As Warren Buffett said, “Rule number one: Never lose money. Rule number two: Never forget rule number one.”
Whether you are the CEO/founder of a startup or an older, privately held business, there may come a time where you and your colleagues are seeking outside capital. In an ideal world, you are doing so to grow and scale a business due to demand. On the flip side, you may be seeking capital to satisfy short- and long-term cash flow issues.
Whatever the case may be, your campaign to raise outside capital will undoubtedly involve sophisticated investors — like private equity investors — deeply scrutinizing your current finances and potential to offer an attractive return. Essentially, if you are considering outside capital from private equity investors, you need to ask yourself one critical question:
“Is my business ready for the demands of private equity?”
As the president of a national executive search firm, I regularly come across scenarios where private equity firms are exerting significant pressure on their portfolio companies to conform to higher performance standards. They retain us to seek talented finance and accounting staff to improve their finances in both quantity and quality. Many of these scenarios require us to replace the existing CFO with a private equity experienced candidate.
So why do private equity firms do this? As alluded to by Buffett, it is to protect their investment. Especially if the private equity firm is investing eight or nine figures into your business, the stakes are extremely high.
Here, I’ll explore this phenomenon in more detail. Specifically, I will discuss some significant changes — in terms of reporting standards and personnel — that private equity firms require of portfolio companies.
Raising The Stakes
Regardless of the funding source, companies that obtain outside capital are playing with raised stakes. Lax compliance standards or incomplete financial statements are simply out of the question. Portfolio companies become stewards of capital, and they must ensure that outside investors are clear about how that outside capital is being allocated.
Often, portfolio companies provide this clarity through more detailed financial statements. In fact, this increased level of detail may be a compulsory part of the fundraising round. As just one example, many private equity firms require their portfolio companies to have a hard close every month. Many private companies forego this practice every month, instead choosing to do it every quarter or every year. While they may prefer a soft monthly close because it places less of a burden on their accountants, private equity firms will disagree. If the portfolio company does not have the resources to quickly implement a monthly close, it may create some significant challenges within the organization.
Along with a monthly hard close, private equity firms often institute stringent financial planning and analysis (FP&A) requirements. These FP&A requirements might include things like cash flow projections, EBITDA (earnings before interest, tax, depreciation and amortization) bridges and more. Again, the ultimate purpose of these stringent FP&A requirements is for the private equity firm to have a granular level of detail on the business. It wants to ensure that the portfolio company is on track to achieve certain key performance indicators, which will appear as a sufficient return on invested capital.
Finally, audit requirements may be a rude wake-up call for portfolio companies. A good number of private companies may not have completed a comprehensive audit. When taking on private equity capital, however, these companies will have to invest a significant amount of time and money into adequately completing the audit. While this is especially true for the first audit, ongoing audit requirements are not insignificant.
For a small company with lax financial controls, the requirements mentioned above can be daunting. An inexperienced CFO may do everything they can to comply with the requirements, but it may not be enough. Private equity firms won’t hesitate to bring in more experienced financial professionals who can not only comply with these reporting requirements but help ensure that the portfolio company delivers the expected internal rate of return.
In the case of private equity firms seeking experienced CFOs for their portfolio companies, in my experience, they generally look for candidates with strong technical accounting backgrounds who operate at a higher level. Not only that, but the individual must be able to execute the company’s growth plan, including mergers and acquisitions, and fit well within the culture of the company. As you can guess, it requires a talented individual to bridge the gap between a CEO/founder and the demands of their new private equity partner.
Raising outside capital can be exciting for any growing company and its founders. It is easy for emotions to take over as company executives contemplate how that capital will take their businesses to the next level. That said, taking outside capital — especially capital from private equity firms — isn’t easy. There are certain reporting and compliance requirements that key executives may not anticipate.
Ultimately, when taking private equity capital, “What got you here won’t get you there,” as executive coach Marshall Goldsmith would say. Portfolio companies will need to implement comprehensive reporting procedures, FP&A and internal controls so that their private equity investors can closely track their investment. And if the existing management cannot do so, private equity firms will find someone who can.
Founders and executives must face this reality before taking on private equity funding. Setting appropriate expectations can avoid some nasty surprises in the future.
Cowen Partners is a national executive search and consulting firm with particular expertise recruiting for private equity experienced Chief Financial Officers nationally. Contact us if you would like to discuss.