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Private Equity as an Exit Option for Venture-Backed Startups

Nov 28, 2018

In the past, private equity groups (PEGs) seldom invested in venture capital backed startups or even in companies known for innovation. Investing in the next “big thing” was not part of the vocabulary of the typical buyout fund. PEGs more likely were looking for companies that dominated a market and had significant customer traction, manageable cash requirements, and recurring and predictable cash flow to pay back debt. Going a step further, startups were also not very appealing to debt providers since they are unproven and typically have no tangible assets. However, let’s fast forward to 2018 and the world is certainly changing with PEGs definitely becoming a significant exit option for venture capital-backed companies.

Over the last couple of years, there has certainly been a shift in strategy for PEGs and maybe one of the most important reasons for the shift has been the tremendous amount of dry powder presently sitting on the sidelines. Private equity buyouts represented 18.5% of all venture capital-backed exits in North America and Europe in 2017, which was a significant increase from 14% in 2016 and only 10% in 2008. In fact, several prominent PEGs, have even raised significant funds to focus exclusively on tech deals.

Today, venture capital investment continues later into the company’s lifecycle. In today’s capital markets, venture-backed companies are staying private longer and postponing exits because they continue to have access to large rounds of private capital. In fact, 2018 might be the first year since the late 1990s that venture capital deal values surpass $100 billion. Since venture capital-backed companies are pursuing exits later in their lifecycles, they are beginning to generate growth rates, revenue numbers and profitability that are catching the attention of PEGs. These companies are making the transition from burning cash to support growth, to having sustainable and predictable earnings. These later-stage startups are generating significant and sustainable revenues that cannot be overlooked by PEGs aggressively looking for places to invest their capital.

PEGs are primarily acquiring venture capital-backed companies as add-ons to existing portfolio company investments. These investments help platform investments achieve immediate revenue increases as opposed to slower organic growth. As PEGs gather more experience in the technology space, platform investments of late-stage technology companies will definitely become more common.

PEGs certainly understand the competitive environment driving up multiples of venture-backed companies with significant customer traction and solid recurring and predictable revenues. In fact, PEGs are completing buyouts at valuations that are comparable to public market valuations and to prices being paid by strategic buyers. An argument can be made that PEGs are actually a strategic buyer, since a majority of their venture-backed deals have been add-ons to existing portfolio companies.

As an exit option, a private equity buyout might be advantageous to a venture-backed company for several reasons. First of all, PEGs are offering prices on par or even greater than strategic buyers and public market comparables. Second, a private equity buyout can provide original shareholders with the opportunity to rollover some of their equity into the new entity and then have a second liquidation event when the PEG exits. Finally, unlike an IPO, a buyout does not create lockup periods for shares that might create valuation uncertainty for shareholders.

With PEGs sitting on enormous pools of capital, the challenge to find good deals has never been greater. PEGs need to continue to explore for more opportunities for growth and one of those opportunities is certainly in the area of later-stage venture-backed companies. Today, these venture-backed companies -- with predictable and sustainable revenue streams, potential for cost cutting and ability to take on debt -- are beginning to match the investment criteria of many PEGs. For many venture capitalists, having a company exit through an IPO might have been a sign of great success, but today the choice of a PEG buyout might be a better financial alternative for your limited partners.

Private Equity Intelligence | Q4 2018

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Alan Wink

Mr. Wink assists clients with capital budgeting, capital structuring and capital sourcing. He has worked with many tech and life science companies on developing the appropriate capital structure for their position in the business life cycle.

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