The investors have come calling, seducing you with multimillion-dollar deals. Before you lose your head, consider what can go wrong. 8 private equity pitfalls and how to avoid them.
"Wanted: Fast-growing company with smart CEO, interested in millions of dollars of investment capital." For an entrepreneur, can there be a sweeter combination of words in the English language? These days, that sentence or some variation of it seems to pop up everywhere. You can hardly open a newspaper or flip on the financial news without hearing about another larger-than-large private equity deal. Get together with a group of business owners, and it won't be long before you're hearing stories about unsolicited phone calls from would-be investors or millions closed on by a once-bootstrapping entrepreneur.
In the third quarter of 2006 alone, investors put $6.2 billion in nearly 800 deals, according to a recent report by PricewaterhouseCoopers and the National Venture Capital Association. Private equity investors, which include angel investors, venture capital firms, buyout firms, and others, either take a public company private or acquire all or part of a privately held company, hoping to make a profit when the company either goes public or is otherwise sold at some point down the road. Names you know, such as the Four Seasons (NYSE:FS), Outback Steakhouse (NYSE:OSI), Hertz (NYSE:HTZ), Neiman Marcus, and Dunkin' Donuts, have recently closed major private equity deals, as have hundreds of smaller companies that don't grab the spotlight. It surely is an exciting--maybe even an exuberant--time to be an entrepreneur.
And that should make you sit back, take a deep breath, and raise at least one skeptical eyebrow. For while it seems that there could be no downside to this, the road to your private equity deal is not without perils. Seek this kind of an investment when you shouldn't, or choose the wrong investor, or botch the negotiation, and it could cost you a really bad five or seven or nine years--or even everything you've worked so hard to build.
It has become a cliché to liken the private equity investment to a marriage. A good one is really, really good and a bad one can be ruinous, financially and emotionally. Like a marriage, a lot of the story is written at the very beginning--during the courtship phase or, in industry speak, pre-money. You're wooing the investor, and the investor, in search of deals, is also wooing you. "I don't think there's any doubt about it--it's a dance," says Alex Temel, partner at law firm Proskauer Rose in Boston and a specialist in private equity deals. "It's a dance that starts when you first meet the investor and lasts until the sale on the back end." As much as possible, you want to lead the dance and exit the floor with a flourish and a smile--and a nice deal for you and your company in your back pocket.
Unfortunately, entrepreneurs often walk away from these encounters feeling spun dizzy. Why? Many entrepreneurs are simply unprepared for their dealings with private equity investors, says Rick Rickertsen, managing partner at Pine Creek Partners, a private equity firm in Washington, D.C., and author of Sell Your Business Your Way. They plunge into pitfalls that could be easily avoided. Here then, the eight most common blunders that entrepreneurs make the first time they consider taking on a private equity investor--and some tips for steering clear of them:
Lawrence Ng founded his Los Angeles-based Internet advertising company, Oversee.net, in 2000, at the age of 21, with $10,000 of funding courtesy of his and his partner's credit cards. Two years later, his company was profitable and growing, and the private equity investors came calling.
Ng still remembers the first time he had a serious encounter with a potential equity investor. It started with a phone call from an analyst, quickly proceeded to a second call, and then a meeting. The investors were saying all the right things, Ng recalls: "'We are experts in this space, we've taken so many companies public, we see ourselves as partners, not as hands-on managers.' It all sounded very nice." It went from nice to exciting when the investor put a value for Oversee on the table. "Here's this professionally managed investment group saying, 'We believe in you, and we feel you can be valued at this.' It felt like, 'Wow, I've been validated." Ng won't say how much "this" was. But he will say that his reaction was "Holy wow!"
There's something profoundly satisfying when you hear that the company you've slaved over not only has been worth the effort but also is only at the start of its potential profitability. The problem: The excitement this can generate might short-circuit your brain and cause you to have fantasies about how you'll spend all that money before you even leave the meeting. At the very least, you might convince yourself to overlook potential downsides of the deal in your rush to move your company to the next level.
Avoid this pitfall by not being in such a huge rush to get a deal done. Take as much time as you need to reflect, to bounce the details off your most trusted advisers and fellow entrepreneurs, and to otherwise deeply research the deal. (More on how to best do all of this in a moment.) Although Ng was sorely tempted by the first deal he was offered, he did the right thing: He took time to think about it. After a cooling-off period, he decided that his company had more room to grow, and he could get a higher valuation if he waited before taking on investors. He passed on the proposal and has yet to take on investors.
