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Home > Financing Best Practice > Understanding and Accessing Private Equity for Small and Medium Enterprises

Financing Best Practice

Understanding and Accessing Private Equity for Small and Medium Enterprises

by Arne-G. Hostrup

Executive Summary

  • Private equity is an important component of funding for small and medium enterprises (SMEs).

  • The goal of securing a company’s long-term financing and becoming independent of banks’ continuously changing lending behavior is one that preoccupies many enterprises, from foundation to sale.

  • Very few companies are familiar with the market structure, processes, framework, and conditions of private equity.

  • There are a number of reservations about this type of financing.

Definition of Private Equity

Private equity is the generic term for all forms of financing through external equity capital in the broader sense. The generic term is often subdivided into:

  • Venture capital (VC) is made available by business angels (who provide so-called informal venture capital, or IVC) and venture capital companies, usually management companies with a venture capital fund under administration. VC is made use of in a company’s early stages—from foundation, market entry, and growth, right down to bridge financing prior to an initial public offering (IPO).

  • Private equity in a narrower sense is made use of in, for example, expansion, internationalization, MBO/MBI, general reorganization of debt capital financing structures, and turnarounds.

The unequivocal characteristic of private equity in the SME sector is that the investor makes the invested capital available without provision of security and thus participates fully in the entrepreneurial risk of a business. Capital is normally made available over the medium to long term (3–10 years) in the form of liable equity. The forms of investment range from acquisition of a stake under the provisions of company law, with payment of the amount invested into the company’s capital reserve, to a completely dormant partnership with no direct relationship under the provisions of company law. A combination of both options is often seen, with the investor becoming a shareholder of the company and making part of his investment as a nonrepayable payment into the capital reserve and another part as a repayable and continuously interest-bearing dormant partnership investment.

As regards the extent of the stakes acquired under company law, the range varies from minority and majority holdings to complete takeovers by the private equity investor. The investor’s objective is to sell the acquired shares at a later point in time within the framework of a so-called exit, thereby making as much profit as possible. The exit can take place within the framework of an IPO, a trade sale, or a buy-back by the previous shareholders. Professional private equity investors usually expect a rate of return of more than 30% per annum. The expectations of business angels may differ.

Market Structure and Participants

As a basic principle, the private equity market can be subdivided into the informal/formal and private/governmental areas. In general, the entire field of business angel financing is regarded as the informal private equity market. Business angels are wealthy private investors who use their own capital to acquire stakes in other companies. The formal private equity market is the entire “regulated area,” i.e. usually private equity funds or their management companies. Depending on the investment motive or situation of the company, the market subdivides further, with investors specializing in the following sectors:

  • seed-financing (business angels);

  • early-stage businesses;

  • later-stage businesses;

  • medium-sized businesses;

  • buy-outs;

  • corporate venture capital.

Within these sectors there are investors who confine themselves to a certain technology or geographic region. Usually, there is an umbrella organization that unites the private equity firms in any major country and, in some cases, major regions. As a rule, umbrella organizations are a good place to find individual investors and to research their respective special interests (see More Info section).

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