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REVIEW: FROM THE FIRM’S VIEW: DEMYSTIFYING PRIVATE EQUITY FUNDING The University of Chicago’s Graduate School of Business sponsored an exciting and highly informative program on private equity funding – from the firm’s perspective. Stefania Aulicino, President of Capital Link and University of Chicago Business School graduate and Edward Paisley, Managing Editor of the Daily Deal, the only weekly publication which reports so extensively on private equity deals globally, collaborated to share their respective expertise on two aspects of today’s complex funding market. Stefania, by relaying the story of one client’s funding adventure, provided a very realistic framework on what a business owner might expect to experience in this process and offered practical information on how to be successful. Edward Paisley shared historical information on private equity financing and commented on the current market. The GSB’s Finance Roundtable series, featuring world-class speakers on financial topics, was created to serve the interests of alumni. This event, on private equity/venture capital, provided invaluable information for both business owners and private investors and was attended by over two hundred. Ms. Aulicino wasted no time in confronting the concerns of the average business owner seeking funding. The thought, “This is the worst capital market in a long time,” has been drummed into most of our thinking. While investors may be taking a long time to make decisions, she confirmed, it is actually an excellent time to explore professional private equity funding opportunities. All an owner needs is an excellent plan for achieving growth and the willingness to radically change his or her thinking about the process.
“I thought attracting resources for our growth would be hard. It wasn’t.” Wayne McFarland, Landmark Industries
Beginning with a client quote, she described how she has used her Growth Catalyst System™ to help entrepreneurs achieve better than expected results (As an entrepreneurial advocate for companies in the growth funding process, over 80% of Capital Link clients closed deals with better terms than those offered in original Term Sheets). Successfully attaining private funding for growth, she shared, requires: 1) each partner, the business owner and investor, have compatible expectations and values; and 2) diligent adherence to a process which minimizes risk for both. A third party advocate, she added, also tends to bring value to both parties.
Developing “Growth” Think.
One of the key funding challenges facing entrepreneurs is holding limiting beliefs about their companies’ business potential. This may come from: past experiences with banks; views that internal cash flow dictate rates of growth; a lack of understanding of private equity options; and the view that private funding is synonymous with “making a deal with the devil” and invariably involves loss of control when trading equity for growth dollars. Limitations to “growth think” also comes from looking at financing in terms of what one needs in order to create incremental revenue increases instead of creating a plan aimed at achieving the company’s full growth potential. In retracing the experiences of a past client (referred to here as “Leslie”), Ms. Aulicino described how they overcame this obstacle when she asked, “What would you do if you won the lottery tomorrow?” Creating this new mindset, they were able to develop an Optimal Growth Strategy for securing private funding. When seeking funding from investors with deep pockets, Ms. Aulicino advises, it is more important to demonstrate how the right amount of capital applied intelligently can generate higher profits and offer greater protection to both investor and entrepreneur than asking for minimal funding for incremental expansion. Before implementing their growth strategy, Capital Link supported Leslie in evaluating both her business and personal ambitions as well as her expectations of how a relationship with a private investor (or group) would work. Private equity funding may not be for everyone.
Finding Gold in a Three-Step Process
Ms. Aulicino guided Leslie through a three-step process that allowed her to secure funding in less than 2 months. Within three years, the following milestones were achieved: Company sales went from $6 million to $60 million with EBIT margins of 18%, up from 2%. Sticking to this three-step process proved to be the winning formula for securing the right investor and helping Leslie satisfy growth and control requirements. Here are the key steps in the process.
Step 1: Position yourself for maximum value.
Starting from the lottery question, a business owner can separate their business strategy from finance assumptions. (These assumptions should never be allowed to limit a business strategy.) To determine the company’s maximum value, Stefania guided Leslie and her management team (from operations, finance, R&D, etc.) in a single-day brainstorming session to evaluate core competencies and market opportunities. Each team member contributed an invaluable perspective for determining economic implications of the company’s core competencies to position the company for maximum value. From this perspective, thinking in terms of unlimited personal resources for growth, and tapping into management’s collective brain trust, Capital Link’s client company put together the following projections.
Based on their “maximum value” strategy, Stefania developed a “corporate resume.” A corporate resume is a two-page document that describes the economic implications of the company’s core competencies.
Step 2: Perform a “Zero Risk Beta”
Before finalizing a plan to secure private equity, it is important to “discover what you don’t know you don’t know.” From a funding strategy, this entails circulating the anonymous corporate resume, which uniquely describes the company only in economic terms, among select professional investors. This allows the company to gather useful feedback on how to make their funding proposition more attractive without affecting their reputation. Written in a format that reflects how a professional investor would actually analyze an opportunity, it also proves to be an excellent tool for getting feedback on how to develop a more detailed plan that would attract the right kind of investor. Stefania circulated Leslie’s corporate resume among a dozen investors from different industries and areas of interest then followed up with information-gathering interviews. This provided real-time financial market intelligence. The feedback included some key facts about what investors saw, both positive and negative, which Leslie had missed about her own company and gave Leslie a more accurate picture of her company’s value.
