Owners of SMEs are without doubt worried about Brexit uncertainty, the state of the local and global economy, and even about tax breaks such as Entrepreneurs’ Relief being removed. This has led some to consider ‘de-risking’ and selling a stake in their business (see Entrepreneur Club article Should you sell up?).
Jeremy Furniss, partner at Livingstone, an international mergers and acquisitions advisory firm says he is definitely seeing a growing number of entrepreneurs considering a partial exit rather than a full exit, and exploring the use of private equity (PE) and other forms of investment to do this.
But, he says: “The most common rationale is a much more positive story than simple de-risking. While there has been a great deal of discussion around the possible removal of Entrepreneurs’ Relief, it isn’t in our experience the overriding factor driving business owners to transact. Rather, they are looking for investment that can help them double or triple the value of their business, the ultimate benefits of which should far outweigh any loss of a tax relief on a portion of their shareholding.”
Whether the primary rationale is growth or de-risking, private equity could be an option. These funds typically buy a stake in a business (anything from around 20% through to a majority stake, depending on the deal rationale), work with the business to increase its value (hopefully), usually for a period of four to five years, and then look to sell their stake to a new investor or acquirer of the whole company.
Paul Cannings, partner at YFM Equity Partners – which has a portfolio of over 40 UK growth businesses and invests up to £10m per company – says they fully understand this ‘de-risking’ motive of owner-managers, and can certainly help. But their involvement does come with some caveats.
The deal must work for all parties
Paul says: “If an owner comes to us and says: ‘I am really ambitious. I have a clear plan, a great team, I want to stay on as CEO and drive the value of the business. But I also want to protect my family and sell 25% of my equity and put that money in the bank.’ That feels right to us and could be an attractive proposition.”
He says this situation typifies one of the most important things about any private equity deal – aligning the interests of management and the private equity investor upfront. In this case, both parties want to grow the business after the initial deal, en-route to an eventual full exit. “We have been through these journeys many times, we can bring a wealth of experience to help the business get ready for the next stage of growth, and then when it is time to exit, we have loads of experience on how to position the business for that.”
However, says Paul, a deal would be much harder if an owner wants to semi-retire, take three-quarters of their money off the table, and stay on as CEO without ambitious growth plans. “In that type of situation, we aren’t aligned. The owner is effectively a seller. For private equity to play a role, the owner should probably think about finding an ambitious CEO to replace them, and maybe step back into a non-executive role with a small equity stake. As private equity investors, we would then be looking at this as investing in the new team to take the business forward, rather than just being an exit route for the current owner.”
What to expect
Paul says one of his top tips for entrepreneurs is to do their research on the investor: “We are going to be assessing you and doing due diligence on your company (see Entrepreneur Club article ‘Ten steps to due diligence readiness’). But you are also taking on a partner, for the next three to five years at least, so you need to make sure that partner is right for you. You should be taking references on the private equity firm itself and the individuals you will be dealing with, talking to other people they have invested in, and especially, finding out how they behave when things go wrong or when things go much better than expected.”
Paul does say that owners should also expect to see some day-to-day changes in the business. The private equity firm is likely to insist on changes such as more formal governance procedures, formal board meetings, more detailed budgets and cash flow forecasts, and putting a strong, dedicated finance director in place. He says: “While these can feel like big changes, they are actually part of the value a private equity partner will bring and also add to the value of the business.”
It is also likely that the private equity investor will insist on robust risk mitigation measures such as key person insurance, which is a life policy taken out by the company on a key executive's life. This protects the financial interests of all shareholders if the executive dies and the value of the company declines as a consequence.
Jeremy encourages entrepreneurs to think hard about what life will be like post-investment. He says: “A business owned by one individual or by one family will be used to having their destiny entirely in their own hands. They might find the idea of sharing ownership quite concerning. This can work well if the interests of the owner-manager and investor are aligned. But with PE investment, owners will to an extent be losing control over their destiny as the new investor will no doubt exert influence over the business.”
He points to one area in particular that owners should give some thought to in advance, which can be a major change and is often a cause of deal negotiations breaking down – that of ‘minority protections’.
Jeremy says: “Because private equity investors often take a minority but significant stake in a business, they will insist on having a say over key strategic decisions – such as making an acquisition, a very large capital expenditure, or CEO pay. Also, they will want the right to be able to step in and take action if things start to go wrong (and to be fair we are really only talking about when they go significantly wrong). This might involve the right to fire the CEO, or under certain conditions, take over management of the business altogether. Even though this is the worst possible outcome for the investor, that potential loss of control can be too much for some entrepreneurs to contemplate.”
If a private equity deal is done, owners will also need to give consideration to how their personal financial planning is affected, in addition to navigating the changes to their business outlined above. How the proceeds of a partial exit will be invested has to be taken into account, as well as updating financial retirement plans to fall in line with the planned full exit date. The adequacy of protection insurance such as life and income protection will also need to be assessed.