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Guide to What Private Equity Is

Guide to What Private Equity Is
Susan Guillory
Susan GuilloryUpdated November 18, 2022
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If you own a small business and are looking for working capital to fund operations and growth, you’ll likely want to explore every avenue. That may include private equity.What is private equity? What are the benefits and drawbacks? Could it be the right fit for your business? Read on for a primer on private equity firms and how this type of investing works.

Private Equity, Defined

Private equity generally refers to a fund that invests in companies that are not publicly traded in exchange for an ownership stake in those businesses. The private equity firm then typically works with company executives to make the businesses — called portfolio companies — more valuable so they can sell them later at a profit.Though private equity funds typically invest in private companies, some funds will buy publicly traded companies with the goal of taking them private, restructuring them, then selling them at a profit. There are similarities between venture capital vs private equity, although private equity tends to be given to mature companies (companies that are well-established in their industry, with a well-known product and loyal customer following), whereas venture capital typically goes to startups in the early stages of development. Private equity firms also may take more ownership of a startup (usually 50% or more) than a venture capital firm.Recommended: Pre-Seed Funding vs Seed Funding 

A Brief History of Private Equity

While private equity may seem like a recent phenomenon, the practice of people pooling their money together to purchase controlling stakes in a private company is not new. It actually got its start over 100 years ago when JP Morgan (of banking fame) bought out Carnegie Steel Corporation and merged it with other steel leaders to create United States Steel. This action actually spurred the Glass Steagall Act of 1933, which prevented large consolidations and mergers like this to prevent monopolies. Private equity picked back up in the 1970s when technology gained momentum in the U.S. Private equity firms became a popular funding avenue for many tech companies that didn’t want to go public. They were able to get the capital they needed without being beholden to the ebbs and flows of the stock markets.Today, the startup scene has exploded, and private equity is a popular option for companies that seek capital once they’ve hit a level of maturity and stability.

What Do Private Equity Firms Do and How Do They Work?

Private equity firms usually get their funding from institutional funds and accredited investors (typically high net-worth individuals with expertise in investing).The fund will then invest in a business (or buy it outright), aiming to grow that company and increase its profitability in a set period of time. Some of the top private equity firms take an active role in the companies they’ve invested in, providing administrative support and weighing in on key decisions, while others may take a back seat, allowing the startup to run operations independently.Private equity funds often target a specific type of company based on where that company is in its lifecycle. For example, some funds may specialize in younger firms with promising futures, while others seek out well-established companies with reliable cash flows. Still others focus on failing companies that need to be restructured.Typically, the ultimate goal is to sell the company or take it public on an exchange through an initial public offering (IPO), then divest and distribute the profits to the investors. 

How Private Equity Firms Make Money

One of the primary ways private equity firms make money is by exiting their investments. The goal is to sell the companies at a much higher price than what they paid for them. Private equity firms also collect management fees from their investors, typically around 2% of committed capital during the investment period (usually the first 5 years) regardless of performance. They charge this management fee to pay salaries and cover the core operating costs of the fund before and between investments.

Why Private Equity? Pros and Cons of Private Equity

Securing a private equity investment comes with both pros and cons. On the plus side, private equity can provide a large infusion of capital. Raising money for a company isn’t always easy. And, if a company is just starting or experiencing financial difficulty, it may be difficult to qualify for small business loans with attractive rates and terms. Also, private equity firms typically provide more than capital. They often also bring operational expertise and valuable business connections that can help take a company to the next level faster than they could do on their own.On the downside, securing a private equity investment can be a long and difficult process. You’ll need to convince investors why they should put their money into your business, leading to months of negotiations that may not ever materialize.Bringing on investors also dilutes your ownership stake in the business. In many cases, private equity firms demand a majority stake. The firm may also want to be actively involved, which means you’ll have less influence over the day-to-day decisions and future direction of your company.

Investing in Private Equity

Private equity investing generally isn’t available to average investors. Only institutional investors and accredited investors are eligible to put money into a private equity fund.Accredited investors are generally wealthy individuals who have the financial know-how needed to evaluate these types of more complicated investments, plus the funds available to be able to handle potentially large financial losses. Accredited investors must meet several criteria, including a specific earned income, net worth, and certain professional certifications, among other things.Recommended: 10 Types of Private Equity 

Alternatives to Private Equity

If you find it difficult to find a private equity firm willing to invest in your company or you’re not interested in taking that route, you do have other options for financing. Here are some you may want to consider.

Small Business Loans

Banks, credit unions, and online lenders offer many types of small business loans, including term loans, lines of credit, and equipment financing. If you have good credit, you may qualify for a bank loan with low-interest rates with favorable terms. Even if you have fair or poor credit, however, you may be able to get a business loan from an online lender. These alternative lenders often have more flexible qualification criteria than banks, and also provide faster funding. However, loan amounts may be smaller and interest rates can be higher.Recommended: How to Apply for a Small Business Loan

Small Business Grants

Another way to raise capital for your business is to pursue a small business grant. These are offered by nonprofits, corporations, and government agencies, and the money that is awarded does not have to be repaid.There are small business grants for women-, minority-, or veteran-owned businesses, as well as those in certain industries or that operate in underserved communities. Competition for business grants can be fierce, however, so you’ll want to be sure you meet all of the qualification requirements and follow the application instructions to the letter.

Crowdfunding

There are numerous business crowdfunding platforms where anyone (not just professional investors) can contribute toward a new business project, product, or service. While it can take time and effort to create a compelling campaign, businesses often don’t have to give up equity with crowdfunding. Instead, you may need to provide a token of appreciation to donors, like early access to your product or a t-shirt with your company’s logo on it. Crowdfunding also allows you to test consumer interest in your product.

Small Business Loan Rates

Finding the right capital funding for your business is an important decision you don’t want to take lightly. One fundamental choice you’ll need to make is whether to pursue equity vs. debt financingIf you go with private equity funding, you typically need to give up a majority stake, as well as a certain amount of control, of your business. With debt financing, on the other hand, you retain ownership and control but need to repay the funds you borrow (plus interest) within a certain period of time.If you’re curious about what kind of business loans your company may qualify for, Lantern by SoFi can help. With our online loan comparison tool, you can quickly access small business loan offers matched to your needs and qualifications all in one place and with just one short application.Lantern can help you find the right financing for your small business today.
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Frequently Asked Questions

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About the Author

Susan Guillory

Susan Guillory

Susan Guillory is the president of Egg Marketing, a content marketing firm based in San Diego. She’s written several business books, and has been published on sites including Forbes, AllBusiness, and Cision. She enjoys writing about business and personal credit, financial strategies, loans, and credit cards. Follow her on Twitter @eggmarketing.
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