To start off my first write-up, I will cover one of the most common and basic asset class, Equity in the early stage, Private Equity.
The most common and basic investment asset class is Equity. Equity is being valued since the formation of a company. Private Equity as an industry, invests and grows private and unlisted companies. Because of today’s environment and ease of creating a new business idea and company, the term “startup” today describes new businesses that have begun its operations. On top of this, there are claims that the new business ideas have to be innovative and new in any industry. However, companies have been built from scratch and grown over hundreds of years, where the big names are sitting on today’s stock exchanges.
The primary reason private equity investment came about was the need to raise operational capital by companies. As companies grow in size, more capital is required for reasons such as expanding its operations, extending the market reach, fighting the competition, increasing their revenue, etc. It is common to see companies raise different rounds of capital investments over a period of time. Each round of funding from Venture Capitals and Private Equity firms are being termed as seed, series A, series B, and so forth. The size of funding are typically associated by the round of funding too.
Startups or businesses raise capital through angels, venture capitalists and private equity firms. Angels are typically funding through an individual coming from 3Fs (friends, family and fools), and High Network Individuals (HNWI). Beyond the capital injections from this group of investors, startups today are more particular on who became their shareholders and sits on their board. Capital is much more accessible today and it allows startups to shop for investors who can bring the most value. Ideally, they see investors who can help them grow the business through the investors’ business network and experience to steer the startups strategy.
There are several variations to the investment agreements in exchange for the equity stake. Given how the private equity market has evolved since it began post-WWII period, transactions have went beyond a plain vanilla money agreement for equity. Variations were structured into agreements such as debt with equity convertible options, adding caps and floors to options, royalties and dividends payout with a cap, etc. The larger the equity deals, the greater the complexity as more stakeholders are involved.
There are many ways to value the companies and startups. In the early stage companies, it is more of an art. One of the reasons is that the companies typically are still in a conceptual stage with an unproven and new market. The success of fundraising depends on the ability of the startups to pitch the vision and concept of the business with an hypothesize market. This has resulted in startups evolving in programs like pre-accelerator, accelerator and incubators. Pre-accelerators and Accelerators are typically structured programs to groom startups to build fast and test out their concept. At the end of these programs, there will be a demo day where the startup graduates are given an opportunity to pitch to angels and seed investors. Incubators have a slightly different operational mechanism where startups work closely and hand in hand with their investors to grow the business. Once the startups are in a suitable or favorable position, they will be seeking to raise funds from larger VCs and PEs and scale up the business.
On the other hand, I see a more matured company with historical financials and an existing sales market, valuation is a mix of art and science. Valuation of the company is backed by existing financials to illustrate how much sales the company has generating and how has it been growing. The art in the valuation comes in projecting a vision of a higher valued company based on the company’s strategy. The strategies whether it’s traditional or innovative, they have to make sense to the investors. Once the startup can convince the future growth and potential to the investors, this is where a premium can be added to the valuation.
The private equity players are much more straightforward than other markets. On the surface we typically see two parties; the investor and the company.
The investors are made up of Angels, venture capitals(VCs) and private equity(PE) firms. A key thing to note that the VCs and PEs usually manage a fund that invest into the companies. The VCs and PEs often have to raise funds from the Limited Partnership(LPs). In some similar ways, the VCs and PEs have to raise money for their funds just like how startups have to raise capital. The LPs have typical make up of pension funds, insurance funds, institutional funds and very HNWI. It is quite common for the VCs and PEs to take a 1.5-2.5% annual management fees. This usually goes into supporting the yearly operational cost of the VCs and PEs including salary, office rental, hiring, etc. It is through the carried interest where VCs and PEs get their big returns. Typically, the VCs and PEs take 20% cut of the profits from the investments.
In a VC and PE setup, the typical mix of profiles in order of seniority; analyst, associates, principals/director and general partner/managing director. Analysts are usually the bottom rung of the ladder who has to prepare research and analysis, and any other administrative matters in order. This is typically the entry level position of VC and PE firms. Associates are the next career progression in line after analysts. Associates will gather more responsibility and involved in structuring the deals for the investment. Principals are one of the more senior positions where they have larger say to deals to invest. However, they would still require the nod given by the general partners who sits at the top of the chain. I see the General Partners as the figurehead of the fund. They are the don, the godfather who ultimately makes the final decision for the investment.
On the other end of the spectrum of the industry are the startups and companies who look to raise funds to invest into their company. During the process of fund raising, the companies could also be bought out and acquired by the PEs or corporations. This is considered rather aggressive as the original founders and management could be replaced. Striking the best deal requires the founders to prepare a negotiation tactic and develop the skill over time. Its a mix of charisma, diligence and wit. It takes time to understand the nature of the discussions and steering the conversations to ones advantage.
Private equity represents the first segment of investing in the financial world. It is the growth of the private equity industry and companies maturing that led to other forms of financial instruments such as loans, bonds, options, futures, etc. I hope to explain each of these markets and why they evolved over my blog in time.