Indeed, it's a red flag when a potential investor doesn't encourage you to take the time to deeply consider an offer. Kirsten Osolind, CEO of Re:Invention, a public relations firm in Chicago, was approached by a potential investor during the summer of 2006. Osolind had recently shifted her company's client base from small companies to large ones and learned that big clients tended to pay their bills more slowly. This had created a cash-flow crunch and made her more receptive than she might otherwise have been to an offer of an investment.
During their initial conversations and quite apart from the deal that they were discussing, the investor, who ran an investment bank in the Midwest, recommended her own personal business coach to Osolind. "It was in a very offhanded way. She said she'd seen her before and that she was really wonderful," Osolind recalls. Osolind was looking for an adviser and made an appointment with the coach. She was sitting in the coach's nicely appointed downtown Chicago office, and they started to discuss Osolind's situation. Then the coach did something startling. "She suggested quite strongly that I execute the contract with the private equity investor, without doing any further due diligence," she says. The coach even picked up her phone to call Osolind's would-be investor.
Osolind realized she was experiencing a bizarre high-pressure tactic and immediately walked out of the office, called the investor, and called the deal off. "I laughed really hard and had a couple of drinks that evening," she says. Osolind decided to revamp her billing procedure, and soon her company had solved its cash-flow problems, sans investors. Reflecting on it now, she says, "Not all investors care about your interests as an entrepreneur, and some will do whatever it takes to close a deal. They'll prey on your cash-flow crisis, they'll prey on your lack of confidence. You have to find the strength to walk away."
While you're not likely to experience such strenuous bulldozing, you will feel the pressure of the rush to close--from yourself and from your investor. Just knowing that will happen in advance will help you prepare for it.
The offer in front of Darrell Pittard, CEO of MagnetBank, was $100 million in funding. Pittard had intended to raise only $50 million, and this was the first offer he'd received, so you'd think he'd be thrilled. After all, he'd already shepherded his Salt Lake City-based industrial bank through its start-up phase and was looking to open more locations and expand his lending operations. Wouldn't more cash on hand--perhaps, even, a more aggressive expansion plan--be a good thing?
This particular investor, a wealthy individual, had owned a bank and offered more than just his funding. "It would have been very easy to take his money," says Pittard. But before he'd set out to find investors, Pittard had given a lot of thought to what, exactly, he was looking for. And for him, the right investor was a group of smaller ones. He didn't want any single private equity investor to have more than a 20 percent stake in the company. This investor wanted 80 percent. "We'd be the hired help," Pittard says. "Working for him would be no different than working for IBM." In the end, he talked to 35 more potential investors before settling on six different ones who offered what he was looking for.
On the other hand, a similar offer in front of Christopher York, CEO of InfuScience, a Gurnee, Illinois-based company that provides intravenous medication services to patients, would have been just right. York preferred to give up more equity--even majority control--to a single investor, get one chunk of change, and get back to work. He recently raised $50 million in private equity, and it came from a single investor, who took a stake of more than 60 percent. Sure, he's giving up his majority control, but the money and the guidance and contacts that come with it make it worthwhile, in his view. "I have a friend in the middle of building a company, and he goes and raises $2 million here, $2 million there; his entire life revolves around talking to investors and raising money," York says. "I raise money once, and then I spend the rest of my time recruiting people, meeting with customers, running my company."
The first step to a good deal is figuring out what it looks like well in advance. After all, you can be sure that serious investors will sort out what an ideal investment looks like for them. Without a detailed picture in mind, you're already a step behind in the dance.
You may be like York and prefer one big kahuna. Or you may be more like Pittard, who likes his investors diluted. Either way, what really matters, and what sets York and Pittard apart from many entrepreneurs, is that they gave lots of thought to what they were looking for--before they'd even cleared their throat in a conversation with a potential investor.
What factors should you consider as you create your ideal investor profile? Tackle the basics first. How much money do you want? How much equity are you comfortable giving up? How quickly is your company growing? How long do you expect the investors to stick around? When you get all of this sorted out, stick with it, advises Alex Temel. He mentions one client he has been advising for seven years. "He told me he wanted to make $200 million when he sold his company," Temel says. Now the $200 million is on the table, and the CEO is dithering. After all, if he can get $200 million, perhaps he can get $300 million? Perhaps. But as often as not, Temel says, deals fall apart when an entrepreneur changes the terms in midstream. "Pick a number and stick with it," he says.
