The two most high-profile moments in the growth of a software business are when the company receives its early funding from venture capital and when it achieves an exit through an IPO or trade sale. While these events tend to dominate the headlines, there is an intermediate funding stage that is arguably just as important that tends to go by unnoticed: growth equity.
Growth equity, which is a sub-set of private equity (“PE”), focuses on providing established, fast-growing businesses with the equity capital, expertise and networks they need to take what can be described as a transformational leap in their development. This transformational leap builds company value by propelling the business along the path to becoming an attractive IPO or trade sale candidate.
The intermediate nature of growth equity is highlighted in the following figure:
In contrast to growth equity funds, VCs typically focus on relatively small minority investments in early-stage businesses. These companies are typically pre-profit, often pre-revenue and even occasionally pre-product. As a result, VC investors specialise in making high-risk/high-return bets that their capital will enable an entrepreneurial team to seize a nascent market opportunity. Given the early nature of these businesses, the holding period can be anywhere from five to 10 years.
At the other end of the PE spectrum are buy-out funds. These funds acquire substantial majority stakes (often close to 100% interests) in large, proven businesses with predictable cashflows. These predictable cash flows are key to enabling an acquired business to shoulder the large debt burdens that are a common a hallmark of these transactions. Buy-out funds tend to hold investments for between three and five years.
The reality is that all PE deals sit on a continuum from VC investments to growth equity transactions and all the way through to buy-outs. In practice, the precise distinction between a growth equity deal and, say, a later-stage VC investment or a majority buyout that leaves the founders with a substantial interest and continuing executive duties, can be somewhat blurry in practice.
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Software growth equity candidates
Because growth equity funds by definition are seeking growth opportunities, they tend to focus on a select number of key sectors of the economy – sectors that have strong structural tailwinds that are supported by widely accepted investment cases. One of these key sectors is information technology. A recent report by research company Gartner estimates that global IT spending will hit US$3.8t by 2020 with strong growth coming from the shift towards the cloud.
These dynamics make software technology an attractive catchment for growth equity opportunities. For example, PE giant KKR announced in 2016 that it was launching a dedicated US$711m information technology growth fund to scour the globe for growth opportunities across technology, media and telecommunications. This fund sits alongside other dedicated KKR growth funds such as the firm’s US$1.45b healthcare growth fund – another common theme for growth equity investors.
The specific strategies of a software-focused growth fund can vary from one fund to the next. Some funds might be software generalists while others may focus on a specific vertical such as cyber security or data analytics. Other funds may prefer software-as-a-service business models over, say, enterprise products and so on. Whatever a given fund’s software focus, there are certain attributes of target companies that all funds’ investments will have in common.
Growth equity funds will typically identify a “sweet spot” in terms of the transaction size that most strongly resonates with them and the risk appetites of their investors. This will commonly be expressed in terms of “cheque” size – or how much equity a fund will need to deploy to complete the transaction. That cheque size is a function of a target’s valuation, which is determined usually via a multiple of revenue and/or EBITDA. Growth equity funds will also have pre-set minimum and maximum sizes of investment that is determined by their mandate.
Assuming an opportunity meets a fund’s size requirements, probably the immediate concern of a growth equity fund is that a target company is, indeed, fast-growing. Ideally, that growth will be in the form of earnings but at the very least a prospective growth equity candidate must be able to demonstrate top-line revenue growth that is being driven by growing customer numbers. Importantly, growth equity funds are looking for companies that are already growing strongly but that possess the capacity to grow even faster with external capital and expertise.
As part of this assessment will be the business’ ability to scale quickly and cost-effectively. Given that growth equity funds aim to exceed minimum internal rates of return, the quicker and more capital efficiently a business can grow, the more attractive it will be to a growth equity fund.
The next key selection criteria is the perceived strength of the founders and management team. While in a buy-out scenario, a PE might decide to install a new management team as part of its strategy, a growth investor, particularly with a minority interest, is overwhelmingly backing the company’s existing founders and management to continue growing the business. There may be identified gaps in skills and room for mentoring, but the basic management raw material must already be there.
