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Insight Newsletter
Financing With Growth Equity
Equity capital could be an alternative for financing a rapidly growing business.
by Michael J. Black
The relationship between the passage of
time and increase in business value does
not follow a smooth curve. At certain
times in the evolution of a business, the next
step can result in an outsized change in the
value of the business. Expansion of a product
to a different channel of distribution, the creation
of a new manufacturing plant, or any
number of strategic initiatives might deliver
the next breakthrough. Taking advantage of
those value-creation opportunities typically
comes with some additional risk, either operational
or execution risk or, because such opportunities
almost always require the investment
of additional capital, financial risk. It is
at this inflection point that growth equity can
be used to raise the business to the next level.
Appropriately, business owners look first
to their lowest cost of capital source, the company’s
banks or senior lenders. Most lenders
seek to fund incremental growth, but may shy
away from funding sizable new growth initiatives,
particularly those that require outsized
investment with uncertain timing for the realization
of cash flow from that investment.
Mezzanine (subordinated) debt offers
another source of capital if senior debt is approaching
its reasonable limit. Although expensive,
the potentially high returns on capital
at this stage of the company’s development
generally justify the cost of mezzanine. Some
owners may understandably resist coupling financial
leverage together with the execution
risk of the strategic initiative given the myriad
of uncertainties in the business outlook.
Therefore, if the level and timing of cash flow
from the growth opportunity is uncertain, the
prudent alternative might be equity capital,
which does not have contractually scheduled
calls on cash flow.
Growth equity is a specialized subset of
the trillion-dollar private equity market. In
addition to private equity, investors might
include wealthy families or foundations. The
parameters of growth equity vary considerably
depending upon the desired use of proceeds
and the capital provider’s industry, size,
and structure preferences. Typically, but not
always, growth equity takes the form of a minority
investment, with the majority (again,
not necessarily all) of the capital going into
the business. The central tenet in a growth
capital investment is that the funds unlock
latent growth potential, creating a sustainable
stream of incremental cash flows that increase
the value of the enterprise.
If an opportunity exists to create incremental
enterprise value (expected returns >
the cost of capital), and taking on more debt
is not available or is not appropriate, business
owners should consider joining forces with
a growth capital investor in order to execute
the plan. Matching the growth investor with
the appropriate company situation involves
several considerations, the most important of
which we address briefly here.
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Growth equity is a specialized
subset of the trillion-dollar
private equity market.
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USE OF PROCEEDS
Growth equity investors generally target
their investments to achieve the business
growth initiative, not to generate liquidity for
selling shareholders. In fact, growth capital
investors typically require that some portion
of current owners’/managers’ capital remain
at risk. That being said, some investors make
the case that by freeing the entrepreneur (or
inactive shareholder) from fear of wealth loss,
business prospects improve through pursuit of
prudent (if slightly more risky) growth opportunities.
In all cases, a need must exist for capital
to address new markets, targeted acquisitions,
facility expansions, or similar strategic uses.
STRUCTURE
Growth equity investors act more like financing
sources than owners, therefore their
objective is not to "take over the reins." The
most common investment by a growth equity
investor takes some form of preferred minority
equity. Typical terms include:
- The new money occupies a priority position
in the capital structure relative to the
common equity owners;
- The new investor is granted rights to a
priority return, typically in the range of 6-8%
that accrue if cash flow is inadequate to pay
on a current basis.
- Although granted certain preferences,
the new equity converts to common for all
"economic" events.
A smaller group of growth equity investors
invest in control positions, and some acquire
entire companies. No set formula or standard
terms exist for these securities and most investors
customize the specific solution to accommodate
the particular situation.
CORPORATE GOVERNANCE
Business owners must also seek agreement
on company governance and what decisions
must have the consent of investors. The minority
growth investor trades receipt of a priority
position and a preferred return for limited
influence over the conduct of the business.
Although they do not intend to control the
board of directors, minority investors require
certain controls on major corporate decisions
such as:
- Operating and capital budgets,
- C-level executive changes,
- C-level compensation,
- Mergers and acquisitions,
- Divestiture of assets,
- Borrowing money beyond specified limitations
- Material capital expenditures
- Divergence from strategic plans and/or expansion into new lines of business.
These decisions generally require the approval
of the minority investor (if there is an
otherwise affirmative vote among the majority
investors). Investors do not want these
provisions to dominate the nature of the relationship,
but put them in place to protect the
integrity of the business.
EXIT DYNAMICS
Growth capital investors, like all institutional
investors have a contractual responsibility
to return capital and profits to their limited
partners in a specified time period. As a result,
minority investors require a "certain" exit plan.
Typically, this takes the form of a put feature
triggered by the passage of time and/or by a
serious deterioration in business performance.
The value of the securities subject to the put
is often at fair market value determined by a
third-party appraiser or may be specified by a
formula based on performance. As a practical
matter, investors and owners almost always
decide together on the timing and type of exit
event regardless of contractual obligations.
In addition to the economic and structural
issues identified above, matching a particular
company or situation with the appropriate
growth investor also involves a compatibility
of styles, a similar investment horizon, a likeminded
culture for making decisions, and an
alignment of risk tolerance. Partnership
dynamics permeate all aspects of the investment.
The role of the financial partner impacts
the specific structure of the investment.
Required involvement ranges from an inactive
or passive investor that simply observes at
board meetings to partners with significant operating
expertise that will weigh in on strategic
and operating decisions. Generally, the
more influence the growth investor has on operational
matters, the lesser need for certainty
of return. All parties must concur on the desired
level of partnership to establish the bedrock
for success of any growth investment.
Successfully employing growth capital
rests on the ability to match the field of potential
investors to appropriate company situations.
The culture and desired use of funds
by existing owners must synchronize with
the level of partnership and appetite of the
financial investor. While this requires a high
degree of understanding and a close working
relationship between existing owners and a
new investor, a healthy partnership results
in funds being deployed to the betterment of
the company’s prospects. Once these prospects
are realized and monetized, the owners
collectively benefit from the creation of increased
economic output and the corresponding
higher company valuation. Owners who
finance expansion opportunities with growth
equity must weigh the loss of total and absolute
control against the potential benefit of a
much larger and more valuable enterprise.
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