In 2021, private equity buyouts reached a record $1.1 trillion, doubling from 2020, and the market continues to grow as investors and companies improve their approach. The recent increase in the number of private equity firms often turns private equity capital into a commodity, leaving business owners with only two institutional alternatives: sell a minority stake to a passive growth investor, or hand over the keys and control to a buyout firm all in one exit transaction.
Some investors want capital solutions for their business that go well beyond the dollar. Others seek a true partnership with an institutional investor that allows for diversification of personal wealth early in the partnership and brings resources, strategic input and operational support in anticipation of the next major transaction.
Many entrepreneurs and their advisors are not familiar with the partner equity solution. Here’s what entrepreneurs looking for equity need to know to understand their full range of alternatives and when a partner equity transaction might be the best equity solution for them.
Assess stakeholder motivations
With partner equity, the motivation of a stakeholder should determine which financing alternative is most suitable. For example, if retirement is the main motivator for stakeholders, handing over the keys and control in a full exit transaction with a buyout firm might be best.
Additionally, for stakeholders whose businesses require little capital to pursue new initiatives and are exceeding their borrowing capacity, a passive growth equity investor may be best suited.
In a situation where stakeholders see tremendous business potential that cannot be unlocked without making operational changes that they see as risky, a partner-equity transaction could be attractive.
Create an incentive-based capital structure that aligns with objectives
The two traditional institutional financing options typically result in 20% to 30% ownership for a growth equity investor and 85% or more in the case of an outright buyout. This makes sense given the respective goals of the stakeholders. Craig Dupper, founder and managing partner of Elan Growth Partners, says growth equity investors are relatively passive, though some apply “ratchet” provisions that give them governance rights when the company isn’t performing relative to agreed-upon metrics.
A full buyout is just that, with typical shareholders retaining only 5% to 15%. Most sellers in this scenario attribute little future value to this retained portion, instead focusing on maximizing the value they receive at closing. This is understandable as most of the time they are no longer active in the business and have little, if any, leadership rights after the acquisition.
In the case of a partner equity investment, post-transaction stakeholder ownership ranges from 35% to 49%. A capital structure designed in this way allows a stakeholder to have a liquidity event in advance that diversifies their personal holdings but leaves a very significant role in play for the next liquidity event. The upfront payment and resulting diversification changes the risk calculation for the stakeholder partner, and now that they have some financial stability independent of the deal, they are more comfortable with the decisions and changes needed to unlock value.
The incentives are perfectly aligned given post-transaction ownership, and the partner equity investor is typically focused on accelerating the execution of growth strategies, adding a positive sense of urgency. It is worth noting that the partner-stakeholder is often still involved either in a direct operational role or on the board where they have the opportunity to influence corporate governance and strategic direction.
Manage processes and expectations
Pursuing an equity transaction can be a stressful process for business owners. Regardless of which alternative a business owner chooses, the due diligence process is extensive, thorough, and often intrusive. Often, a business owner should allow four to nine months from the time they begin their search for an equity partner to completing a transaction. However, some of the variables that affect this timing are within the control of the business owner, including the status of books and records, financial records, and customer and supplier contracts.
While growth equity and buyout investors will be heavily focused on the past and short-term prospects, the partner equity investor will be just as focused on the future and how the parties work together. They often create a strategic plan with business owners prior to completion to demonstrate the process and set expectations for the partnership.
At this stage, they ask questions like: How will we adjust our plans to respond to market changes or deviations in our forecasts? What tools and processes will we use to resolve potential strategic or operational disagreements? What are the agreed milestones that indicate it is time to pursue a second exit transaction? As an entrepreneur, it is worth thinking about these situations.
Establish a collaborative dynamic for the partnership
Many growth equity investors position themselves as “value add”. However, the nature of their investment is passive in nature. Usually not much close cooperation is considered by the parties, especially if the company continues to thrive. Likewise, in a buyout transaction, the business owner exits with no further involvement required or expected.
In contrast, in a partner-equity transaction, good chemistry between the investor and the partner-stakeholder and the collaborative dynamic between the two are critical, as the partner-stakeholder remains involved after the close. Dupper describes the relationship as comparable to a marriage. He says: “It is important for a business owner to assess whether the institutional investor shares their values, operating philosophy and vision for the partnership. Communication styles and interpersonal skills must be compatible to execute the plan effectively, work together through the inevitable challenges, and ultimately maximize value in the second, hopefully larger, transaction.”
In an increasingly standardized private equity market, a partner equity investment structure stands out as unique. For business owners looking for a hybrid capital solution that facilitates asset diversification and offers the opportunity to participate in the company’s future growth, Partner Equity could be an excellent solution. Business owners and their advisors should be aware that there are hybrid investment alternatives, such as equity, in addition to traditional passive growth and control buyout transactions.