In the past, when a startup firm was ready to expand, it often turned to the public market for investors to buy out the initial venture capital investment. However, as an article in the Economist noted last year (“American startups are less inclined to list on the stock exchange because they no longer need to,” September 29, 2018), many startups no longer do so: they are turning to the private equity market instead.
One reason for this relates to the types of startup being funded. Tech firms whose value is based around ideas typically need less capital for their expansion than do brick-and-mortar firms, so they can look to smaller pools of investors for financing. Moreover, for such firms, private equity may represent a better strategic fit: “Listed firms are obliged to make public how they are using their capital. That is fine for a firm with lots of fixed assets. … But when an ideas-led firm reveals plans for its spending, it gives away details of its business plan to rivals. It would be better off seeking funds from a select group of private investors.”
The numbers demonstrate this trend: in 2017, private equity accounted for 18.5% of all venture-backed exits, up from 10% in 2007, according to Pitchbook (“PE firms venture into new territory,” February 26, 2018). There are more startups that “are selling products and services in big enough numbers to justify PE interest” at the same time that there is a larger supply of PE looking for investment.
Private equity can take out venture capital …
With this larger pool of both supply and demand, PE firms are now looking beyond high revenue, high profit targets to “early- to mid-stage profitable and unprofitable companies that a few years ago would have been unable to secure interest from these buyout firms,” writes Ajay Chopra, who considered selling his NASDAQ-listed firm to a PE before turning to a strategic acquisition (“Private equity buyouts have become viable exit options — even for early-stage startups”). The competition can benefit the startup’s owners: “in the past few years, private equity firms have become aggressive buyers of private companies, sometimes bidding as high as or higher than strategic buyers.”
Moreover, PE firms that move into early-stage buyouts or investments are able to augment the startup’s management in areas where it needs help, such as in marketing or sales, to help them scale up. In these situations, the investors’ goal typically is “to increase the value of the underlying asset by augmenting founder teams with the buyout firm’s own operational experts, sometimes combining newly acquired assets with already existing assets to create a stronger whole, or doubling-down on promising products (while shedding less promising offerings) to unlock potential,” so the startup can move to the next round of financing.
… but private debt funds can, too.
VC investors may seek an exit for profitable but slower-growing startups in their portfolio that aren’t meeting their growth targets; and at the same time, these startups may be seeking to control their own pace of growth. As reported in the Wall Street Journal (“Ditch the Venture Model, Say Founders Who Buy Out Early Investors to Make a Clear Break,” July 17, 2018), a number of startups have left the equity track entirely and turned to private debt to buy out their VC investors.
This strategy “provide[s] liquidity to venture firms that are sitting on a backlog of startups and they free founders of pressure to meet venture investors’ high-growth expectations.” Firms such as Accel-KKR, a tech-oriented private equity firm, and O’Reilly AlphaTech ventures, offer debt financing, typically on the strength ofthe revenue coming in. “We know the value of that recurring revenue,’ said Samantha Shows, an Accel-KKR principal.”
Meanwhile, other startups are able to fund their own buybacks from company profits. The WSJ article mentions SweetLabs Inc., an app development startup. Last year it agreed to buy out its initial investors using funds from company profits.
“Darrius Thompson, co-founder and chief executive at 10-year-old SweetLabs, said the deal was better than private equity buyout offers he received, which had draconian terms, he said. His deal increases the value of shares for founders and employees, who hold common stock, by reducing the number of shares outstanding.”
This strategy reflects the recognition that many startups, while solid performers, will not be the unicorns their VC backers hope. “‘We’re continuing to grow,’ Mr. Thompson said. “We happen to be very good at generating revenue. The venture model doesn’t happen to reward that. The venture model’s really about growth.’”