Dean Stoecker wanted to expand SRC, his business-intelligence software firm based in Orange, California, into a $100 million powerhouse. To get there, he figured he needed to invest between $12 million and $15 million to fund new sales and marketing initiatives, and he set about the task of raising the money through private equity investors. The fun part, he says, was figuring out how he'd spend all the money he was raising. But actually talking to the investors? "It was horrible," he says. "I was very turned off to the VCs and to their approach to business." He felt that he was talking to "young whippersnapper M.B.A.'s who know a ton about money but not a lot about the entrepreneurial spirit." When investors mentioned exactly how involved they planned to be in managing the company, his blood ran cold.
He aborted the plan. "This is not us," he recalls telling his partners. "We'll no longer be able to spend our Monday-morning team meetings talking about all the great things we did last week and plan to do this week. We'll be talking about burn rates." He envisioned spending his time managing the investors instead of running the business. "We will hate these guys," he said. Instead, the company decided to plow its profits back into growth, and "we continue to grow quite well," Stoecker says--about 20 percent a year.
Stoecker may have been able to grow faster with outside investors, but given his goals, he probably was right to abandon his pursuit of outside capital. Although private equity investors vary in their level of managerial involvement with a company--some are more hands off than others--it's definitely not going to be zero. "If all you want is money, there are cheaper ways of getting it, like going to a bank," says Walter Kortschak, managing partner at Summit Partners, a private equity firm with offices in Boston, Palo Alto, California, and London. The key question to consider, he says, is this: "Is this about you, or is it about the company?" If, like many entrepreneurs, you have a hard time separating one from the other, then private equity probably is not the way to go.
Sort out in advance exactly how much control you're willing to give up. Are you willing to hear that a key colleague who helped build your company is not the right person to take you the rest of the way? Management is one of the first things equity investors take a hard look at, and they often seek to bring in their own people. How important is the quality of connections to potential clients or companies to acquire that the private equity investor brings to the table? How often would you prefer to communicate with them?
Allen Gray knew he needed investors. His business, BMC Products in Chicago, made tubular components for automobiles, such as spare-tire holders, as well as tubular office furniture. The business was growing fast and Gray and his 120 employees were having a tough time keeping up with the demand. An infusion of capital not only would put some cash in Gray's pocket but would also give his company the means to keep growing. A business broker hooked him up with a potential investor, which Gray describes as "a good-size private equity firm in the East that was interested in getting into the home office business and the auto aftermarket business." The investor soon delivered a letter of intent, for an amount in the multiple millions and 80 percent equity. "I'm a guy who grew up delivering newspapers and worked my way through college. When I saw a piece of paper with that many zeros on it, I got very excited," he says. "Being a multimillionaire sounded very good to me."
The offer was nonbinding, and the investor started conducting due diligence. Due diligence, of course, is the term that investors use to refer to checking out every aspect of your business--a serious vetting to give them the confidence level that you're a good investment. It's not a lot of fun, says Kortschak: "I've never seen an entrepreneur conclude that the diligence process was not thorough, or think, 'Boy, that was super easy and super efficient."
In Gray's case, due diligence, which was supposed to take 90 days, stretched out for almost seven months. The investor always had at least one person on Gray's premises, researching and asking questions, and often sent teams of two and three people. They wanted loads of data. They wanted to interview key customers. Gray spent a lot of time working with the investor and less time managing his company. "Bottom line is I took myself off my business, and I didn't have a strong management team that could fill in for me," he says. "Costs got out of line, orders didn't ship on time, and I started losing money."
As the business suffered, the would-be investor kept lowering its price. Finally, at the end of seven months, Gray called off the deal. Several months later, he struck a deal with another buyer at just over 10 percent of the initial offer. "It really ate me up," says Gray, now an investment banker who spends quite a bit of his time brokering private equity deals. "I built a successful manufacturing company from nothing, and I made a total shambles of selling it to a private equity group. I lost everything."
Obviously, a reputable investor doesn't want your company to be ruined by the due diligence process. "The last thing anyone wants is for the process to consume the entrepreneur to the point that the business gets impacted," says Kortschak. On the other hand, even in the best of circumstances, handling the details of due diligence is going to take time out of your week--you need a good management team that can pick up the slack. "You're going to get distracted," says Gray.
