Background
Private equity placements are minority (less than majority) investments in the ownership of private businesses that need capital for a variety of reasons, including: to expand operations; to restructure their balance sheets; to enter new markets; or finance major business acquisitions.
Generally, businesses that seek private equity funding generate revenue and operating profits but are not able to produce sufficient cash flows to support new initiatives, or to borrow needed funds from senior lenders.
Private equity investments can be in the form of ownership units (common stock, preferred stock, partnership units or LLC units, depending on the legal structure of a business); or in subordinated debt with warrants, also referred to as mezzanine capital, which are loans which require periodic interest payments and allow holders to buy business ownership units in the future for a de minimis price per unit.
Issuing new ownership interests in a business is usually very costly to existing owners in terms of the ownership give up, the likely loss of management’s prerogatives to run the business as they wish, and the potential for additional ownership dilution if the business plan, on which the new equity investment is based, is not accomplished.
On the positive side, additional equity capital allows a business to pursue opportunities it could not otherwise undertake. The important issue for existing owners is to weigh all of the costs and risks associated with the issuance of new equity against the potential increase in their personal wealth resulting from accomplishing the business plan that requires the new equity capital.
Private Equity Analysis
Key metrics in a private equity analysis are the estimated "pre-money" and "post-money" values of a business, and the ownership splits immediately after the equity financing.
The estimated pre-money value is the value of a business (that is, its enterprise value less its liabilities) before the new equity funding is added to a company’s balance sheet.
The estimated post-money value of a business is equal to the sum of the pre-money value, plus the amount of new equity investment, minus issuance expenses.
Subordinated debt with warrants is a hybrid security. The principal amount of the subordinated debt is not added to the post-money value of a company because subordinated debt is a debt obligation. It adds identical and offsetting amounts of assets and liabilities to a company’s balance sheet and therefore provides no net change in the value of a company. While the value of warrants "attached" to subordinated debt are expected to be valuable to subordinated debt investors, their value to a business at the post-money valuation date is immaterial.
Estimated pre-money and post-money values are unique amounts that are derived from the interaction of a large number of financial forecast assumptions and investment inputs. Accordingly, changes to assumptions or inputs will result in changes to both values.
Building a Private Equity Model
The amount of equity and/or subordinated debt sought in a private equity placement is usually an amount that bridges the gap between a conservative estimate of the amount senior lenders will lend a company and the total funding a company needs to achieve its long-term financial plan.
We suggest forecasting, by month, the first two years subsequent to the planned private equity placement to determine if the amount of equity capital sought is sufficient to withstand expected monthly variations in net sales and cash flow; and to satisfy intra-year compliance with debt covenants. Funding and compliance that may appear satisfactory on an annual basis may not be so during yearly interim periods.
- The sales, profit, asset and liability assumptions contained in a business’ five-year forecast. Because additional equity capital usually supports higher growth rates than can be accomplished without that funding, it is possible that the original five-year forecast (without the new equity capital infusion) should be adjusted to reflect increased business opportunities.
- The amounts, investment types and pretax annual rates of return (RORs) required by new investors on their equity and subordinated debt investments.
- The EBITDA multiple used at the end of the forecast period to estimate the gross value of a business at that point in time. That gross value, minus the liabilities of a company retained/paid off by the investors at the end of the investors’ ownership period, is a proxy for the pretax value of all investors’ future interests. That residual value is the amount that is divided among the original and new equity investors in accordance with their respective percentage ownership interests.
New investors annual pretax rate of return target on common and preferred stock investments is effected by a number of factors, including: the level of competition among investors for private equity investments; the perceived risk associated with an investee’s industry and the likelihood of achieving the forecast results; the rate of return target for the investor’s private equity fund; and possible dilution in ownership percent due to possible follow-on financing rounds.
Generally, the higher the pretax rate of return required by new investors, the lower the pre-money valuation of a company and the lower the percent of ownership retained by the original equity investors.
Providers of subordinated debt typically want to earn a total rate of return on their investment in the 15-20% range, with that return coming from the combination of quarterly interest payments and a share of the sales proceeds when a business is sold. As such, the higher the coupon rate on subordinated debt, the smaller the share of the sales proceeds paid to subordinated debt holders when the business is sold.
The EBITDA multiple used to value a business at the end of the five-year forecast period is a key private equity valuation assumption. Like investors’ annual pretax rate of return targets, EBITDA multiples vary over time due to changes is various economic, credit and competitive conditions affecting the market for business investments and acquisitions.
