Private equity’s role in creating optionality

In this article, I discuss the role that private equity can play in creating optionality for a tech company’s management team as well as its investors.

I was the founder of Pagemill Partners, a boutique investment bank located in Palo Alto, California, which was incredibly active with top-tier tech PE firms.

My experience taught me that while the North American market contains more than 500 PE firms, the number of firms that I was interested in having a dialogue with was less than 5 percent of that total base.

Ultimately, there are two key characteristics that separates the “true” partnership PE firms.

The first is whether or not a PE firm allows investors and/or management to roll their equity into the same preferred equity they’re receiving. This first criterion separates about 85 percent of the firms who are only interested in themselves being the holders of preferred stock while everyone else stands behind them.

The second criterion I looked at was whether or not they were pure EBITDA buyers. There is a substantial group of PE firms that in spite of everything they tell you have investment values that are denominated as a reflection of trailing twelve months EBITDA or next twelve months EBITDA.

Top-tier PE firms, in my experience, offer valuation outcomes that are closer to strategic buyers.

Scott Munro, venture partner, Inovia Capital. Photo courtesy of the firm.

Understand as well that there is a significant difference between a “platform” transaction where the PE firm will use the target as the main strategic platform, and then do additional acquisitions that will be consolidated into that platform, versus an add-on acquisition into an existing platform, which almost always falls back to something closer to EBITDA valuations.

It is important to realize what classic PE firms are looking for to determine if a given tech company may be a good candidate.

The fact that a tech company is receiving numerous inbound calls from PE firms actually means very little because the bulk of these calls are handled by the most junior people with little to no authority other than to help identify potential investment opportunities. Junior members of PE firms are highly motivated to make these calls as often their long-term survival is tied to finding at least one opportunity.

My focus for this article is platform acquisitions where a PE firm buys at least a majority stake in a tech company.

From my experience, the best PE firms will value the following elements:

1) Annual growth rates of at least 40 percent;
2) Annual revenue of at least $20,000,000;
3) The management team and investors are willing to divest control but ideally have management roll a large portion of their equity into the go forward business;
4) A management team that is committed to remain with the company and has already developed mature financial reporting capabilities;
5) A fragmented market that offers opportunities to consolidate other targets into the platform;
6) A profitable business or short-term path to profitability at the EBITDA/free cash level. This element is often more flexible for recurring revenue companies.

Assuming a tech company fits into the majority of these elements, there are general circumstances that dictate whether a discussion with a high-quality PE firm could be beneficial.

From my experience, the following situations would drive me to consider embarking on some PE meetings:

1) A strong opportunity in a fragmented market to consolidate targets that would be very difficult to fund with current investors. This happens most often when the current investors are early-stage;
2) Investors who have been in the company for a long period of time and the fund with which they invested is close to its end of life;
3) As part of an overall “optionality program” that uses a PE firm as one path to provide potential alternatives to management and investors;
4) As part of the first phase of an M&A strategy that uses a PE firm as a stalking horse. I often reached out to PE firms first as part on an overall M&A strategy to establish a competitive process as well as to create urgency for strategic buyers who realize that if they didn’t move before the transaction they would be buying the company in the future for significantly more money;
5) A high velocity management team that is cash constrained but could quickly capitalize with additional resources that would allow a dramatic acceleration of revenue (organic and inorganic).

While PE firms can be incredibly helpful in opening up new avenues of growth, it is essential that a tech company perform its own due diligence around finding the best partner.

Culture, style, geographic location and available resources are important to understand before moving forward with any one PE firm. I often encourage a discussion around how the add-on acquisitions will be funded to make sure the teams are perfectly aligned.

The better PE firms have created strong relationships with banks that provide the ability to generate more accretive transactions.

Finally, having conversations with some of a PE firm’s past and present portfolio company CEOs will round out a preliminary diligence effort.

Selecting the right partner is not easy, but using the filters I’ve provided here will bring a tech company much further along in determining which PE firm best meets its requirements.

Scott Munro is a venture partner at Inovia Capital. Based in Carmel, California, he works with Inovia on the acceleration team, helping portfolio companies understand and prepare for M&A activities.