Growth equity investment criteria
To understand growth equity investments, first we must discuss typical investment criteria for deals. Growth equity investments typically embody many (if not all) of these characteristics:
- Significant customer traction and/or revenue
- Strong growth in revenue (e.g. at least 10%, but usually 30% or higher)
- Offer technology-enables services or products
- Established business model (e.g. paying customers with path to sustainable long-term margins)
- Positive (or nearly positive) profitability; typically, no further fundraisings are planned until after IPO or exit
- Deal involves the purchase of a non-controlling, minority ownership stake (less than 50%)
- Proceeds from investment are typically used to accelerate growth (or provide secondary liquidity to shareholders)
- Do not typically high loads of debt
- Growth (instead of debt) is primary driver of deal returns
Among the criteria listed above, perhaps the most contentious are: “positive (or nearly positive) profitability” and “established business models.” These factors create a schism of sorts among growth stage investors.
While many growth investors have made a fortune investing in successful venture-backed startups that have reached the growth stage, some growth investors (e.g. TA Associates and Summit Partners) tend to eschew such investment opportunities, reasoning that these companies are further away from profitability and have less evidence of a sustainable business model — especially given their high valuations.
Instead, such firms seek out investment targets that have strong, profitable businesses that are growing quickly but are more under-the-radar (e.g. family-owned, non-tech industry, etc.).
How does a growth equity investment work
Most growth equity investors describe their core job responsibility as “identifying the fastest growing markets in the world, and then investing in the best companies in those markets.”
While there are diverse philosophies among firms on how to best to do this, many growth equity funds would describe the ideal process as:
- Firm develops a “thesis” about why a market is attractive or poised for growth
- Firm becomes expert on this industry through research and meeting with companies
- Firm identifies the market-leading companies within that industry
- Firm invest in the best one
Of course, every process and every firm is different. The reality is that, given the competition within growth stage investing, many firms operate more opportunistically, frequently evaluating markets and prospective deals reactively after being notified by sell-side bankers.
Growth equity investment process
Developing a Market Thesis
The first step in the growth equity investment process is to create a market thesis. This means finding sectors or industries that are likely to have significant growth. Investors do this by researching market trends, looking at competitors, and studying economic factors to decide which markets have the best investment potential.
Key Activities:
- Market Research: Gathering data on industry trends, growth drivers, and potential disruptors.
- Competitive Analysis: Evaluating the competitive landscape to identify leading companies and potential market gaps.
- Economic Assessment: Analyzing macroeconomic factors that could impact market growth.
Conducting Due Diligence
Once a promising market is identified, the next step is to conduct due diligence on potential investment targets. This involves a comprehensive evaluation of a company’s financial health, operational capabilities, and strategic positioning.
Key Activities:
- Financial Analysis: Reviewing financial statements, cash flow projections, and profitability metrics.
- Operational Review: Assessing the company’s operations, supply chain, and production capabilities.
- Management Evaluation: Meeting with the management team to gauge their vision, experience, and ability to execute the business plan.
- Risk Assessment: Identifying potential risks and developing strategies to mitigate them.
Structuring the Deal
After due diligence, the next step is to structure the deal. This involves negotiating the terms of the investment, including the size of the equity stake, valuation, and any protective rights such as board seats or veto power over major decisions.
Key Activities:
- Valuation: Determining the appropriate valuation based on financial performance, market conditions, and growth potential.
- Negotiation: Discussing and finalizing the terms of the investment with the company’s management and existing shareholders.
- Legal Documentation: Drafting and reviewing legal documents to formalize the investment agreement.
Adding Value Post-Investment
Once the investment is made, growth equity investors work closely with the company’s management to drive growth and enhance value. This can involve strategic guidance, operational improvements, and leveraging the investor’s network to open new opportunities.
Key Activities:
- Strategic Planning: Assisting in the development and execution of growth strategies.
- Operational Support: Providing expertise to optimize operations, improve efficiency, and scale production.
- Network Leverage: Connecting the company with potential customers, partners, and industry experts to accelerate growth.
Exit Strategies
The final step in the growth equity investment process is planning and executing an exit strategy. The goal is to sell the investment at a significant profit, typically through an IPO, sale to another private equity firm, or a strategic acquisition.
Key Activities:
- Exit Planning: Developing a clear exit strategy aligned with market conditions and company performance.
- IPO Preparation: Preparing the company for a public offering, including financial audits and regulatory compliance.
- Sale Negotiation: Identifying potential buyers and negotiating the terms of the sale to maximize returns.
