What is private equity: answers to 5 frequently asked questions
Reading time 7 min.
Selling a company
What is private equity?
Private equity is one of the potential buyers for your company. These parties are constantly looking for new companies to invest in so that they can generate a return on their capital. What is private equity and how does the sales process work? In this article, you can read about the meaning of private equity and find answers to 5 frequently asked questions.
Private equity meaning
What is private equity? Private equity (PE) refers to investors who invest in unlisted companies. These investors aim to achieve the highest possible return on their investment. PE parties invest in a company by purchasing shares from the current shareholder(s) or issuing new shares. When shares are acquired, the capital contributed by PE is paid to the selling shareholder(s). Private equity parties often require that the selling director-shareholders (DGSs) remain associated with the company. This is done by reinvesting part of the purchase price received in the company (rollover).
This ensures that key personnel remain with the company and that PE does not purchase an ‘empty shell’. This increases the likelihood that the company will grow and create value. In addition, PE investors also gain some form of control over the company. This allows investors to contribute to optimizing processes and increasing profitability, resulting in a successful sale. This emphasizes the importance of private equity as a key growth factor for companies.
How does private equity finance the purchase price?
When private equity acquires a company, the purchase price is broadly financed by:
- Equity capital
PE parties invest from a fund. That fund consists of money contributed by, for example, pension funds, family businesses, wealthy individuals, and partners of the PE party.
- Debt capital
Mainly loans from the bank in the form of leveraged buyouts.
- Seller
Loan from seller(s) and rollover by seller(s).
How does private equity increase returns?
What is private equity for increasing returns? We briefly mentioned earlier that a PE party has the following objective: to achieve the highest possible return on its investment. That objective is achieved by using bank loans. In this animated video, you can see how returns are increased with bank loans. A bank loan has another advantage: structure in the organization.
The bank requires monthly or quarterly figures, which provide insight into the company’s performance and repayment capacity. This allows the bank to achieve two goals: (i) the bank monitors whether the company can meet its interest and repayment obligations and (ii) by reporting, the bank subtly encourages the company to meet its forecasts.
How does the sales process work with a PE party?
The negotiation process with a PE party is not fundamentally different from that with a strategic party. However, private equity does play a different role during the sales process.
- New company
A new company is often set up to ‘buy’ the business. Through the ‘rollover’, the seller participates in the new company and thus pays part of the purchase price. When distributing the proceeds, a private equity party often tries to gain priority over other shareholders. A high bid during price negotiations can therefore turn out to be a ‘cigar from one’s own box’ if developments after the takeover are disappointing. - Two valuations
It is becoming increasingly common for a private equity party to already have a stake in a company similar to that of the seller. If the seller then ‘rolls over’ into that similar company, two valuations are necessary. The first valuation concerns the shares of the company that the seller is selling. The second valuation relates to the valuation of the similar company into which the seller is rolling over. In order to properly compare bids from strategic parties and PE, it is therefore necessary to look beyond the price offered for the seller’s own company. - Binding the seller and management
A private equity party often lacks the knowledge to continue the business independently. The current management and seller are needed to achieve the return targets. That is why provisions are included in the transaction documentation that bind the management and/or seller to the company for a certain period of time. This binding is achieved on the one hand by offering the prospect of an attractive return and on the other hand by making early departure unattractive. For PE, it is a major setback if the seller leaves prematurely after receiving the purchase price, contrary to all agreements.
Selling your company to private equity or not?
Usually, a lot changes after a takeover by a PE party. If the company was not previously financed with a bank loan, the bank’s regime often feels uncomfortable for the ‘rolling’ entrepreneurs. If the private equity party only provides refinancing and monthly checks via spreadsheets, a conflict with the rollers is looming. If the private equity party contributes additional expertise and can facilitate growth, then selling your company to private equity is interesting for all parties. A clear vision for the future, in which the interests of all parties involved coincide, is therefore important.
What is private equity without the right guidance?
Entrepreneurs who have little experience negotiating with private equity parties would be wise to seek the assistance of expert and experienced advisors. BrightOrange has more than 25 years of experience in private equity strategies. Do you have any questions, or would you like to know more about our services? Feel free to contact us.
Get in touch
Hermen Dam
Consultant
Hermen Dam
Consultant
Hermen Dam
Consultant
“Many entrepreneurs see their business as a ‘life’s work’. Making the decision to sell it, they often only take it once or twice. I really enjoy guiding these entrepreneurs through this process. I really enjoy the variety of assignments, businesses and entrepreneurs we help. And especially the combination of the financial and human aspect.”
Personal fact:
Footballer and amateur chef
About the author
“Many entrepreneurs see their business as a “life’s work.” The decision to sell is often made only once or twice. I truly enjoy guiding these entrepreneurs through this process. I particularly enjoy the variety of projects, businesses, and entrepreneurs we help, and especially the combination of the financial and human aspects.
Do you have any questions for me?
+31 6 37 35 68 42
Hermen@brightorange.nl
