Entrepreneurs know that even the smallest of small businesses can be expensive to operate. In many cases, obtaining private equity through an "angel investor" or another source of business capital can help a nascent business grow into something great.
But what is private equity? How do entrepreneurs access it, and what are its risks and benefits? Learn more about private equity from the investor's perspective.
What is Private Equity?
Private equity broadly refers to any form of private financing, where an individual or organization with enough financial resources can devote a portion of them to a business in exchange for a future return on their investment.[1] Some private equity investors are known as "angel investors," or those who swoop down to provide some cash flow to a new or struggling business.[2] Others are much more structured and primarily focus on buying out businesses that are currently public. [3]
Many large companies that have declared bankruptcy ultimately wind up being sold to a private equity firm, which then can opt to revive the business or parcel out its assets.[4] (Toys R' Us and Payless ShoeSource are two recent examples).1, 2
Risks and Benefits of Private Equity
Some of the main advantages of private equity are its flexibility, easy access to liquidity, and privacy.[5] Publicly-traded companies often operate at the whim of their shareholders,[6] which can sometimes stifle the types of activities that can lead to growth and innovation (but aren't immediately profitable). By having the freedom to try—and fail—without worrying about the wrath of shareholders who are concerned about their dividend payments, companies can truly experiment.
However, these benefits aren't without some drawbacks. Private equity firms earn their income through management fees.[7] These fee structures can contain some steep rates or large lump-sum payments if the business is sold.
What Should Investors Consider?
Private equity investing can present a 180-degree difference from stock investing.[8] It can be far more difficult to liquidate your investment if you find yourself in need of the money. If the business goes south (which may happen so suddenly, the investor can't plan for or control the situation), the value of the investment may even drop close to zero. Stock investing doesn't always offer the same financial and emotional thrill of having a direct impact on a unique business, but it can allow investors to better hedge their risk.
For businesses hoping to gain access to private equity, it's important to thoroughly review and understand the terms of the agreement you're negotiating. While signing over 20 or 30 percent of the future value of your business may not sound like a sacrifice when you're not sure you'll ever turn a profit, giving up a significant percentage of the next TikTok or Amazon can be a different story indeed.[9] What happens if you need to liquidate your business during a divorce or while sending your children to college? What options will be available? Think of how you see the future of your business when deciding whether private equity should play a role.
Important Disclosure Information
The comments above refer generally to financial markets and not Bazis Young portfolios or any related performance. The content of this article should not be considered financial advice. The article is not intended to offer specific investment recommendations and is general in nature and should not be considered a comprehensive review or analysis of the topics discussed. This article is not a substitute for a consultation with an investment adviser in a one-on-one context whereby all the facts of the attendee’s situation can be considered in its entirety and the investment adviser can provide individualized investment advice or a customized financial plan. Opinions expressed are current as of the date shown and are subject to change. Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk including loss of principal. Information or data shown or used in this material was received from sources believed to be reliable, but accuracy is not guaranteed. This information does not provide recipients with information or advice that is sufficient on which to base an investment decision. This information does not consider the specific investment objectives, financial situation or need of any particular investor and may not be suitable for all types of investors. Recipients should consider the content of this information as a single factor in making an investment decision. Additional fundamental and other analyses would be required to make an investment decision about any individual security identified in this report.
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Content Provider: WriterAccess
[1] https://hbr.org/2007/09/the-strategic-secret-of-private-equity
[2] https://learn.sba.gov/learning-center-launch/learning-center-financing-your-business/angel-investors
[3] https://www.sec.gov/spotlight/sbcfac/expanding-retail-access-to-private-markets-finley.pdf
[4] https://www.nytimes.com/2020/05/14/business/coronavirus-retail-bankruptcies-private-equity.html
[5] https://smallbusiness.chron.com/advantages-being-private-company-20236.html
[6] https://www.mnat.com/files/epub/MorrisNichols_ThePublicBenefitCorporationGuidebook_PDF_Sept2019.pdf
[7] https://www.cfainstitute.org/en/research/cfa-digest/2014/04/do-private-equity-fund-managers-earn-their-fees-compensation-ownership-and-cash-flow-performa#:~:text=Private%20equity%20funds%20typically%20have,owns%201%25%20of%20the%20fund.
[8] https://www.nerdwallet.com/article/investing/private-equity-investments
[9] https://www.ft.com/content/36e778c4-4bfa-11e9-bbc9-6917dce3dc62