Exit strategies in growth equity investments
Exit strategies are a critical component of growth equity investments, as they determine how investors realize their returns. Growth equity investors typically plan for exits through several avenues, each with its own set of advantages and considerations. Below is an overview of the primary exit strategies implemented in growth equity investments:
Initial Public Offerings (IPOs)
One of the most lucrative exit strategies for growth equity investors is taking the company public through an Initial Public Offering (IPO). This process involves listing the company’s shares on a public stock exchange, allowing investors to sell their shares to the public.
Advantages:
- High Returns: IPOs often provide significant returns if the company’s growth potential is well-received by the market.
- Liquidity: Public markets offer higher liquidity, enabling investors to sell their shares more easily.
- Visibility: Going public increases the company’s visibility and can enhance its reputation and credibility.
Considerations:
- Regulatory Compliance: The IPO process requires rigorous regulatory compliance and disclosure, which can be time-consuming and costly.
- Market Conditions: The success of an IPO is heavily dependent on favorable market conditions and investor sentiment.
Example: Alibaba’s IPO in 2014 is a prime example, where growth equity investors such as Silver Lake achieved substantial returns upon the company’s public listing.
Strategic Acquisitions
Another common exit strategy is selling the company to a strategic acquirer. These acquirers are often larger companies within the same industry seeking to expand their market share, acquire new technologies, or achieve synergies.
Advantages:
- Premium Price: Strategic buyers may be willing to pay a premium for the company due to potential synergies and strategic fit.
- Faster Execution: Acquisitions can often be executed more quickly than IPOs, providing a faster return on investment.
Considerations:
- Integration Risks: The success of the acquisition depends on the successful integration of the acquired company into the buyer’s operations.
- Negotiation Complexity: Negotiating the terms of the acquisition can be complex and requires careful consideration of various factors.
Example: Facebook’s acquisition of Instagram in 2012 is a notable example, where Instagram’s investors benefited from a strategic sale to a larger tech company.
Sales to Other Private Equity Funds
Selling the company to another private equity fund is also a viable exit strategy. This is often referred to as a secondary sale and involves transferring ownership from one set of private equity investors to another.
Advantages:
- Specialized Buyers: Private equity funds may have specialized knowledge and capabilities to further grow the company.
- Flexible Terms: Secondary sales can be structured to meet the needs of both the seller and the buyer, offering flexibility in deal terms.
Considerations:
- Valuation Differences: Differences in valuation expectations between the buyer and seller can complicate the sale process.
- Market Saturation: In a crowded market, finding the right buyer can be challenging.
Example: The sale of Skype from Silver Lake Partners to Microsoft is an example where a strategic acquisition followed a private equity investment phase.
Share Buybacks
In some cases, the company may buy back shares from investors as an exit strategy. This approach allows existing shareholders to increase their ownership percentage while providing liquidity to existing investors.
Advantages:
- Control Retention: Allows the company to retain control by reducing the number of external shareholders.
- Simplified Process: Share buybacks can be less complex and quicker than other exit strategies.
Considerations:
- Cash Availability: The company must have sufficient cash reserves to buy back shares.
- Impact on Financials: Large buybacks can impact the company’s financial health and cash flow.
Example: A private tech company might use profits or additional financing to repurchase shares from early investors, providing them with an exit while maintaining control within the company.
Which stage is growth equity
In theory, “growth” investments can occur at any stage or round; there are no exact cutoffs for which rounds qualify (e.g. Series A, B, C) as a “growth” round. Rather, it can be helpful to remember that any round can qualify as a “growth” round so long as it has the attributes listed above.
Given that provision, a given startup today would likely start to meet the “growth” qualifications above in the Series C or later. While this Series C cutoff is debatable, this is when many investors start looking to approach profitability while still taking on expansion capital.
That said, a company may have never taken any outside investment previously (so-called “bootstrap”), and still have reached a level of traction and de-risking to attract growth stage investors.
While investments in IPOs or public-traded companies can be considered “growth” investments — given the company’s characteristics — most growth equity investors do not participate (instead focusing on investments in privately-held companies) in accordance with their Limited Partners preferences. (In case you’re curious why, LPs do not want to pay such high fees to growth equity funds to simply purchase publicly traded shares they could easily purchase themselves on their Schwab account!)
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What makes a good growth equity investment
An attractive growth equity investment usually meets many or all of the core criteria of strong growth, minority stake, low debt, proven business model, and positive or near-positive profitability.
