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2017-07-06 15:38:40 | Legal Services
The popularity of the Private Equity investments has grown rapidly over the last decade. Private equity investment usually refers to an equity investment in a potentially successful company which is thus not traded publicly in the stock market. Private equity investments are thus usually made by the private equity firms and by high net worth individuals in a business which is operating as a Private Limited Company . In this article, we would review the basics of Private Equity investment and also about the must-knows about private equity for the startups.
Where private equity funds come from?
Private equity firms raise funds from the institutional investors, pension funds, endowments, and the investment companies and also from high net worth individuals. These firms allow the fund managers and also high networth individuals in order to diversify their portfolio and then reduce the risk. Private equity firms are thus expected to return the capital back to the investors within 10 years along with handsome profits.
The stages of private equity investment are :
🔗 Seed stage investment: In the seed stage, capital is thus provided for a business idea. The capital is generally the support product development and the market research.
🔗 Early stage investment: In the early stage, capital is thus provided for the companies that are moving into the operations and also before commercial sales have occurred.
🔗 Formative stage investment: In the formative stage investment, capital is thus provided for starting or scaling up of the operations.
🔗 Later stage investment: In the later stage investment, capital is thus provided for further expansions and also for scaling up prior to the company going public.
How private equity firms value companies?
Unlike shares of a public limited company that are thus traded on the stock market, the shares of a private company are also not traded in public. Hence, the value of the shares of a private company cannot thus be evaluated readily and it is the outcome of a negotiation process between a private equity firm and the founders. In order to ascertain the value, private equity firms thus use a number of valuation techniques. The selection of an appropriate valuation technique thus depends on the stage of investment. The following are some of the well known valuation techniques which are used by the private equity firms for evaluating a startup.
Discounted Cash Flow Method
In the discounted cash flow method, the value of the company is thus estimated by discounting the expected future cash flows of the company at an appropriate cost of capital (discount rate). High risk will thus translate to a higher discount rate – which is a lower valuation for the company.
Relative Value Method
In the relative value method, the earning multiples of a comparable publicly traded companies are thus applied to the earnings of the target company. Earning multiples are then calculated by the averaging of the earnings and also value of similar companies, which are traded in stock markets. Commonly used multiples are generally Price/Earnings (P/E), Enterprise Value/EBITDA, Enterprise Value/Sales.
Replacement Cost Method
Replacement cost method is the method that estimates the value of a business by calculating the estimated cost in order to recreate the business as it stands as of the valuation date. Replacement cost method is thus usually used to calculate the value of the companies that are operating in the seed or early stage.
How private equity firms manage their investment companies?
The following are some of the features of private equity investment that help the private equity firm in order to control the portfolio company:
Corporate Board Seats: Inducting a person from the Private Equity firm on the Board of Directors of the company will thus ensure that the private equity firm’s interests are protected in case of major corporate events such as share sale, business takeover, restructuring, IPO, bankruptcy, or liquidation.

Non compete Clause: Non compete clauses are the clauses which are imposed on the founders and they prevent the founders from restarting the same activity during a pre-defined period of time.

Preferred dividends and liquidation preference: Private equity firms generally come first when the distribution takes place, and maybe they guaranteed a minimum multiple of their original investment before the other shareholders receive their returns.

Reserved matters: Some of the strategic decisions such as the change of business plan, acquisitions or the divestitures are however subject either to approval or either to veto by the private equity firm.

How private equity firms return the capital to investors?
Exiting from the company is the most critical element in order to unlock the value in private equity investment. Most private equity firms thus consider their exit options prior to the investing. The following are some of the exit options that are available for private equity investors:
Initial Public Offering (IPO): IPO is one of the most favourite exit option for the private equity firms as it provides for higher valuation multiples, enhances the liquidity and also provides the business with more funding to fuel further growth.
Secondary Market: Secondary market sale refers to the sale of the shares which are held by the private equity firm to a financial investor or also to other financial investors or to the strategic investors. Secondary market exits are thus the most common type of exit.

Management Buyout: Management buyout refers to the purchase of the shares which are held by the private equity firm by the management group by raising of debt or other type of funds.

Liquidation: This is considered as the worst option wherein the private equity firms thus liquidate their shareholding in the company at the floor price if the company is no longer viable.

This article has been contributed by Simmi Setia, Content Writer at LegalRaasta, an online portal for Section 8 company registration, Nidhi company registration, IEC registration

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