In a recent survey, two out of five SME owners (40 per cent) stated they would consider taking up private equity financing, up from only 12 per cent in 2012. But, whilst the benefits of private equity financing are appreciable, the advantages come with a host of problems that many small businesses do not consider. These issues are easily avoidable, particularly bearing in mind the host of financing options available to small businesses today.
The rise of private equity
British SMEs have always been an important part of private equity deals, and the appetite continues to grow. Given that private equity has been around since the days of the industrial revolution, it is worth examining why this interest in private equity should be on the rise.
Over the course of the last few years, alternative finance has become more established, validated and conventional: according to Nesta, the alternative finance market grew to £3.2 billion in 2015. Having earned an air of authority, sites like Crowdcube and Kickstarter are now mainstream: the upshot being that a growing number of SMEs are considering the many alternatives to a traditional bank loan.
The 2008 financial crisis also had a hand to play in establishing private equity. When banks were damaged private equity firms were able to quietly amass funds, and in doing so, established themselves as a fresh and viable finance routes.
For small businesses, there are many reasons why private equity funding can be tempting. In addition to the inevitable ego-boost associated with being deemed ‘worthy’ of institutional investment, private equity provides a solid capital base for businesses: investors are locked in over the medium to long term, and offered a reliable source of expertise. And, should the business run into trouble, business owners have somewhere to turn for help and advice.
I worked with a company called Brewhouse and Kitchen, and for them, the introduction of private equity was a means to an end in terms of buying assets. They needed to buy pubs freehold to then put in their microbreweries. Private equity was perfect for them, it was a way to see out their business vision and give tax relief to investors. In their case, private equity has been perfect for them and allowed them to really flourish.
What are the hidden risks?
All SME owners should be aware of the hidden risks associated with private equity, before accepting any finance deals. Whilst it would be unfair to say that every PE firm will be valuing the investor over the entrepreneur, it should be appreciated that their primary concerns are likely to be different from those of the business owner. The firm’s concerns will be valuation, exit strategy, and payback for clients; meanwhile, businesses will have their own specific ambitions.
Give careful consideration to the fact that, by handing over shares to a PE firm, a business will lose some modicum of control. The firm will have the right to insist on employee appointments, or even ask that some members of staff are let go. Equally, it may be that the firm assigns junior associates to your business; their skill set and level of expertise may well be a far cry from that of the management team that most likely pitched for your company.
Having knowledge of small business funding personally, I know that people watch Dragon’s Den on the BBC, and that really is where they get their initial understanding of funding from. I have seen far too many SMEs, particularly in the niche food and beverage market and particularly brands, on the cusp of giving away control to private equity firms. In many cases, they have actually ended up struggling to raise the money, found another way to get their cash, and then gone on to be really successful. Particularly when these businesses are run as lifestyle projects, private equity just wouldn’t have been right for them and they’ve very nearly gone down that route. Having said that, you can absolutely have more than one type of funding and do very well.
What are the questions to ask?
Before sourcing private equity finance, it is important for business owners to ask themselves the following questions:
- Is my supply chain in place?
- Does my business have a strong management team in place in which I have faith?
- Do we have a business plan together?
- Is someone in my business confident with financial forecasts?
- Do we have a strong product/service with real proof of sales?
If the answer to all of these is ‘yes’, it’s time for a follow up question: do you want to hand over control of your business decisions to a relatively unknown party?
If the majority of business operations are in place, then consider what exactly is the cause of the financial problems. Often what initially seems like an overwhelming need for cash can be the result of a few separate and smaller issues, some or all of which may be able to be untangled and rectified with the help of some friendly advice. For example, if the problem stems from customers or clients consistently being late to pay invoices, a timely phone call or email to remind them of the due date may be enough to make a real change.
What to do next
Firstly, it’s vital to do plenty of research and self-examination. Before seeking finance, businesses should get a real sense of how much money they need and what they need it for; if the cash is needed for something specific, it is important to have a sense of how long finance will be required for to achieve that goal.
Once this is done, businesses must look into all the finance options available and ensure that the once that’s chosen is aligned with the needs, values and ambitions of the business. There are many finance options to choose from, from invoice financing or crowdfunding to peer–to-peer lending or seeking out venture capitalists. All of these means of finance have their significant merits and should be considered carefully.
Alex Fenton is founder and CEO of GapCap.