The popular notion of startups is that they have one of three options:
- Explode in growth to IPO
- Get acquired by a FAANG
But a viable option rarely talked about is exiting to private equity.
We wanted to answer the questions of whether it's a viable option for startups at many stages to exit to private equity, how long it's been a trend, and whether it's a good idea.
Is this a new, growing trend?
Yes, this has been a growing trend since 2000.
According to Institutional Investor:
“Almost one-fifth, or 19.2 percent, of VC-backed companies, primarily technology companies, were exited through a private equity buyout. In 2000, that figure was just 2.4 percent.”
“The number of private equity buyouts of start-ups funded by venture capital grew at an annual rate of 18.1 percent between 2000 and 2019, according to PitchBook. That compares to a 9.5 percent annual growth rate for all buyouts over the same 19-year period.”
So essentially, PE buyouts of tech companies have grown twice as fast as all buyouts.
I speculate this likely mirrors both the overall growth of tech companies as well as a reduction in perceived or actual risk of tech companies.
Essentially, private equity can model out tech company business models now that they have decades of data to go off of.
Software-as-a-service (SaaS) was once an unknown and unproven business model, but it's now among the most lucrative.
“The PitchBook analysts explained that private equity fund sponsors are increasingly looking to tech companies, particularly as they can no longer rely on financial engineering alone to generate high returns.”
Investors are continuing to look for blue ocean opportunities as the old playbooks get saturated.
I think an important note here is that private equity is still fairly conservative. From my understanding, there are different PE models, but they are mostly going to buy companies with revenue and cashflow they can wrap their MBA models around. You're not going to see many PE firms buy unproven AI startups – that's the job of VC firms.
When/why should startups sell to private equity?
Private equity firms are buying earlier than ever:
“While most readers are familiar with private equity buyers at later stages, what’s new is the emergence of PE activity at early stages. These firms acquire majority stakes in startups that have only raised early-stage investments but are having trouble scaling or raising the next round.”
Do Private Equity Firms Innovate or Just do Financial Engineering?
In my perspective, it seems they just buy firms, cut costs, extract value, and resell.
But do they actually add value?
“After a buyout, these private equity firms typically provide value by adding the missing elements, such as marketing or sales know-how, in order to kick-start the business and achieve scale. Their goal is to increase the value of the underlying asset by augmenting founder teams with the buyout firm’s own operational experts, sometimes combining newly acquired assets with already existing assets to create a stronger whole, or doubling-down on promising products (while shedding less promising offerings) to unlock potential.”
Conclusion: Another Avenue for Startups is a Good Thing
At the end of the day, it's a good thing to have more liquidity in the market for startups to exit.
While exiting to an IPO or staying private for good is the primary goal for many ambitious startups, exiting to PE is a pretty lucrative backup plan.
Last Updated on June 24, 2021 by Joe