Private Equity Lessons for the Start-up or Entrepreneurial Company

The November issue of the Harvard Business Review[1] poses a tough question to the management of public companies: “What If Private Equity Sized Up Your Business?” The question comes on the heals of recent revelations that public companies are facing increased scrutiny by private equity funds both favorably as, for example, an acquisition target or adversely, as a mismanaged and underperforming asset in need of reform. The article goes on to identify five trends that develop when Private equity gets involved.

The purpose of this article is to highlight the premise upon which these five trends are based. Understanding this premise will lend valuable insight and strategic fodder for Start-up or Entrepreneurial companies.

1. Increased shareholder value through better cash management.

Business is largely the exploitation of resources to generate value. Capital is often, if not always, the catalyst for unlocking the potential value of various types of resources, e.g. assets, people, intangibles. In al practical sense, capital is synonymous with “cash.” The trend inn private equity against regarding cash as a “rainy-day” fund or a “war chest.” Therefore proper management of cash to return the highest value to shareholders is to balance “husbanding of near-term use” fro strategic R & D and acquisitions against the value in returning some cash to investors.[2]

2. Understanding the true cost of capital.

For the entrepreneur, this is a fundamental question. In order to grow a business, companies often have two choices: selling an ownership interest in the company or borrowing money form others, often on less-than-preferable terms. While the HBR article focuses on the analysis of credit ratings and borrowing parameters affecting public companies, the premise is equally applicable to small or entrepreneurial ventures: the cost of capital will affe4ct your ability to leverage that capital. For the entrepreneur, in a private equity context, this essentially translates to how much money do I need to execute my plan and how much control am I willing the cede the acquire it?

3. Long term profit and value growth come from operational performance not just efficiency.

“If you fail to plan, you plan to fail.” Operational performance doesn’t just happen. It occurs by design. Chart a strategic course to improve operational performance, but don’t stop there. Evaluate achievement through subsequent monitoring of its implementation. Private equity firms are often know for “near continual review and revision,” measuring progress against key indicators. Although rigorous control of costs is typical, there are no generic formulas. One suggested method is to measure similar kinds of performance gains against its peer group. Lastly, companies need a fair amount of self-evaluation. Looking within, a company should look to non-core businesses to determine whether such businesses should be jettisoned or whether additional funding will lead to new markets or competitive advantages. Looking outside, management needs to target acquisitions that either “consolidate the company’s market position or realize economies of scale.”

4. Focus Incentive Compensation on Top Executives.

Private Equity focuses attention on the method with which the top executives are compensated with equity as opposed to just cash. There method commonly follows a two-tier approach. First, compensation needs to be focused in those who are the proven drivers of company performance, not simply broadly spread across company employees. The rationale is that these employees have the greatest direct contribution to shareholder value.

Second, large equity packages are often triggered by proven successes that achieve a financial goal for the Private Equity backer. Keep in mind that for every investment, Private equity is looking for a “Liquidity Event” that will inject new capital into the business and free up the investors to profit from the increased shareholder value. In order to balance against wind-fall profits and serendipitous accumulation of ownership, companies should place restrictions on stock options such as financial performance targets.

5. Maximize Advisor Influence.

While larger, public companies are required to have Board of Directors composed of members who fall into a some-what limited class, non-public companies are advised to create similar Boards. Utilise a broader class of prospective Board members to accumulate persons with extensive industry operating expertise. To get the most value out of these Board members, expertise and time should be structured and organized to increase effectiveness.
[1] www.hbr.org
[2] The article highlights recent changes in the Tax code that ameliorate the different tax treatment received by cash dividends versus stock repurchases as it affects shareholders.