After growth and management, the next priority for growth investors is being convinced that the company’s underlying technology offering is proven and defensible. Whereas a VC is prepared to speculate on the future take-up of an early-stage business’ technology – indeed that is their very business model – growth equity investors need to be assured that the target company has developed a robust offering that meets the needs and expectations of a sizeable market.
This can typically be demonstrated through a demonstration of either the quality and/or quantity of a company’s client base. A target with a list of sticky blue chip clients will give an incoming investor confidence that the company’s offering is not only proven but that the company also possesses the ability to effectively sell to high-value clients. The other option is that the client base is not made up of high-profile brands but is still expanding rapidly in terms of acquiring and retaining customers.
Growth equity is a partnership
Often growth equity funds do not take a majority stake in a business and even when they do, they typically leave existing founders with a meaningful equity interest. As a result, it is critical that growth funds foster an effective partnership with the company’s existing owners and managers. Probably the most important dimension of a successful growth equity partnership is locking in the economic alignment between the parties by ensuring that everyone maintains sufficient ‘skin in the game.’
This helps ensure that no matter how robust internal discussions may be throughout the life of the investment, everyone is ultimately motivated by a shared objective: building company value. That is why in growth equity transactions it is less likely for founders to take ‘money off the table’ as part of the deal. At the very least, the initial shareholders would need to demonstrate that they remain overwhelmingly invested in the business.
Successful partnerships are also built on values such as mutual understanding, transparency and open communications. It is essential that all the parties to a growth equity deal have a clear sense of exactly where a company is initially positioned, what the strategy is going forward as well as agreement on the nature of the end game. This ensure that everyone is pulling in the same direction with the same motivations and that disagreements can be resolved rationally and expeditiously.
As any growth equity deal progresses through its early stages of discovery and negotiation, a key consideration for all parties is whether there is ultimately a meeting of the minds in terms of culture, business philosophy and personalities. These intangible considerations can often have a greater impact on the success of a deal than any other aspect.
Growth equity and transformational change
The key focus of any PE fund – whether VC, growth equity or buyout – is to create shareholder value; value that the fund hopes to capture for itself and its investors through an eventual liquidity event. While all PE investors look to build value by implementing operational enhancements to their investee companies, for growth equity funds, this tends to be the key focus.
The transformational changes that growth equity funds look to implement can be broadly divided into two separate categories: new initiatives and professionalisation.
New initiatives span strategic, operational and financial activities. Strategic initiatives are probably the most high-profile of these activities and the ones that carry the greatest risks for the business. Strategic initiatives include undertakings such as developing and rolling out new products or entering new markets with new and existing products. Product experience and networks in targeted new geographies are a compelling strength that growth equity funds can offer.
In addition to assisting companies with new initiatives, growth equity investors also look to enhance the overall level of a target company’s professionalism. It is not uncommon for fast-growing businesses to have not invested heavily in corporate governance and reporting protocols. Putting these regimes in place not only protects the incoming growth equity investor's interests but also builds value by preparing the business to withstand the levels of scrutiny inherent in any future exit.
Growth equity funds also look to focus heavily on improving an investee company’s systems and processes. Often, fast-growing business have internal methods that have grown reactively, often without the input of expensive outside specialists. Growth equity investors focus heavily on systems and processes and typically have the necessary skillsets in-house or have access to trusted external consultants.
Another value-add that growth equity investors bring to a target is experience in preparing for and completing an exit. That exit might be a full or partial sale to a trade or finance player (ie. another PE firm) or an IPO. Most founders of fast-growing businesses often do not have experience in preparing for and completing exits. Having operators at the board level who have typically been involved in tens of such transactions is invaluable. The same is true for a business that intends to include acquisitions as part of its own growth strategy.
All the planned transformational initiatives a growth equity fund intends to implement will be carefully documented with expected timelines and systems of accountability to maximise the outcome of the change program. These plans are commonly distilled into a 100-day and a 500-day plan. As with any transformation program, success lies in fostering strong partnership relationships from the outset with realistic goals and open and transparent lines of communication and accountability.
Growth equity is increasingly being recognised as an important steppingstone in the development of a fast-growing software business. If you want to discuss how CFSG can assist you to effectively secure growth equity funding for your company, we invite you to contact us.