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The Elusive Private Investor

While business owners are out seeking capital, venture capitalists are looking for strong firms. It pays to understand the other side.

April 15, 1998|JUAN HOVEY

Business owners know first-hand how much work it takes to find private capital to make a company grow. What they don't know is that private investors work just as hard to find solid businesses in which to invest.

Indeed, it comes as a surprise to many business owners that it's even possible to raise private-investor capital to grow a business, much less that investors actually want to put their money to work in small and middle-market businesses.

But they do, and they make more capital available every year. In 1996, according to the Private Equity Analyst newsletter published in Wellesley, Mass., 194 private investment groups raised $36.1 billion in capital to invest in U.S. businesses big and little. In 1997 the groups numbered 233 and raised $50.9 billion--an increase of nearly 41%.

About one-third of this money went into venture capital funds to provide seed money and later-stage financing to new businesses. The rest went to funds targeting established small and large businesses, some to finance buyouts and some to provide working and expansion capital to growing companies across the nation.

These numbers mean that every year, more growth capital flows to businesses of all sizes notwithstanding the very real difficulties that countless individual business owners encounter every day in their own search for capital.

Indeed, if you draw a picture of the process by which business owners and investors find one another, you show a long narrow pipeline with business owners trying to crowd themselves into a funnel at one end and investors doing the same at the other--along with a few actually in contact in the middle.

This does not mean, of course, that business owners and investors set themselves an impossible task in seeking contact--because the owners of solid businesses and investors do find one another. They just have to work at it.

And if you need financing for your business, it helps to understand what happens at the other end of the capital pipeline.

"Most of our clients prefer to invest in private emerging companies through pooled investment vehicles--for example, limited partnerships--rather than directly in small businesses on a one-off basis," says Andrew Craighead, a J.P. Morgan vice president in New York who handles the firm's private client group worldwide. "This gives our clients active management and diversification."

A smaller part of Craighead's client base is the investor "looking to take an active role in companies--someone who is sophisticated, maybe retired and has experience in, say, marketing or telecom and wants to spend his or her retirement sitting on a board advising a business owner or even rolling up the sleeves and getting involved."

"But that's the unusual investor," says Craighead. "For the others, we spend most of our time looking for growing companies or investment partnerships with good management teams."

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If this sounds like the litany of the venture capitalist--find me a good management team first, then tell me about the product--it is. As they grow their own capital, private-equity investors, like venture capitalists, care less about products and services than about the management team they back, Craighead says. No good business idea catches fire without top-flight management in control.

More often than not, he adds, business owners make their way into the capital pipeline with the expectation that a good idea will carry the day. You need a skilled management team in place to get private investors to buy your idea, Craighead says.

You need an exit strategy, too. Investors want to make 25% to 30% per year on their money and get out in three to five years, Craighead says, so the business owner must offer them a plan-- maybe a public offering, maybe a new round of financing, maybe a sale to a larger competitor-- allowing them to cash themselves out rapidly.

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Some investors also want control, in effect, if not in fact, Craighead says. In a particularly risky deal, for example, investors may demand voting control over a majority of the stock if the business fails to meet certain performance goals.

Private investors drive hard bargains because they operate at the high-risk end of the investing game, Craighead says. They want to enliven their portfolios, but they don't want to lose money any more than the business owner does.

The good news is that private investors want to do business in the small and middle-market arena, and they don't all chase technology deals. Many groups target companies with ordinary products and services, such as distributorships and manufacturers of ordinary household items.

Some private equity groups search for what Craighead calls "sector inefficiencies"--fragmented industries without national players. A big chain of dry cleaners, for example, might achieve a great deal of operating leverage over neighborhood shops, and similar opportunities exist in other industries.

Although consolidation plays of this type look particularly good to private investors, Craighead says capital is also becoming more available for other kinds of small and middle-market businesses--as long as they have solid management teams.

"Venture capitalists give you the stock line that good management is the most important thing in any business," Craighead says. "And it's particularly true in small and middle-market businesses. You can have a terrific idea for your business, but investors are very wary of putting their money into any company if they don't think the management team has the capability of making good on it."

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Freelance writer Juan Hovey can be reached at (805) 492-7909 or via e-mail at jhovey@gte.net

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