Target companies. Target companies with high organic growth and a solid business model. Growth equity funds are available to those companies. Companies that are targeted have the potential to grow and scale.
Type of investment. Growth equity funds invest in mid-sized companies to acquire minority stakes. However, they negotiate protection rights for their investors, like board representations and change of control provisions.
Value-add operations. Equity managers often look to create value by providing capital for expansion and growth. They can also offer strategic advice to management teams and scale operations.
Exit strategies. Equity managers assist with exit planning.
What is growth equity?
Growth equity, also known as expansion capital or growth capital, is an investment opportunity in mature companies going through a transformational period in their lives that has the potential for dramatic growth.
Growth equity managers are focused on buying minority stakes in rapidly-growing businesses that have passed the startup stage. This is earlier than leveraged buyout funds but later than venture capital.
Growth equity managers will acquire minority stakes, but they will retain control of the company. They will also negotiate investor protection rights, like board representation and change-of-control provisions.
Target companies are usually middle-market businesses with high organic growth rates, established business models, and upside potential. Companies can add value by investing in growth equity managers to provide capital for expansion and growth, such as new products or sales efforts.
Exit options for growth equity funds include a sale to another fund, a buyback, or an IPO if you are more extensive.
How can growth equity managers add value to their portfolios?
Revenue growth: Optimizing sales efforts, scaling production, and identifying growth opportunities in new geographies and products. Managers can leverage their networks to introduce potential clients and business partners to the target company.
Enhancing management. Although they don’t have a controlling stake, they cannot insert a new CEO as buyout funds might. However, growth equity managers can use their networks to supplement existing leadership.
Exit planning. Growth equity management plays an advisory role in guiding companies to exit options such as IPO, strategic sale, or buyback.
Growth equity – expansion capital investment strategy
Most companies in the early stages need help at some point. This could be in the form of either operational guidance or equity investment.
Growth equity funds invest in companies already gaining traction in their markets but need additional capital to get there.
These companies are well-positioned and have achieved “top-line” revenue growth. They also retain significant upside potential for scalability, market share, and other factors.
Reluctance to accept capital or guidance from outside can hinder a company’s ability to realize its full potential and capitalize on the opportunities ahead.
Growth equity investments can sustain or accelerate growth by growth-stage companies.
Growth equity: target investment criteria
Attributes for investment
The target company must have proven its value proposition and product-market fit at the growth equity stage.
Growth equity funds invest in companies with proven business models and need capital to finance a specific expansion strategy.
These high-growth companies, similar to early-stage start-ups, aim to disrupt existing products and services in established markets. There is one difference: the product/service has been established to be feasible, the target market has been identified, and a business plan has been created – although there are still many areas for improvement.
The company has raised capital and can raise additional capital if necessary. This means that the priority is often growth and capturing market shares, which can lead to a loss of profitability.
The company can improve its business model and should be able to achieve profitability by focusing its efforts on the bottom line (profits) rather than just the top-line sales.
Ideal targets are companies that don’t necessarily need the growth capital to keep operating (and therefore, the decision to accept the investment is discretionary).
This indicates that the company has sufficient funding and/or cash flow to fund its expansion plan. A company that is struggling to make ends meet may need capital.
The growth stage is also known as the adoption stage. Products and services at this stage are beginning to be widely adopted, and their brands are starting to get more recognition in the markets.
With increased scale, revenue tends to rise, and operating margins start to grow; however, likely, the company is not yet net Cash flow positive (i.e., the “bottom line”) and has yet to turn a profit).
Companies should theoretically have made significant progress toward profitability. Although most late-stage companies achieve good profitability levels, companies are often forced to spend aggressively due to the competitive nature of specific industries.
Companies in the late stage often have to spend aggressively (i.e., on marketing and sales) to maintain profitability.
Unsustainable cash burn in growth-stage businesses can often be attributed to their singular focus on revenue growth and capturing market shares. These companies have high capital requirements and operating capital spending required to sustain growth and market share. Therefore, there are minimal FCFs at the end.
These companies could use growth capital proceeds to fund the following:
Expanding into new markets to reach more customers and new demographics
Develop existing products/services or add new features
More sales reps and back-office staff needed
Marketing and advertising campaigns should be more expensive
Establishing a business model is a key priority during the commercialization phase. This will determine how the company will generate revenues. These topics include deciding on the price of products, branding and marketing strategies, and how it will differentiate itself from competitors.