This real-time market intelligence included acknowledgement of training, logistics and cost-controls expertise which Leslie had taken for granted. Another key insight she obtained from her zero risk beta involved a new understanding of the success she had achieved in customer penetration. When confronted by what investors perceived to be customer concentration, Leslie was stimulated to take a rigorous look. In examining customer activities, she discovered that 40% of her company’s business came from five clients who used them as an exclusive supplier. This demonstrated that her company had clients who were actually dependent on them and willing to pay premium prices, a fact that, once properly articulated, was extremely impressive to her plan’s evaluators. Equipped with feedback from the “zero risk beta,” Leslie learned how she could accentuate her company’s strengths and address legitimate concerns a potential investor might raise. Incorporating feedback from the zero risk beta, a twelve-page “investor plan” was created. The purpose of this plan is to educate investors on the opportunity and equip them with the economic justifications they need to invest. It did NOT however, include a stated valuation for Leslie’s company.
Step 3: Create the Right Partner to Implement Your Growth Strategy
The activities of an entrepreneurial advocate can be instrumental in securing the right partner – and doing so quickly. At this time, it is crucial for a business owner to focus their attention on building the value they intend to present to an investor, i.e., maintain their focus on taking care of their business. An advocate with extensive contacts can also expedite the process immeasurably. Stefania arranged for Leslie to meet with 13 investors in eight states over two weeks. This allowed her to talk to multiple investors at one time, condensing the timeframe for this funding round and giving her maximum control over the process. In each meeting, Leslie had the chance to educate potential investors about her business and test her economic model for it. She determined this part of the process, this “investor exchange,” to be one of the most significant learning experiences an entrepreneur can have as it allowed her to learn more about her business from top experts. After this round of discussions, Leslie received five term sheets, reflecting a wide range of valuations and conditions. This demonstrated how subjective the valuation process is and allowed Leslie and Stefania to craft a sixth term sheet. This one incorporated the best terms and the highest valuation of the five she had received. In evaluating potential investors, Stefania coached Leslie on the importance of asking two due diligence questions to the portfolio CEO’s of each investor candidate to determine who would make the best “partner.”
· How did this investor team react when things went better than expected? · How did this investor team react when things went worse than expected?
Selecting the right partner, one who shares values and expectations, and is committed to the growth plan, is vitally important if the optimal growth strategy is to be achieved.
Before a final decision was made, Stefania and Leslie discussed the merits of working with a “syndicate” of investors. Based on the sixth term sheet they had created, Leslie invited 2 of the 5 investors she liked best A group of investors working together provides a stronger safety net if things do not go as planned. An investor syndicate also assures deeper sources of equity should later rounds of financing become necessary. Another benefit of syndication is that it allows the business owner to seek out their ideal lead investor regardless of geography. As an example, if a lead investor is savvy about your business and industry, is not domiciled in Illinois where you are headquartered, Chicago is rich in professional Private Equity investor talent with whom any out-of-state lead would be happy to syndicate. Armed with this information, Leslie chose a syndicated deal. As it turned out, this syndicate of committed partners offered sufficient investment depth and yielded critical breathing room for Leslie when things did not go as planned in year 2 of her 5year growth strategy. Her investors stepped up with the additional capital and knowledge she needed to see her through the unexpected.
The Role of Entrepreneurial Advocate
In guiding an entrepreneur through evaluating her assumptions, helping her communicate in the language preferred by the investment community, or by introducing appropriate equity sources, an advocate can be a tremendous asset to both the business owner and the investor. Stefania closed her presentation with a reminder that growth capital is available. Acquiring it requires a well-conceived and executed plan. The result is a safer, more profitable growth strategy for the entrepreneur.
The $64,000 Question
Ed Paisley opened his presentation, with a couple $64,000 questions that, today, is actually a $106 billion dollar question: “What is private equity?” and “What is the current state of this market? There is over one hundred and six billion dollars of private capital currently available. He estimates that immediate investment opportunities exist for $40-60 billion of this total. Notwithstanding recent history where investors took beatings as individual companies were over-valued and entire industries demonstrated themselves not to be the “next great thing,” he reminded Roundtable attendees that money is available and both VCs and equity managers are looking for good investment opportunities. His presentation introduced historical perspective on leveraged investments (like buy-outs), and venture capital deals. Paisley also indicated that funding issues will vary greatly depending on what stage of capitalization a company may be at (seed stage; follow-up (growth); pre-IPO; and IPO or sale to a strategic buyer. His “firm’s view” presentation focused more on institutional and syndicated sources of private equity, generally sought at later rounds of capitalization. At these later stages, and as funding amounts increase, issues of risk, return, and control are evaluated differently. Institutional investors (managing funds from pensions, endowments, corporations, individuals and banks) tend to operate under a ten-year plan where the first three years are spent making investments in new companies; the following three are spent monitoring these investments; and the last four years are devoted to executing an “exit” strategy. Illinois, he pointed out, is a good place for securing private equity investors. In the first quarter of 2002, the state ranked third only to California and Massachusetts in terms of investments. While there are many challenges involved in securing private equity, he, like Ms. Aulicino, ended on a positive note. Returning to his original $64,000 question – his $106 billion dollar market statistic -- he reminded attendees that investors, especially the large ones, want to make deals because they may lose their funds if they don’t use them to invest.
July 10, 2002 Copyright 2002
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