Get ready for private equity expectations
Abundant capital and tantalizing returns have given private equity (PE) firms a voracious appetite for tech company deals, and now they’re looking at the early-stage firms on the table.
Earlier this year, our PitchBook survey showed that PE software deals hit a record $56.7 billion in 2020 — five times the level in 2010. Growth-stage companies accounted for part of that jump. “Investors have a lot of money available, and they want to put it to use — to go for the big returns that venture capitalists are reaping,” said Andrea Schulz, Grant Thornton technology audit partner. Venture capitalists are often more willing to bet on early-stage companies, and they are often seeing 20% returns.
In today’s strong market, those returns come even faster and companies roll from one round of funding to the next as they rapidly raise market capitalization. By the time investors notice that a young business has established solid income with a path to success, the buzz from other investors is intense. “To follow the money, and the transformative role of technology in all industries, many PE firms are moving ‘down market’,” said Steven Perkins, Grant Thornton national managing director for technology, media and telecommunications. “PE is looking to tap into early-stage tech companies, and many of those companies are staying private longer.” Early-stage investment can infuse companies with cash much sooner than they would traditionally expect, creating a big boost to move tech products forward. To tap into that investment, though, tech companies need to understand what PE firms are seeking and the questions they are asking.
What investors are seeking
Often, start-up companies are little more than an idea for a product or service that’s still being developed. However, “growth-stage” companies have moved past that phase. “Growth-stage companies actually have a product that they believe is viable, and they’re now building a customer base from it,” Schulz said.
Usually, a growth-stage company is starting to generate revenue and prove its initial market. It might only be one product, for one customer segment or territory, but they’ve proven their potential. “They are looking for funding that will help them scale their operations, build the next set of products in an adjacent product area, make an acquisition that complements their product, take a horizontal product down into industry specifics or go from the U.S. to Europe, which is usually the first port,” Perkins added.
PE firms traditionally held off until companies had further established their business — but now, they are making tech deals at a record-setting pace and looking for small companies with big potential. However, these small companies also need to answer some big questions.
What investors are asking
Technology companies often come out of the gate with no more than a skeleton crew of the software engineers who developed the program they now want to sell. That’s fine for a start-up. But, when PE investors come knocking, companies need to be well-versed in the administrative and financial aspects of their business — because that’s what bigger investors are used to seeing.
To prepare for quick investment and growth, tech firms must be poised to answer complex questions and have a solid handle on its finances. Growth-stage companies should do three things to prepare for discussions with PE firms:
- Organize your business and financial information, to present a clear picture of the way your company runs.
This will involve some key decisions: Do you have an enterprise resource planning (ERP) system to collect and organize your business operations? Do you want to add one or more full-time professionals to your company’s staff to handle administration, or do you want to contract with an outside firm that specializes in back-office operations instead? - Be able to show quality of earnings as a route to future success.
A company’s quality of earnings determines how it accounts for net income — whether from increased revenue, reduced costs, or from other accounting techniques. Investors use the data as a guide for projecting the company’s future earnings, which helps them decide if they want to put their money into the business. Audited financial statements require a lot of preparation and a couple of months of lead time, but growth-stage companies need to go through that process to demonstrate that they have defined accounting policies, a disciplined approach to spending and can show a good quality of earnings. - Build relationships with potential investors and learn which ones can best help your company grow.
Be selective about which investors you choose. They will likely take positions on your company’s board of directors and will have a say in setting the tone and the direction for your company’s operations.
Think big — think of your company as the size it will be in the next phase, because proactively establishing a solid base of administration and a robust data trove is essential.
“At many growth-stage companies, I’ve seen that the necessary investments aren’t being made in the back-office head count. It’s all about the engineers,” Schulz said. “Growth-stage companies need to step back at this point and think strategically about how they’re going to build out their back-office accounting, if they’re going to be entertaining these types of investors. That’s critical.”
Whatever comes next
Given the accelerated growth and shifting market factors of today’s tech industry, PE investors might also want to make sure that your business is ready for whatever comes next — an equity investment, debt transaction, merger, acquisition or an initial public offering (IPO).
To prepare for quick investment and growth, tech firms must be poised to answer complex questions and have a solid handle on its finances. Growth-stage companies should do three things to prepare for discussions with PE firms:
To help prepare these answers, consider the following:
- Understand cybersecurity risks.
Investors often ask about cybersecurity and other potential risks. Perkins suggested that companies should consider the following questions: What are the risks around data privacy, and what are the risks around cybersecurity? What has the company done to harden its infrastructure? Cybersecurity is particularly crucial for technology companies, Schulz said. “If you have a misstep in that arena early on, that could be very costly. That’s basically a one-way door. You can’t go back if you have a big implosion there.” - Identify potential efficiencies.
Now is a chance to take action or make advance plans to integrate services so that you can achieve economies of scale as your company grows. - Track tax exposures.
Even as a small company grows, it’s important to stay ahead of tax exposures. Tax analysts can also help you find research and development tax credits or other opportunities. - Prepare for the Financial Accounting Standards Board (FASB).
FASB sets generally accepted accounting practices (GAAP) for the U.S., and the Private Company Council is the primary advisory board to the FASB on matters relating to privately owned companies. Prepare for these accounting standards to help ensure that you are ready to answer questions from both investors and regulators. - Prepare for further changes.
Consider speaking to experts who maintain regular contact with the U.S. Securities and Exchange Commission, the Public Company Accounting Oversight Board, industry committees and related organizations to stay aware of the changing regulatory landscape. Advisors can work with your company’s owners and founders to help translate changes into your overall strategy, and goals that meet your company’s needs, while also satisfying regulators and investors.
If you call upon an advisory firm to help plan your growth, choose one that will be able to scale with your company. Advisors must understand the full lifecycle of private companies and support them through their IPO or other next phase. Ideally, the firm will also work with PE investors, and might be able to make introductions or help broker deals.
Preparing to seek investment during the growth stage can be rigorous, but investors are hungry for new opportunities and tech companies can reap big benefits if they answer tough questions. These rigorous questions and the standards they involve also serve as preparation that helps companies get ready to scale and succeed into the future.
Contact:
Andrea Schulz
National Managing Partner, Technology Industry
Andrea Schulz serves as Grant Thornton LLP’s national managing partner for Technology. In this role, she oversees the growth and operations of the firm’s Technology industry practice, which encompasses a full range of audit, tax and advisory services.
San Jose, California
Industries
- Technology and telecommunications
Service Experience
- Audit
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