There's another type of depth you want to have in a deal: multiple offers on the table. Since Gray had just one interested buyer, he could not credibly threaten to go elsewhere. Says Gray: "One buyer is no buyers."
Spend as much time selecting the right lawyer (or investment banker, or whomever will be acting as intermediary for you) as you'd spend on anything else. "Don't hire your cousin, the lawyer," Rick Rickertsen says. You don't necessarily need someone from a huge law firm, but you do want someone with solid experience in the size of deal you're trying to make. That someone is most probably not the lawyer you've worked with on other matters. As with any other important hire, ask for references and check them.
And once you find great advisers? Keep on top of them. "Don't let your lawyers run the process," says Alex Temel. "Make decisions about what's important to you and have your service provider implement that." Sure, this is time consuming, but you want to make sure that your lawyer isn't wasting time arguing over points that are really not that important to you. "Look, at the end of the day it's your deal, and it might be the biggest one you ever make," says Rickertsen. There are plenty of times that CEOs need to learn to trust and delegate. This is not one of them.
Once you've found an investor you feel good about, you'll want to pull out all the stops and make the best case for your company. But don't get carried away. "Entrepreneurs think the investor wants to see a perfect company and try to position their company as perfect or nearly perfect," says Rickertsen. "Investors know that all companies have challenges, and saying that there aren't any almost always gets the business plan thrown in the trash can." If you have a strong competitor, a major contract that isn't going well, or the threat of a potential lawsuit, fess up early, he advises. The investor will find out in due diligence, and then you've got a credibility issue, which can be the end of the deal. "I've seen a number of deals crater because the investor doesn't believe the founder can be trusted," says Temel.
Of course, it can be difficult to acknowledge weakness, and you'll want to do so with some finesse. You definitely want to lead with your strengths, says Temel. "It's like dating--you meet someone at the bar--you don't tell them about your parents right away." Adds Rickertsen: "Put your best foot forward, lay out the selling points for your business, and then be accurate about your weaknesses, and explain what you're doing to address them."
All investors perform due diligence on potential deals. But few entrepreneurs return the favor. "Entrepreneurs do a lousy job researching their investors," says Rickertsen. To be sure, most investors aren't out to do you wrong, but it's up to you to make sure that you aren't dealing with someone who will seem crazy on closer examination or otherwise be a bad fit for your company.
Investigating a would-be investor is not particularly difficult. Talk to other CEOs the investor has worked with. Rickertsen suggests you speak to at least three of them--including people running companies currently in the investor's portfolio and those who have moved on. Any reputable investor should provide you with names and contact information. Ron Norelli, chairman of the Norelli Group, a private equity and financial advisory firm in Charlotte, North Carolina, suggests you talk to CEOs whose companies the investor has held for the whole cycle--from initial investment through sale, merger, or IPO. Ask the same questions you'd ask a potential employee.
Next, Rickertsen suggests, ask the investors how they'd handle things when times get tough. "Find out what their definition of failure is. If you miss your plan by 15 percent, what will you be hearing from them?" It's not a fun subject, to be sure. "Some people are uncomfortable with having those hard conversations in advance," he says. "But it's just a mistake in the long term not to."
When Christopher york sought funding for his company, he met with half a dozen potential investors. He was seeking the right financial terms, of course, but York was also looking for something else: someone that he wouldn't mind spending a lot of time with. "It's one of the most important things to figure out: Can I get along with this person?" he says.
While you're sussing out your private equity investor, don't overlook a very important indicator: your gut. While the private equity investor is trying to figure out what you're about, "the entrepreneur also has to be asking, are these the people I want to deal with, and for five, seven, nine years?" says Norelli. After all, these are people you'll be talking to on a monthly, if not weekly, basis. If you don't like them, your life is not going to be pleasant.
This is perhaps the most subjective part of choosing the right investor. A deal can look great on paper, but if the investor gives you the willies, you probably should find another deal to pursue. As in romance, it's hard to say what will create that "click." Obviously, everyone has different tastes and preferences. In retrospect, York thinks that communication style is what helped create the needed chemistry with his investor. "I'm the kind of person who isn't overly formal, and I wanted to make sure that I wasn't dealing with a bunch of stodgy investors," he says. He got that too-formal feeling from the investors he rejected and went the people he felt the most comfortable with.
Contributing editor Alison Stein Wellner also writes in this issue about CEOs who hate making sales calls.