Financial profile – growth stage
Once a company has passed the proof-of-concept stage, it can focus on sustaining growth, improving the unit economics, and becoming more profit-oriented.
Commercialization is when companies try to improve their product or service offering, increase sales and marketing functions, correct operational inefficiencies, and refine their product/service offering mix.
In reality, however, the shift to profitability isn’t as rapid or efficient as one might think.
The CLV/CAC ratio is one of the most important KPIs for software companies. It should slowly normalize to around 3.0x-5.0x.
This indicates that the business model can be repeated and that enough customers generate enough profit to justify marketing and sales spending. This is a good sign for scaling up.
For saturated industries, however, companies tend to be focused on revenue growth and metrics related to new user count rather than profit margins.
The average revenue growth during the commercialization stage is around 10% to 20%. However, exceptional start-ups will show even more significant growth – i.e., “unicorns.”
To increase its revenue and create reliable income sources, a company could consider the following:
Targeting larger-sizing customers (i.e., more spending power)
Secure long-term customer contracts
Increased upselling and cross-selling
Growth equity investment structure
Most growth equity firms do not hold a majority stake in portfolio companies. This means that the investor has less control over the operational and strategic direction of the company. The following three components are crucial for investors to ensure successful investment outcomes.
Partnerships in growth equity
The key difference between growth equity investments and buyouts is that the management team retains an active role, along with the presence of other investors who invested in previous funding rounds.
Contrary to buyouts, where the operational and strategic decisions are made by management, growth equity does not involve any of these investors.
After a growth equity company has invested, it will now have a minority stake in that company through newly issued shares or existing shares from previous shareholders who saw the growth capital investment in an exit strategy.
Growth equity funds invest primarily in late-stage VC companies. This means that founders have given up many of their equity or governance rights in previous funding rounds.
In the absence of a majority share, a partnership built on trust is necessary to ensure that the management team can be relied on to lead the company to the next level of growth.
The structure of growth equity investments means that the growth equity firm can’t take control of matters if the direction or decision-making of the management is not in their favor.
Growth equity investor value-add
These companies do not need money to get to the commercialization stage.
Access to all operational resources is equally important to scale efficiently and overcome any obstacles that may arise at this crucial moment.
A growth equity firm’s ability to provide more than just capital makes it stand out.
Aligned interests in growth equity
When the company is already at a certain level, growth investors are most likely to be interested in it.
This timing can make it less critical for management to invest since the market potential and product idea have already been validated.
Building trust with management and key stakeholders is the biggest hurdle to growth equity funds.
A growth equity firm should gather information about the near-term, long-term, and influential shareholders who hold majority stakes before acquiring a minority share.
There must be a general understanding among the management team, key stakeholders, and growth equity investment firm on:
Market share estimates on the excellent portfolio company.
The rate of growth that the company should aim to grow at.
Capital is required to finance growth plans, which will dilute existing shares.
Planned, long-term exit strategy.
This is done to ensure their objectives align with the investment thesis, which focuses on continued expansion. The firm must confirm that the growth targets are within the threshold of the growth equity fund to ensure a positive outcome.
Growth Equity vs. Venture Capital vs. Private Equity
Growth equity is right between venture capital and private equity.
Growth Equity vs. Venture Capital
In most cases, Venture Capital is the first infusion of institutional capital to finance market research, product development, and other projects of early-stage companies.
A start-up must raise enough capital to move on to the next stage.
Once they no longer focus on just having enough cash, this stage focuses more on establishing a niche for the company and sustaining its top-line growth.
Joint initiatives are to improve the product or service, expand the sales and marketing functions and fill in the gaps in the organization.
Growth rates for early-stage companies are often close to or even far above 30%. However, growth-stage companies typically grow at around 10% to 20%. The rapid growth experienced at the beginning slowed down, but revenue growth is still high in double digits.
Other Important Notes About Growth Equity vs. Venture Capital
While growth equity might seem like venture capital, there are key differences between the two types. These are the key differences between the investment options:
1. Holding period
On average, venture capital investments have a shorter holding period of 5-10 years. On the other hand, growth equity investments typically have a shorter holding period (3-7 years on average). It is because early-stage companies require more time to realize their potential than mature companies.
