Finding the Right Investment Partner (Fit Matters!)
We get it – for many founders (especially bootstrapped companies) private equity and/or growth equity firms tend to coagulate into one amorphous blob devoid of differentiation. Similar buzzwords on the websites (“deep sector expertise”, “operationally hands-on”, “collaborative approach” etc.), similar sounding inbound emails, similar sounding firm names – lots of variations of rocks and rivers (heck we are guilty of this too with “rock” in our name!). But the truth is there are a TON of differences between firms and not familiarizing yourself with these differences can result in major heartburn post-transaction. Below are some of the key categories you should be thinking about as you compare and contrast firms to make sure you’re thinking beyond just check size and valuation and about fit too.
Majority vs. Minority (or Hybrid)
Majority deal means giving up control. Minority means you keep control. Sounds cut and dry, right? Well, sort of. Yes – doing a deal with a majority firm means you don’t control your own destiny as much as you would doing a deal with a minority firm. But don’t fool yourself – there are nuances you need to be aware of. Minority investors tend to invest with more structure to protect their downside (e.g. liquidation preference) which can potentially eat away at your equity. Minority investors will take a Board seat, have veto rights. You may retain control but there’s a cost. For these reasons we find that it tends to be the case that founders who are initially inclined to pursue minority transactions tend to pivot towards more strongly considering majority vs. vice versa. Interestingly many firms have moved to a hybrid model to preserve optionality and so may be able to invest as either majority or minority.
Price (and Target Financial Profile)
Founders sometimes misconstrue private equity firms in particular as being “cheap” vs. strategics. While it’s broadly true that strategics tend to ascribe higher valuations due to synergies and a premium associated with 100% control there is a wide price spectrum across PE firms. At the top end of the range are PE firms who pay premium multiples but only for sterling assets. If your financial profile is top decile these firms will often be competitive with strategics. At the mid part of the spectrum are the growth-at-a-reasonable-price (“GARP”) firms whose valuations tend to fall into the fat part of the bell curve. These firms are looking for 20-50% type growers with 50th percentile plus KPIs. Sitting below the GARP firms are the firms that pay lower multiples for businesses that are growing <20% or so, maybe have some challenged metrics, and are generally overlooked by the GARP / premium profile firms. While these firms may pay a lower multiple at close perhaps your rolled equity will end up with the largest upside relative to today’s value as they tend to be a bit more hands on operationally in helping improve a business’s profile for exit. A good advisor will have a deep understanding of which firms sit in which category and curate your investor list accordingly as you’re wasting your time marketing to firms that aren’t a match for your profile.
Sector Expertise
Most firms in the early-stage segment of the software investing market market themselves as generalists. That said, many of them over-index towards certain software verticals (e.g. cybersecurity, fintech, healthcare IT etc.) and so it’s wise to understand how this might impact their ability to drive value for your own business. Other funds may not necessarily specialize in certain verticals but may be thematic style investors instead. I.E. perhaps looking for verticalized solutions that favor embedded payments to drive upside. Either way there are some key questions to be pondering as you think through who the right partner might be. Do they have experience in your sector? Do they understand the competitive landscape? Do they understand the sector-specific value drivers? Can they make channel partner introductions? Do they have a good feel for what the strategic acquirers are looking for at exit? Remember when you roll equity as part of the transaction, you’re ultimately placing a bet on the PE firm’s ability to help drive value for that equity. We would argue that ability is highly levered to just how well they know your sector and the underlying secular trends.
Firm Track Record
As alluded to above, your rolled equity’s value is greatly impacted by the quality of the PE firm you partner with. What does their historical track record look like? What do their hold periods look like? The last thing you want is to be stuck with is illiquid equity in a poorly performing company that a PE firm is holding well past the normal 4-5 year hold period. In fact, hold periods in particular are at record levels. Conversely, partnering with the right PE firm can realize massive upside at exit. As you get into the later stages of a process it’s important to diligence the various firms’ track records that you might be considering a transaction with. A good advisor will help you ask the right, pointed questions in a tactful way to get to informative answers as they’re certainly ways for PE firms to obfuscate poor performance with fuzzy math. Sometimes founders are wary of partnering with new funds but perhaps the founding partners have a solid track record at previous firms – and not only that but newer funds may be hungrier to prove themselves which could benefit founders selling to the debut vintage.
Operational Playbook
It’s no small secret that PE firms tend to take a hands-on approach to running companies. What is less obvious to many founders, however, is that the approach can vary dramatically and hence your experience working for any given PE firm post-transaction will too. You need to familiarize yourself with what each firm’s “playbook” looks like as it will have a massive impact on what the next 4-5 years of working for that PE firm will look like. Board meetings’ structure and cadence, senior hiring decisions authority, sales reps’ compensation framework, decided on hiring locales, potential for intra-portfolio crosspollination of best practices, operating partners’ oversight, intra-portfolio cross-selling of products…this is just a tiny sample of the various topics that will impact your day-to-day depending on the “playbook” of the PE firm you’re considering transacting with. Similar to ascertaining a firm’s track record, there are nuanced ways to inquire about a firm’s operational philosophy to balance becoming informed with not coming across as difficult to work with.
Investment Thesis
As mentioned above, firms tend to have an operational playbook that they apply to portfolio companies. A layer below that is what is the investment thesis specific to any new investment. The days of PE firms realizing impressive investment returns from simply buying and holding are long gone. The secular increase in early-stage technology funds has created more competition which means when a PE firm is considering investing into your company, they probably have developed a detailed investment thesis specific to your company. It’s important to understand what that looks like because similar to their operational playbook it will have a large impact on your post-transaction experience. Are they considering “buy and build” via bolting on smaller targets? Do they want to lean on organic growth with R&D to fund new products? Do they want to shut down an underperforming product? Are there adjacent markets they want to expand into? New geographies? You want to make sure you’re bought into whatever the strategy will be because especially in a majority deal scenario once the transaction closes, you’re going to be expected to execute accordingly, and the value of your rolled equity will be subject to the effectiveness of that strategy.
Personality Fit
One of the more overlooked aspects of an investment firm’s fit is personality fit. What is the team going to be like to work with as people outside of just writing a check and advising on strategy? Have you spent enough time with them outside of the formal management presentation setting to get a real feel for what their like as people? This may sound corny, but it really matters. You’re signing up to partner with this firm for the next 3+ years…you wouldn’t hire even a junior employee without getting a feel for personality so why should bringing in an investment partner be any different? This is obviously an extremely subjective question and so some firms’ teams may mesh well with certain founders and others not so much. A good advisor will of course facilitate the right dialogue to help you figure out personality fit but should also have a good understanding themselves for what firms are like once you peel back the formalities.
Conclusion
Hopefully this was helpful in thinking through some of the attributes that you should be thinking about as you seek out the right investment firm to partner with. You should ensure your advisor is thinking through fit beyond just check size and valuation. Ultimately this will matter not only to your day-to-day enjoyment of working with a new capital partner but the value of the rolled equity at exit as well.