However, it’s important to remember that one factor is usually most important — growth. As the name implies, “growth” equity investments generate returns through growth. This means that the rate of revenue (or EBITDA) growth for any prospective deal is of utmost importance. There’s not usually a hard-and-fast rule, but many growth investment firms target companies that have a higher rate of growth than the fund’s return target (say, 25%+).
Every investor has his or her own framework for assessing companies. At General Atlantic — a top growth fund where I worked — a Managing Director once taught me his favorite mental model for what makes an attractive growth investment. It’s called the “3Ms”:
- Market – Large and growing market that provides strong tailwinds
- Business Model – Company has a strong business model that, once at scale, can provide durable margins and defensibility for the company
- Management – A visionary management team that will drive and execute against ambitious growth opportunities
Above provides a simple and easy framework to assess the key merits of growth equity investments quickly. Just note, however, these are just a few of the criteria. There are several other considerations one must take into account when actually determining the merit of a deal. For instance, here are a few more considerations related to the transaction itself:
- Competitive Deal Dynamics – Are there many firms competing to do this deal, or is the opportunity “proprietary” to your firm?
- Sector Fit – Does your company invest in companies within this industry?
- Investment Size & Ownership – How large of an investment is the firm looking for, and given your desired ownership stake, does this fit into your firm’s investment parameters?
- Governance – Is the company looking to add board seats as part of the transaction, and does your firm require this as a condition for investment?
- Value Add – Can your firm provide expertise or services that will help the company with strategic initiatives (e.g. hiring, geographical expansion, future fundraising, etc.)?
How growth equity investors provide value
Growth equity investors play a crucial role in the success of their portfolio companies by providing technical insights and strategic guidance. Their involvement is extensive – covering various aspects of business operations and long-term planning. Here’s a detailed look at how they add value:
Optimizing Sales Efforts Growth equity investors help streamline and improve the sales processes. Specifically:
- Sales Strategy Refinement: Collaborate with the company to refine sales strategies, ensuring they are aligned with market opportunities and company goals.
- Technology Implementation: Introduce advanced sales technologies, such as Customer Relationship Management (CRM) systems, to increase efficiency.
- Sales Training: Provide targeted training to the sales team, improving their skills and overall performance.
For example, a company might adopt a new CRM system recommended by investors, which can lead to better tracking of sales leads and improved customer interactions.
Scaling Production Efficiently scaling production is critical for growth. Investors assist by:
- Process Optimization: Implementing lean manufacturing techniques to streamline production workflows and eliminate bottlenecks.
- Supply Chain Management: Enhancing supply chain operations to ensure timely delivery of materials and products.
- Quality Control: Establishing rigorous quality control measures to maintain product standards as production scales.
This might involve restructuring the supply chain to reduce costs and improve delivery times, ensuring the company can meet increased demand without sacrificing quality.
Identifying New Market Opportunities Investors leverage their market knowledge to identify and capitalize on new opportunities. They help with:
- Market Research: Conduct thorough market research to uncover trends, customer needs, and competitive landscapes.
- Geographic Expansion: Develop strategies for entering new geographic markets, including detailed market entry plans.
- Product Line Expansion: Identify opportunities to expand the company’s product offerings to address unmet market needs.
For instance, an investor might suggest entering a fast-growing international market or launching a new product line based on emerging consumer trends.
Strategic Planning and Execution Collaborating with management, investors help set clear goals and develop strategic plans. They participate in:
- Goal Setting: Work with management to set ambitious yet achievable growth targets.
- Performance Metrics: Define key performance indicators (KPIs) to measure progress and identify areas for improvement.
- Regular Reviews: Conduct regular strategy reviews to assess performance and adjust plans as needed.
An investor might help a company set a target of doubling its market share within five years, using specific KPIs to track progress toward this goal.
Enhancing Management Capabilities A strong management team is essential for executing growth strategies. Investors assist with:
- Executive Recruitment: Leveraging their networks to attract top talent for key executive positions.
- Leadership Training: Offering training programs to enhance the skills and capabilities of the existing management team.
- Mentorship and Support: Providing ongoing mentorship, offering strategic guidance and industry insights.
For example, an investor might help recruit a seasoned CFO to strengthen the financial management team or provide leadership coaching to the CEO.
Growth equity examples
An iconic example of a growth stage investment was Silver Lake’s investment in Chinese goods marketplace, Alibaba. Over multiple investment rounds in 2011 and 2012, Silver Lake invested $500 million for a minority ownership stake in Alibaba (estimated to be less than 5%, valuing the business at over $10 billion).