2. Source of returns
Venture capital investors are primarily driven by successfully introducing products and services to the marketplace. Growth equity investments are based on the company’s ability and willingness to scale up, which results in substantial revenue growth and profitability growth.
3. Risk profile
Growth equity deals, unlike venture capital deals which carry high levels of risk, are considered investments with moderate risk. Venture capital investments are high-risk due to various risk characteristics, including market and product risk. These risks include operations in new markets (market risk) and the lack of a commercially viable solution.
Companies targeted by growth equity deals tend to be in mature and established markets where their product is commercially viable. These deals have high execution and management risk.
Growth Equity vs. Private Equity
Financial engineering and debt repayment generate significant returns from private equity and leveraged buyouts.
The most striking difference between growth equity and LBOs is that LBOs are focused on using debt to achieve their required returns.
However, growth equity firms rarely resort to debt. The amount of leverage in the capital is usually in the form convertible note. This amount is much lower than the amount used in LBOs.
Private equity firms often acquire majority stakes in companies. However, their investment thesis doesn’t necessarily require rapid growth. PE firms often only look for the portfolio company’s historical performance to realize their required returns.
Similar to venture capital, differentiation plays a crucial role in growth equity. Both are centered on “winner takes all” industries that can be disrupted by-products that are hard to replicate or proprietary technology.
Traditional LBO funds, on the other hand, focus on the defensibility and viability of FCFs to ensure that all debt obligations can be met on time. They also ensure enough debt capacity to avoid breaking a covenant. In an LBO context, stable, consistent, and defendable companies are more valued than companies with high growth.
Companies targeted by growth equity funds do not have a market position or a track record of profitability, unlike companies that go through buyouts.
Product, execution & default risk considerations
Venture capital has one of the most critical risks. It is called product risk. This can be in the form of not being able to create a product that meets users’ needs, lack of demand, non-functional products, or the existence of a better alternative.
Execution risk is the primary concern for growth equity. This refers to failure to implement a plan to achieve the desired outcome. This can happen, for example, if you lose out to competitors who offer similar products.
Execution risk is also a concern for private equity but to a minor degree. The main concern is the credit default risk owing to the leverage.
Also, as targeted by private equity/LBO firms, mature companies may be more vulnerable to market disruption and external competition (i.e., new entrants).
Although growth equity firms can invest in almost any industry, capital allocation tends towards software and other industries like healthcare and consumer discretionary.
Venture investments can be made in almost all industries. Control buyouts, however, are limited to mature and stable industries.
Growth equity shares specific characteristics with other private investment methods, but its appeal is more than just “splitting venture capital and private equity.” One could ask why or if now is the right moment to look at these strategies.
The growth equity asset class is attractive for at least three reasons.
Reliance upon Secular Growth. Growth equity investors look for companies with rapid organic growth. This is a beautiful strategy in low-growth macroeconomic environments.
Less risk profile relative to buyouts and ventures. Growth equity investments have a lower risk profile than other equity investments. They are typically minority positions and do not involve leverage. However, they are protected by shareholder and governance provisions that mitigate downside risks. Companies with growth equity portfolios tend to be less at risk of adoption and technology than venture capital-backed companies earlier in their development.
Strong Investment Performance. Growth equity fund returns since 2000 have been comparable to U.S. leveraged Buyouts and more than U.S. Venture Capital. Further, venture returns tend not to be concentrated among a few managers. Moreover, the conditions are there for successful managers to continue their success.
While growth equity shares specific characteristics with venture capital and private equity, it should be considered a distinct strategy with its own risk and reward profile. It is distinguished by its low use of leverage and portfolio companies that have strong organic growth. Growth equity has a similar return profile as leveraged buyouts but without leverage.
It could also be considered a low-octane proxy for venture capital, with a lower dispersion between company returns due to the lower risk of losing but little chance of the legendary ten-baggers essential to long-term venture success.
A term sheet is a document commonly used in venture capital and private equity investing to outline the terms of an investment agreement between a company, investor, or syndicate of investors. It typically includes various financial and legal considerations that govern the relationship between the parties and serves as a blueprint for the more detailed investment documents that eventually need to be drafted.
Management fees in venture capital are fees charged to the limited partners by the venture capital firm to cover its operating expenses. These fees are typically calculated as a percentage of the total committed capital to the venture fund.