What really excites Private Equity, Part III? Beware of the Genie! — Lionesses of Africa

by Lionesses of Africa Operations Department

Over the past two weeks, we have looked at what excites PE Investors at the back end of your business (production, supply etc) as you come to them to catapult your business into the next stage of its growth. We then looked at the front or sharp end of your business – can your current customers handle the massive increase of products, or will you need to find new customers? If so, why the PE Investor is interested in your cost of acquiring these and just how sticky they are. Oh and what your retention rate is over this time, can you hold onto customers, or are you expensively bringing in new, to replace old as they leave for whatever reason? We also pointed out that we as Lionesses need to expect difficult questions, because as the Harvard Business Review has shown here, there is a dis-balance between questions asked of male founders (promotion orientation) and of female founders (prevention orientation) – as if we haven’t enough issues to work around!

With perfect timing (and as we all know, timing is everything in business, as in life) we came across an article by Tessa Clarke, the cofounder of OLIO (here). OLIO is a fascinating women-led business that connects neighbours and local businesses with each other so surplus food can be shared, not thrown away. This could be food nearing its sell-by date in local stores, for example, as well as a full fridge in expectation of the kids coming home, only to find they forgot to mention they were round at friends (yes, we have all been there!) What a simple but fabulous idea! She came across one of the authors of the HBR article, Dana Kanze, giving a TED Talk on the subject (here) and realized suddenly why her own experiences raising capital had been so tough.

What interested us by Tessa’s article was not only the title, ‘Female founders need money, not more mentoring’ (here), but that she then backed this up, showing her belief that “It’s not that female founders aren’t up to scratch on pitching, but that the VC industry is structurally biased”. 

She writes: “This week [08/02/2022] it was announced that 43 of the good and the great from the VC world — with a collective £900bn in assets under management — are launching a new mentoring programme to tackle the persistent underinvestment in female founders.…

…However, I’m not convinced that the “200 Billion Club” will have any meaningful impact in shifting the meagre amount of investment going to female founders. Why? Because the focus of the 12- week programme is on “getting participants pitch-perfect and VC investable”. This clearly implies that the root cause of the problem lies with female founders not being up to scratch, rather than the VC industry being structurally biased.”

This certainly follows our recent experiences where we listened in on various pitches by a number of Lionesses that we had introduced to female friendly PE Funds – all had fabulous pitches and were brilliantly presented. Granted, the Lionesses we assisted were a very small sample of the huge number within our 1.5 million membership. We are sure as well that Tessa has only listened to a relatively small sample, AND who knows, perhaps we are both ignoring survivorship bias – whereby only those who survive (and are great at pitching) go onto the next stage and therefore become part of the sample that we look at. Who knows. However, the fact is we do need to be prepared for prevention orientation questions and if we get a more promotion orientation discussion – how great is that!

But to take a step back, there are some home truths that we need to understand before we embark on the Investor route, before we rub that bottle and release the Genie that will answer all our dreams…

Raising capital costs. In time, in effort, and in hours hunched over a pitch deck making it flow effortlessly, but also in fees to lawyers, accountants and advisors. Legal fees can cost as much as 15% to 20% of a smaller offering and can go as high as 35% of the capital raised – that’s a huge wad of cash – and if you get a no? Will the lawyers and accountants tell you not to worry? Thought not! They can’t be squeezed back into the bottle!

Think you can do without decent legal help? Don’t forget small print could include such fabulous items as a ‘Liquidation Preference’ which could read: “Following any sale, Investor will receive 100% of proceeds up to the value of their investment.” This is a 100% protection on sale (assuming you sell for more than their investment of course) for their investment. If they invested $1mil and you sell in 5 years for $1mil, you get nothing – Zip, Nanna, Nothing.

Sometimes there is a ‘Multiple Liquidation Preference’, which means you only start to get any share of the proceeds from the sale once the investor has been paid 100% of a multiple of their initial investment… Yes, nice! So sell for US$2mil and if the investor invested originally $1mil and the small print has a 2x Liquidation Preference and you guessed it – you still get nothing out of a sale of US$2mil.

Following this then yes, you each get 50% of the extra (assuming the investor has 50% of your company) – but wait there is then a ‘Participating Liquidation Preference’ which could read as ‘50% Participating Liquidation Preference’. The investor participates in not only the normal 50% of the residue but ‘double-dips’ into your proceeds as well by 50%. Nice (not) – suddenly the legal fees are looking a bit of a bargain aren’t they!

The reason, the Investor will argue, is because it was only due to their involvement and their investment that you were ever able to sell your company for a multiple of the original valuation. If you are so determined to keep 100% of your business and it is worth very little, 100% of very little is always going to be very little, but with their cash, knowledge and assistance, this is why you now enjoy a valuation higher. This is indeed a valid point, 100% of nothing is nothing, but the Investor has allowed you this growth (even if it is on the back of your hard work, blood, sweat and guts). This is all part of the negotiation at point of sale/investment. The power to your company that a good PE / VC deal brings can be greater than your wildest dreams, but you do need to go in with your eyes wide open.

Note clauses on Accrued Dividends – these may have built up to something quite serious prior to exit or sale. Pre-Money or Post-Money Valuation? If your company is valued ‘pre-money’ at $2mil and the investor puts in $1mil, then this values the company at $3mil, so they get 33% of the company. If valued ‘post-money’ at $2mil this means the investor’s cash is part of that valuation, so they get 50% (yes, you are starting to think of a bonus for that lawyer now aren’t you!). This is not some dark art or magic, but it is certainly magical if you are on the right side of this!

Anti-Dilution Clauses, or Subscription Rights, Subscription Privileges, or Preemptive Rights? These all protect the investor from any further equity sales diluting their holding – guess who takes the hit, it they aren’t? Yes, you guessed it.

Finding investors brings incredible stress even before all these small print minefields. Oh, and you’ll start to find that your business may suffer as customers are ignored and deadlines missed. Employees and managers find they are being ignored and feel unloved. The whole process can drag on and on. If you are lucky enough to get a ‘Yes’, it will still take around 6 months, a ‘No’ can often be a far longer drawn out process!

But is this a really good use of your cash? One easily forgotten item is that often PE Investors want business owners to put actual cash on the table as well… It may only be a small percentage of the total being raised – but really – can you find the cash, can you remortgage your house, should you remortgage and put at risk your home? Raising a million US$? The investors may expect over $50k, perhaps even more to show you have ‘skin in the game’. Take a moment – what if you took that cash and instead invested it into your company? Can you continue to bootstrap and build organically to something close to your dreams – albeit slower?

If buying assets such as machinery to multiply overnight your production capabilities, then perhaps Asset Backed Finance might be the easier answer – there are Debt Funds that may look at this. If such an increased production is a serious reality (obviously your dreams, but a reality with off-take deals signed and in your drawer), then what about Revenue Based Finance?

Selling equity in your company is not the only route to financing when Banks are not an option, but make sure you are prepared and well advised, because once you open the bottle, once you have signed, the Genie (and the small print) is always so difficult to put back!

Stay safe.