Many SMEs are turning to private equity investors, rather than banks, family and friends, to fund expansion into overseas markets.
Cameron Cooper finds there can be benefits beyond money in the right deal but, unlike the ethereal winged variety, these angels will expect to profit from the help they offer.
Before turning to private equity investors for capital to expand his business, Paul Angell courted all the usual suspects: family, friends, banks, and even "a benevolent landlord".
"I did it very tough," says Angell, the founder of Life & Balance, a Sydney-based business that offers life-enhancing services such as yoga, pilates, chiropractic and natural medicine. "Like most people in my position, I had no money. I didn’t own a house, so I didn’t have any second mortgage that I could get equity and secure a loan against."
Aid came from an unusual source. "I started the whole business with $1000 and a benevolent landlord who gave me a deal on rent," Angell says. "It happened to be a church actually, so you expect them to be nice."
With consistent annual growth of 20 to 30 percent in recent years, Life & Balance needed more money to keep expanding and improving its operations, which have tapped into the demand for ‘well-being’ services. Angell has taken a path many small and medium-sized businesses go down: securing private equity investors.
He sees private equity as a preferable option to using the "bank of friends and family".
"It can screw up all your relationships if you do that wrong," he says. "So if you want to protect your friends and family relationships, you’ve got to develop other strategies."
For many SMEs, whether they are start-ups or more mature businesses, a lack of working capital is often a barrier to success. Bringing in a partner to inject funds into the venture is a real option for some, particularly at the larger end of the SME scale.
Private equity refers to finance that is given in exchange for a stake in a business, and is usually provided over a three to seven-year period. The investors are typically business ‘angels’ or fund managers who invest capital on behalf of institutional clients such as superannuation funds and insurance companies.
They become part-owners who expect a rate of return from their investment that will vary with the business’ risk profile: high-risk seed and start-up deals often require a minimum return of more than 40 percent a year, while returns for more mature business ventures may drop to the range of 20 to 30 percent.
The type of equity capital describes the stage of growth that is being funded, from seed and start-ups to management buyouts (using investors’ funds to acquire a business or product line) and management buy-ins (acquiring a business with a view to managing it themselves) through to pre-listing and stock market listing. As a guide, private equity and venture capitalists invest between $1 million and $10 million.
It’s important for businesses to engage in tough negotiations from day one over the equity they give away. Handing out too large a stake can limit the chances of bringing in other, larger investors at a later date when international expansion may be on the agenda.
SMEs considering a private equity deal are advised to consider a range of issues. Should they go for local investors or overseas funding? What are the pros and cons of bringing in outside managers? And how can such deals affect a business owner’s control?
Whatever the scenario, SMEs have to be prepared to go under the griller. Most private equity investors and venture capitalists view hundreds of business plans, so SMEs have to present a compelling case.
Mike O’Neill, chief executive of the Executive Connection, a worldwide organisation of CEOs, says bringing in outside skills and funds can transform a business. He warns SMEs, however, to expect would-be investors to drive a hard bargain.
"Anyone investing in your business is going to want a return on it," O’Neill says. "And the only reason they are going to put money into your business rather than the stock market or bank or property investment is because you’re going to give them a better rate of return."
Be prepared, too, for investors to want a say on management decisions. "While the business is performing well, the investor will stay away, but the moment there is a hiccup they’ll ask questions."
For companies seeking international expansion, a choice between local and international private equity partners will have to be made. O’Neill advises businesses entering non-English-speaking markets to link up with partners in the target country. China, for example, has a legal system that differs substantially from Western counterparts, and contracts often have to be translated. In this instance, O’Neill says, a Chinese partner "can bring a wealth of experience to the table".
Even in the US, where language and the law is not such a problem, an American investor can access networks that speed up and smooth out the business process. O’Neill notes, too, that the US has lower interest rates than Australia, so American investors may be content with relatively lower rates of return than Australian counterparts.
