionXpress executives to key players in public markets. It helped the company build a top-notch board and recruit an experienced CFO who upgraded the company's financial systems and reporting to public market standards, further assisting the company in its IPO path. In January 2005, optionsXpress (Nasdaq: OXPS) completed a successful public offering.

There's no set timetable for seeking out private equity. Some companies operate perfectly successfully on their own for decades; others like Facebook, seek an infusion of capital earlier in their life cycle. Regardless of the exact timing, most successful entrepreneurs and management teams do eventually reach a stage where exponential growth is possible, and where they want to reap the financial rewards associated with the company they've built. When your company comes to this crossroads, you, like many other successful entrepreneurs, may wish to consider taking on a private equity partner.

Canada doesn’t have an innovation gap, but a commercialization gap

Davos gave Stephen Harper the opportunity to discuss the issues about how to allocate capital (tax payer money) to strengthen Canada for all of our futures. Quite the job and we can see how hard it is for government experts to be Venture Capitalists (Solyndra is one boondoggle costing the US tax payers a crazy half a billion dollars. If only Canada had a government fund that size) or even more staid private equity investors up at the RIM size of business.
It ain't easy. Business grows and then declines. Canada and America have their 100 year old companies that have survived, along with ones that the government has helped during struggling times. The problems come if the government takes over the business, just look to the UK in the 70s as their well meaning government meddling destroyed many a British pearl - Rover, Rolls Royce, etc.
Barry McKenna has a great article in the Globe and Mail about being a top politician and debating how to boost business growth in the country. Barry's opening sentence is a beauty:

Stephen Harper’s Davos manifesto is the Throne Speech he never delivered at home.

Better late than never. Best to know what’s coming. It’s now clear that innovation – or more precisely, the dearth of it – has rocketed to the top of the Harper government’s agenda. The Prime Minister is not happy about the return the country is getting on the roughly $7-billion a year Ottawa pours into research and development. “We believe that Canada’s less than optimal results for those investments is a significant problem for our country,” Mr. Harper said last week at the World Economic Forum in Davos, Switzerland.

He vowed to act “soon” on the recommendations of an October task force report chaired by Tom Jenkins, chairman of software maker Open Text Corp. The report’s central finding is that Canadian companies are investing less in R&D than they did nearly a decade ago, falling worryingly behind foreign rivals in spite of one of the most generous tax regimes in the world.

Mr. Jenkins’ main prescription – revamping the $3.5-billion-a-year Scientific Research and Experimental Development program – is now apparently also Mr. Harper’s plan. And the next budget, likely coming in late February, will no doubt signal big changes.

Mr. Jenkins argues the SR&ED tax credit should be simpler and less generous, diverting the savings to more focused funding of business innovation. Among suggested changes: limit the credit to labour costs and reduce the generous refundable credits available for smaller Canadian-owned companies.

Nearly 25,000 companies across Canada use the tax break, from the majors to tiny startups, covering virtually every industry in the country. But a recent Globe and Mail investigation found widespread abuse, including bogus claims and oversized consultant fees paid from credits.

And a report by federal Taxpayers’ Ombudsman Paul Dubé to be released as early as this week is expected to expose a litany of complaints from users about how the Canada Revenue Agency runs the program, including confusing and inconsistent decisions.

Mr. Jenkins would put innovation spending under the control of one federal minister and one agency, shifting the balance from tax breaks to direct funding, putting more money into “late-stage” venture capital and better use of government purchase to spur home-grown innovation.

These are sensible suggestions.

In spite of all the money Ottawa spends, there are large and significant breaks in the financing chain needed to take great ideas from the lab to factory floors, and global markets. Shrinking the $7-billion envelope, including the SR&ED, won’t produce more of what Mr. Harper wants. It could produce less. And if the money is going to be diverted from SR&ED, to where? Should some industries or companies be favoured? The Harper government isn’t saying yet.

Part of the problem is a chronic misallocation of capital – too much going to some sectors, such as housing, and not enough to the country’s innovators. Canadian business leaders say high risk loans and venture capital for startups and entrepreneurs is severely lacking in Canada, and that impairs companies’ commitment to innovation, according to a report being released Monday by the Conference Board of Canada. “There is an urgent need to identify solutions to the weakness in Canada’s capital markets for innovation,” concludes the report, From Perception to Performance.

The Canadian Advanced Technology Alliance, which speaks for the high tech industry, has been making the case to Ottawa that Canada doesn’t have an innovation gap, but a commercialization gap. “Too often our businesses are not effectively growing their firms into international successes. Too often, the full rewards of our innovators are leveraged offshore,” CATA senior vice-president Russ Roberts lamented in a recent update to members.

The biotech industry, meanwhile, is pushing the idea of flow-through shares – now used by resource companies – to help companies reach the stage of commercialization when they have high capital needs but few revenues.

The same model has helped turn Canadian resource companies into global leaders by encouraging startups to go public and tap investors willing to take big risks in return for tax breaks, argued Rick Sutin, a partner and corporate finance specialist at Norton Rose in Toronto. So why not technology-focused companies? (Flow-through shares allow companies to transfer tax deductions to investors, who can then use them to lower their personal or corporate tax.) The idea might not cost taxpayers anything, Mr. Sutin said. There’s a limited pool of non risk-averse investors, and they would simply shift from mining and oil to tech.

Canadians have a lot to say about how to steer more capital to innovation.

Odd, then, that Mr. Harper would choose the Swiss Alps to launch such a crucial debate.

The best private equity funds are skeptics

"People will generally accept facts as truth only if the facts agree with what they already believe." 

Andy Rooney said these wise words and with his long history in the media, he would know.
Mistakes happen in private equity when the buy side--the fund managers-- fall in love with what they want to see.  Good funds want to critically assess the financial numbers long before meeting the personalities in order to make logical decisions. Once the fund meets the owners, their decision is 50% made. Now to see if they can get along as partners for the next few years.
Before you approach a private equity fund, ask, "Do the numbers fit with what you are selling as your business story?"
If not, get an exempt market dealer to help you develop your case and financial story. If you have revenues, debt is not the issue, you will be of interest to some investor.