Two-thirds of UK businesses are currently family owned (accounting for a quarter of UK GDP and employing over 12 million people between them). There are potentially a significant number of companies at any one time working towards securing either private equity funds or growth capital from investors to assist in the next stage of their development. But in the run-up to such a transformation, what should business owners focus on, if they want to be attractive to a new equity backer?
The truth is that mid-market private equity investors look at a wide array of factors when considering making an investment, some of them financial, and some much broader. Tim Nye, a partner in the corporate department at Trowers & Hamlins, says: “From a financial perspective, an investor will look for predictability of earnings, with recurring revenue streams being very attractive, and the solidity of the underlying customer base. Statutory or needs-based revenue streams in areas such as health and social care, whether from local authorities or NHS trusts, give a defensive element to the revenue stream that is always attractive to investors.”
As well as drilling into revenues, investors will also be keen to understand the history behind the current numbers, seeking to identify an enduring growth story over time as opposed to a recent boom that may be followed by bust.
“Aligned to that are some non-financial characteristics,” says Nye. “The key one being the management team and whether that is strong and cohesive.
"The financials are a snapshot of where the business is and where it has come from, but it is the future that an investor is focused on and that is represented by the management team."
Potential backers will seek assurances that the management team has the talent, market knowledge and foresight to remain at the forefront of developments and that they are all pulling in the same direction with the commitment and motivation to drive growth.
Another factor that routinely features on an investor’s shopping list of must-haves is a diversified customer base, to avoid any over-reliance on either a single client or a single industry sector. More defensively, most will focus during due diligence on the possibility of regulatory or legislative change that might impact the business, because such developments have the potential to cause significant harm. In recent years we have seen valuations in certain sectors impacted considerably simply by politicians threatening, for example, caps on the rates of interest that can be charged by payday lenders, caps on the prices that health and social care suppliers can charge the NHS and caps on prices chargeable by energy and utility providers.
Turning to the bigger picture, there will be considerable focus given to the potential for the business to expand, whether into new markets, geographies or products and services, and also to the exit strategy. Nye says: “Typically these investors see themselves as custodians who, after a period of time, will want to realise their investment and move on. They will look for the existence of aggregators or large strategic buyers, and the prospects for an initial public offering, by considering recent exits by competitors and what returns those have generated.”
Outside of the private equity space, where investors are usually looking at businesses that have proved a concept and are now looking to build that out, there is a whole other set of owner-managed entities that are at a much earlier stage in development. These start-up businesses are typically yet to build a convincing track record and so represent a bigger risk, making them attractive to a different set of investors, including high net worth individuals, private offices and smaller venture funds.
Adrian Jones, a Trowers corporate partner, says: “These types of investors are focused on predictions of growth, because the business probably has limited or no turnover today, which means the business owner has to convince an investor of his or her vision and how that is going to be achievable.”
In this space, the challenge is much more around articulating an ambition, explaining how the idea differs from current offerings available in the market and producing a robust business plan showing the value creation on offer to an investor.
“Investors are looking at the potential for growth and the timescale to realise a return on their investments,” says Jones.
“They are looking to the founder and the managers to see if they have the capability to deliver a transition from a start-up into a fully-fledged business.”
One fundamental skillset that investors are seeking at this stage of a business lifecycle is the ability of management to lead change. “There comes a point at which achieving the growth that everyone wants requires bringing in outside help,” says Jones. “The more successful businesses that we see clients investing in are those that can smoothly manage that transition and bring in professional management and nonexecutives where needed.” Investors may be keen to inject their own strategic boardroom expertise and support the professionalisation of key functions with enhanced financial analysis, digital capabilities or marketing skills. Owners seeking investment need to be ready to welcome and embrace that new level of sophistication.
Whilst many investors may expect to professionalise practices and procedures, good corporate practice is important to potential investors, who will typically scrutinise a company’s corporate governance arrangements as part of due diligence. They may not necessarily walk away from a deal because policies and procedures need improvement.
Nye says: “There’s a level of due diligence that is always done on an investment and a level of expectation as to how a business should be run. A mid-market investor is going to look at whether there are regular board meetings, are recommendations implemented, are there protective practices in place such as an anticorruption policy, what do the employment policies look like and are they adhered to, and so on. But they are not looking because they won’t invest if those things are not right. Rather, it is about understanding how much may need to be changed and understanding what the impact of that change is going to be, particularly on the culture of the business.”
That said, any owner-manager seeking external equity would be well-advised to consider what investors might be focused on ahead of time,
"Every business should go through a bit of pre-sale grooming – a kind of preinvestment audit"
Jones says. “The intention is to ensure that the sort of things that an investor will want to see, such as customer contracts, employment terms, details of IP ownership are present and correct. This is an opportunity to fill in any gaps and prepare answers to inevitable questions. It gives people a warmer feeling that if they ask questions, proper answers will be forthcoming and can avoid scrabbling around trying to ‘fix’ things in front of an investor.”
At the end of the day, most investment decisions rest on the strength of the relationships built up between management teams and those looking to inject capital, so putting time into preparations is rarely wasted.
