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PRIVATE EQUITY IN
FUNDING YOUR BUSINESS
INTRODUCTION:
While most
people in the United States are familiar with buying stocks and bonds
(and mutual funds which are conglomerates of stocks and bonds) on the
open market, there is confusion in the minds of many as to what “private
equity” is and how it relates to the standard purchase or sale of stock
publicly traded.
In reality,
most of the money for most of the business in the United States is
raised by “private equity.” Almost all stock and property ownership in
the United States is owned privately, which means it cannot be sold
publicly on the typical large stock exchanges such as the New York Stock
Exchange or NASDAQ.
But it can be
sold. While an attorney and accountant are usually necessary to draft
the relevant documents for the sale of the stock or interest, and while
careful disclosures must be made and
due diligence
achieved by the buyer, the simple fact is that more equity sold is
private than public. And a recent phenomenon is the increasing use of
private equity to purchase what used to be publicly traded stock for
reasons discussed below.
This article
shall briefly describe the role of private equity in United States
business. The reader should also review our articles on
Limited Liability
Entities and
Corporate Struggles: Who Has
Power When Push Comes to Shove?
PRIVATE EQUITY: A
MAJOR FORCE IN CAPITAL RAISING
When someone
decides to start a company, they often need cash. Assuming they do not
want to borrow it from a bank, the normal source is asking friends,
family and others to invest directly into the Company being formed,
either by purchase of interest (stock or limited liability company
units) or loans (either Notes or Bonds). If the number of people is
below the strict limits set by California and Federal law, it remains a
private offering and not subject to rigorous State and Federal
registration and disclosure requirements. If the offering is seeking
above a certain amount of money from over a certain number of people, it
is a “public offering” which is time consuming and expensive. The
typical public offering takes about a year, costs hundreds of thousands
of dollars in accounting and attorney’s fees, and remains subject to
close scrutiny by federal and state authorities.
The
fiduciary duty applies to corporate officers and
directors whether or not a company is public. The major difference is
that the procedural requirements and scope of fiduciary duty (and
criminal sanctions) become significantly greater for a public offering.
The techniques
for creating a private offering include creating a full prospectus and
business plan and good legal advice is still required even for a private
offering. The danger in not fulfilling these requirements is a later
action brought by the investors for failure to follow the State and
Federal requirements for a private offering and for securities fraud.
Any good lawyer or certified public accountant experienced in business
can assist in creating that package and that package should be created
before accepting the first dollar.
But the world
of private equity goes far beyond the Mom and Pop business now. Even the
largest entities that were once public are going private (buying back
all their shares) and much money being raised for new entities or to
purchase new subsidiaries now stems from private investment. Many
entities exist precisely to buy stock or other ownership in other
entities and these are called private equity firms. Most venture
capitalists (famous in High Tech) are actually merely private equity
firms.
For example, no
sooner had Maytag received one buyout offer from a private equity firm (Ripplewood
offered $1.125 billion plus debt-assumption for the beleaguered
washer-dryer maker on May 20), it received a second such offer. (This
one announced by Maytag on June 21 from a consortium consisting of
Chinese appliance maker Haier and private equity firms Bain Capital
(which already bought Toys "R" Us and tried to buy the currently still
on-ice National Hockey League) and the Blackstone Group, which offered
$1.28 billion plus debt-assumption). When private equity deals make CNBC
in the morning, you know they have worked their way onto the public
radar. Private equity has mushroomed to a greater than $350 billion
annual alternative investment vehicle.
WHAT IS PRIVATE
EQUITY?
So what is this
private equity? At its most basic, it is simply a security that is
exempt from the registration requirements of the securities laws because
it is not issued in connection with a public offering. People invest in
private equity for the same reasons they invest in anything else...to
make money. But whereas stock market investors tend to try and buy the
best and brightest, private equity investors will often seek out the
untested and even downtrodden at bargain prices. And the returns from
private equity have tended to beat those of traditional equity and debt
investments, hence the surging popularity.
The private
equity market "is an important source of funds for start-up firms,
private middle-market firms, firms in financial distress, and public
firms seeking buyout financing." See The Economics of the Private Equity
Market, Board of Governors of the Federal Reserve System, December 1995,
at 1. Why does private equity find itself focused on these kinds of
entities? Well, "issuers generally are firms that cannot raise financing
in the debt market or the public equity market." Id. at 3.
A company like
Maytag finds the private equity market attractive because its place in
the public markets has been eroded by competitive pressure that makes a
return to its former glory, i.e. growth, a difficult, long-term
proposition, something investors in the public equity markets don't
always have the patience for. In a case like Maytag's, private equity
firms provide capital to buy out the public holders of the company
(hence taking it private), and they also assume outstanding debt, after
which they attempt to remake the company, hoping to resell it several
years down the line, either to another private investor or via an IPO.
Private equity investors are not seeking short-term gain.
The primary
intermediaries between private equity issuers and private equity
investors are limited partnerships and firms like Bain Capital and
Blackstone Group that manage huge funds that engage in private equity
investing. They collect investment monies from pension funds, wealthy
families and individuals, endowments, foundations, insurance companies,
investment banks and so on and then scour the markets for private
companies that need seed money for research or an infusion of capital to
fund product development or expansion, or they will search for private
companies whose initial or current investors are looking to cash out in
part or to exit the scene entirely. And as in the case of public
companies like the Maytags of the world, they will look for distressed
entities where management is actively seeking a buyout because the
company, while maintaining an established business, cannot make a go of
it in its current, public incarnation. The hope is that the private
equity investors reinvigorate the brand. And to the extent that Maytag
sticks around and thrives, not to mention Burger King, Domino's Pizza
and other companies benefiting from the latest hot trend, you can thank
the private investors.
AVAILABLE FOR NEW
BUSINESSES?
While getting
an investment of five thousand dollars from Uncle Joe to start your new
restaurant is actually a private equity investment requiring the
techniques and contracts of any other type, many new companies seek far
larger funds in the private equity market, seeking “Angels” or “VCs”
or “Venture Capitalists” to get them on their way. Such funds ARE
available but are not easy to get and when negotiating with these
professionals it is vital to be fully prepared for some tough
bargaining.
A complete
business
plan; realistic projections; and a good team of lawyers
and accountants are vital if one is to succeed either in raising money
or in raising money without giving away control of the entire business.
Or, as one new business owner told this writer after several months of
very tough negotiations with some very smart VCs, “These guys know what
they are doing and know how to get it. If I can sell to them, I can sell
to anyone…but who would have thought I’d have to jump through so many
hoops?”
He ended up
raising some money but he later commented that creating his invention
was easier than raising the money to promote it.
Using private equity is
what allows the Unites States to remain ahead of most other nations in
its quest for newer and better business and is the source of most
funding for most new businesses. But before you walk down that path, be
sure to learn how the game is played and be ready for some very tough
examination of your business plans.
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