Katherine Woodthorpe, chief executive of the Australian Private Equity and Venture Capital Association Limited, says private equity is an increasingly popular form of funding for SMEs. She says the sector is becoming more sophisticated about opportunities to access capital and is looking beyond the old model of "getting a government grant and limping on until they could list on the stock exchange".
"While the person in the street is sceptical about the long-term patience of private equity investment, compared with being on the stock exchange it’s a very patient beast."
On whether to opt for domestic versus international investors, Woodthorpe says it is a 50:50 decision, but recommends that any Australian investors bring advisors and board members who can actually help with that international growth. "Quite often by going overseas [for funding] you are jumping into the lion’s den, whereas a lot of Australian venture capital fund managers have a lot of experience in helping companies grow into their overseas markets."
The cost of overseas board meetings can also be a drawback with international investors.
It’s clear that more and more SMEs are turning to private equity investors rather than going cap in hand to banks. An Ernst & Young survey of 208 private companies reveals that 25 percent planned to raise funds through private equity or venture capital options last year, compared with 15 percent for the year before.
Patrick Winter, managing partner of strategic growth markets at Ernst & Young, says increasing sophistication of capital markets and greater media coverage of private equity deals has led to greater SME understanding of this funding option.
"We only see private equity growing," he says. "It is now another form of capital financing that properly coupled with debt financing can be extremely advantageous to SMEs looking to grow."
Winter says businesses eyeing a trade sale or stock market listing are using equity funds for "bolt-on acquisitions" that can lift revenue streams and improve governance and accountability measures. He adds, though, that many family-owned and operated businesses find it confronting to suddenly be answerable to business partners.
"Often the difficulty for the owner is their pe
rceived loss of control. That is a harder thing for many SME owners to come to terms with than you may think."
The key, Winter says, is for business partners to have a "shared vision". Most private equity partners will want to see a business sold within a few years, whereas an owner-operator may want to hand the business down to their children. "The clearest advice we try to give SMEs is to have that discussion upfront," Winter says.
On the subject of domestic versus international investors, Winter advises a "horses for courses" approach for businesses looking to expand globally. For many SMEs, the jump to taking on any private equity partner is often big enough without the added cultural pressures of striking a deal with an overseas investor.
"Generally, domestic businesses will look for domestic equity partners," Winter says. "But sure, if there is an added benefit from an equity partner that can provide distribution networks overseas, that is great."
Money aside, the big advantage of bringing in a private equity partner is the potential to bring other skill sets to a business such as accounting, governance, book-keeping and management experience.
Thomas Taylor, an executive with private equity firm Tin Chook, says SMEs stand to get ongoing management advice from such alliances at a relatively cheap price. He stresses, too, that in putting their own money on the line, equity firms are eager to help a business succeed.
"We feel that we are much more committed than someone who may come in and give impartial advice that may or may not work."
In assessing investment targets, Taylor says Tin Chook often places more importance on the business person than the business itself. "If you are going to weigh the criteria, it’s more towards the calibre of the people than the flashness of the business model," he says. "A good-quality person who is committed and hardworking will make an average idea work."
For those considering getting a private equity partner, Taylor warns that many SMEs fail to provide enough evidence of the business’ market potential. A vague, unsubstantiated prediction about getting 1 or 2 percent of market share in a particular sector is not sufficient.
At Life & Balance, Paul Angell has a business plan that envisages rapid national expansion through a franchise model and, ultimately, an international presence. He hopes private equity partners will continue to play a key role in the growth of the business.
He is an advocate of using investor alliances to get more than just money.
"The main thing I was looking for besides money was skill sets that I don’t have," Angell says.
He advises SMEs seeking private equity investors to ensure that both parties do their due diligence before signing on the dotted line. And he urges business owners to strike deals that ensure they still control day-to-day business decisions.
"I had no problem giving away equity," he says. "I just didn’t want to give away control."