As a new author to entreVIEW (more about me [here]) I wanted to write about a topic near and dear to the hearts (and pocketbooks) of entrepreneurs—money! While private capital raising remains tough, there has been a shift to alternative asset classes and the “private equity” landscape has been robust.
Depending on the type of business and on the amount of money needed to begin or continue operations, equity financing may be the only capital available for your start-up. However, it doesn’t hurt to know and understand a little about private equity funds, which could be a source of later stage capital or an exit. What follows is a summary of what we mean by private equity.
Simply put, a private equity fund is a collective investment vehicle used for making equity or debt investments. Some common attributes:
Usually structured as Delaware limited partnerships. Under this framework, the fund is not subject to taxation on its income or gains but limited partners (“LPs”) are taxed based upon their share of the fund’s profits or losses.
Managed by a general partner (“GP”) with capital raised from institutional investors, universities, insurance companies, foundations, endowments or high net-worth individuals.
Key economic incentives for the GP are the management fees and the carried interest, which is a share of the profits of the fund’s investments (typically 20%), usually with some minimum rate of return (typically 8-12%) before the GP shares in the success.
The key economic incentive for an LP is the opportunity to earn a high rate of return on their invested capital through access to a diverse portfolio of investments that are made by experts.
As with so many things, there are a host of regulations that apply to these funds, including the Investment Company Act of 1940 and possible registration under the Securities Act of 1933, if there isn’t an available exemption like Regulation D, which is often available in offerings to accredited investors.
Investing in private equity funds allows groups of sophisticated investors to pool their resources to mitigate the customary risks associated with investing while attempting to maximize the synergy created by the collective “thought equity” of the LPs. These investors are known as “angel investors.” Angel investors are accredited investors who invest in businesses in exchange for convertible debt or an ownership stake in the business. These individuals or institutional investors conduct their own due diligence and make their own determinations about individual investments (like the “Sharks” on “Shark Tank,” without millions of people watching). Like “Shark Tank,” angel investors will often make investment decisions based upon a personal interest in the business or the entrepreneur.
Of course, nobody should take money from angel investors without their eyes wide open about the potential perils. Alignment of interests between the entrepreneur and the angel is critical (e.g., what type of exit in what timeframe?). For this reason, remember that raising angel capital can be like getting married. Make sure that each side has done their due diligence so their eyes are wide open to problems (like whether to leave the toilet seat up) and defined their rights and obligations (sort of like a pre-nuptial agreement) to ensure that everyone is on the same page. At the risk of sounding self-serving, getting your lawyer involved early in the dialogue is a good idea.
Taking on the right angel investors can actually have many positives in addition to securing capital needed to build your business. The ideal angel investor will be someone who has experienced success before (and has not just been born with a Silver Spoon) and who brings contacts and relevant expertise. With interests aligned between investor and entrepreneur, all parties should have the incentive to see the business succeed.