By 2011, it was clear that Alibaba had significant traction, was growing rapidly, and had an attractive marketplace business model. The company had also identified ways they could scale even faster if they had more capital. In summary, the stage was set for an awesome growth investment.
That said, there were also clear risks. At such a high valuation and low ownership stake, Silver Lake wouldn’t have much (if any) official oversight of management. Further, Western investment firms didn’t have as much experience investing in Chinese companies. Finally, what if China’s weak currency and strong industrial advantage — arguably, catalysts underlying Alibaba’s huge market opportunity — weakened in the future?
How’d it turn out? Well, in 2014 when Alibaba went public, Silver Lake’s stake was valued at more than $5.1 billion, achieving more than a 10x return and $4.5 billion in net gain. If we assume Silver Lake itself would earn 20% of the net gain, as is the standard “carry” for growth funds, the firm’s partners would have earned nearly $1 billion on the deal. Not. Too. Bad.
Other examples of iconic growth deals include:
- General Atlantic / Adyen – General Atlantic invested $250 million in 2014, which valued the company at $1.5 billion. At IPO in 2018, this stake was worth $1.4 billion (5.5x or ~53% IRR).
- DST / Facebook – DST led the Series D investment of $200 million in 2009, which valued the company at $9.8 billion. At IPO in 2012, this stake was worth $2.0 billion (10.2x or ~115% IRR)
- Tiger Global / Stripe – Tiger Global invested nearly $345 million across two growth rounds in 2018/2019, each time valuing the company at over $20 billion. At Stripe’s $95 billion valuation achieved in March 2021, this stake was worth $1.6 billion (4.6x or ~89% IRR)
Protective rights and governance in growth equity
In growth equity investments, protective rights and governance safeguards the interests of investors while ensuring that the company’s growth trajectory remains on course. These protective measures are negotiated as part of the investment agreement and can significantly influence the decision-making process within the company.
Board Representation
One of the primary protective rights that growth equity investors negotiate is board representation. By securing seats on the company’s board of directors, investors can have a direct influence on strategic decisions and ensure that their interests are represented at the highest level.
Key Aspects:
- Direct Influence: Board seats allow investors to participate in key decisions regarding the company’s strategic direction, major expenditures, and significant operational changes.
- Monitoring and Oversight: Board representation provides a platform for investors to monitor the company’s performance closely and offer guidance based on their expertise.
Veto Rights and Change of Control Provisions
Another important protective right is the ability to veto certain decisions that could significantly impact the company’s future. This includes decisions related to mergers and acquisitions, changes in business strategy, and other major corporate actions.
Key Aspects:
- Veto Rights: Investors may negotiate veto rights over key decisions to prevent actions that could jeopardize their investment or alter the company’s growth strategy.
- Change of Control Provisions: These provisions protect investors in the event of a significant change in ownership or control of the company, ensuring that they have a say in such pivotal decisions.
Anti-Dilution Protections
Anti-dilution provisions are designed to protect the investor’s equity stake from being diluted in future funding rounds. These provisions adjust the investor’s ownership percentage to reflect the issuance of new shares.
Key Aspects:
- Price Protection: Anti-dilution clauses ensure that the investor’s shares are not devalued by future issuances of stock at a lower price than what they initially paid.
- Ownership Maintenance: These provisions help maintain the investor’s proportionate ownership and control within the company.
Information Rights
Investors often require detailed and regular updates on the company’s performance and financial health. Information rights ensure that investors receive timely and comprehensive reports, which are critical for making informed decisions.
Key Aspects:
- Regular Reporting: Mandated regular financial and operational reports help investors stay informed about the company’s progress and any potential issues.
- Transparency: Information rights promote transparency and accountability within the company, fostering a relationship of trust between the company’s management and its investors.
Protective Covenants
Protective covenants are specific agreements that restrict certain actions by the company without the investor’s consent. These can include restrictions on incurring new debt, changing the business model, or making large capital expenditures.
Key Aspects:
- Operational Control: Protective covenants provide a mechanism for investors to prevent the company from taking actions that could negatively impact its financial stability or strategic direction.
Risk Management: These covenants help manage and mitigate risks associated with significant business decisions.
Conclusion
Check out the rest of my growth equity primer if you’d like to dive deeper into the industry, investment strategy, or career path.
Also, if you’re interested in a career in growth equity, check out my step-by-step course on how to get into growth equity.
