AS SEEN IN PRIVATE EQUITY by CARY MUSECH Minnesota Are you ready for private equity? Here’s how to tell “YOU’RE BUYING an...airplane?!” This was my partner’s shocked response when a business owner informed him that he was using precious capital to buy an asset that flies. Our firm was considering an investment in his business, which had attractive growth characteristics and needed capital to expand. Our negotiations ended abruptly when we discovered that our investment may be used to fund an asset with a questionable return on investment. The business owner was surprised at our response, but it was clear to us that he was not ready for private equity. Our firm, Tonka Bay Equity Partners, manages two private equity funds with combined capital of $200 million. Our capital comes from institutional investors, such as banks and pension plans, and high net-worth individuals who expect a return on their investment. We pool this capital to acquire and invest in small and medium sized businesses with EBITDA (earnings before interest, taxes, depreciation and amortization ) of at least $2 million. We are typically the first outside investors in our portfolio companies. Part of our investment strategy is to help develop the management team, infrastructure, and growth strategy of portfolio companies, so that they will be attractive to larger institutional investors or strategic partners. Companies that have developed a foundation in these areas, and are ready to take on 98 The most successful entrepreneurs supplement their skills with professional managers. We look for professional 2 management in the key functional areas of the company, which typically include sales, finance and operations. By “professional,” we mean 3 managers who have been trained and have demonstrated success in growing a business and managing for profit. We like to see outside experi4 ence, maybe at a larger company that has a strong training culture. This is in contrast to most entrepreneurs’ business experience, which may be homegrown. [tips] 1 a “partner,” will be ready for private equity. The following are some suggestions that will help you demonstrate to an investor that your company is ready for private equity. Professional management The most successful entrepreneurs supplement their skills with professional managers. We typically look for professional management in the key functional areas of the company, which include sales, finance and operations. By “professional” we mean managers who have been trained and have demonstrated success in growing a business and managing for profit. We like to see outside experience, maybe at a larger company that has a strong training culture. This is in contrast to most entrepreneurs’ business experience, which may be homegrown. We’ve learned that companies with management teams that are stocked with family members and relatives are probably not ready for private equity. In these situations, our desire to earn a return for our investors may be at odds with building a family legacy. We’ve seen many situations where the owner’s spouse keeps the books for the company — an obvious conflict. During one onsite visit, a business owner pointed out an empty spacious office that was reserved for his 12year-old son. In general, private equity firms are attracted to situations where management is separate from ownership. Good advisers Business owners that surround themselves with good advisers — and heed their advice — show a readiness for private equity. Retain the best advisors you can afford including accountants, attorneys and board members. The most basic requirement of a private equity firm will be accurate finan- AS SEEN IN UPSIZE MINNESOTA, JUNE • JULY 2006 • reprinted with permission, all rights reserved www.upsizemag.com cial statements. If private equity is in your future, have your financial statement audited. We’ve had good experience with regional firms that provide senior level attention and great service. A good attorney can be an asset to a business when it comes to negotiating material contracts and protecting trade secrets. Attorneys are also critical in dealing with human resource issues, a complex area of the law and a weakness in many small companies. In addition, a strong attorney will help streamline the due diligence process for a private equity firm. Having a board of directors is a sign that a business owner is open to outside opinions and ideas and is an important step in attracting private equity. Improving corporate governance is a current issue for larger public companies. We believe that smaller, privately held companies can benefit from this trend. We recommend that you form a board of directors and use it. Recruit directors who have run successful businesses that will challenge you and supplement the skills and experience of your management team. Boards don’t need to be large if they have the right composition. We typically structure five-person boards. Articulate strategy Smaller companies can often protect themselves from larger competitors by carving out a niche or by developing a proprietary product or service. Be prepared to articulate your niche and how you can protect it. We can usually tell when a company has developed a niche, and when there are meaningful barriers to entry, by the profit margins on their products or services — which are typically higher than normal. Barriers to entry can include patents and other kinds of intellectual property protection, extensive capital requirements, or proprietary know-how. Private equity investors are typically looking for companies that have proven business models and are historically profitable. One of the questions we like to ask is whether a company knows where they make their money. www.upsizemag.com [quote] “One of the questions we like to ask is whether a company knows where they make their money. Companies who track profitability by customer and by product line have made a major step in preparing for private equity.” — Cary Musech, Tonka Bay Equity Partners Companies who track profitability by customer and by product line have made a major step in preparing for private equity. The Achilles heel of small businesses is customer concentrations. It is difficult to turn down large customers, such as a Wal-Mart, if they want to give you more business. While this may be attractive in the short term, having a large customer concentration will be perceived as very risky by a private equity firm. It is important to develop a strategy to diversify your customer base and make this a top priority. through the business. These things have to go if you want to attract private equity. While we like to have fun, from our perspective, business is business. There is no real magic to attracting private equity. Sound business principles and the willingness to fly coach is what you need to succeed. [contact] Cary Musech is the managing principal of Tonka Bay Equity Partners in Minnetonka: 952.345.2035; cmusech@tonkabayequity.com; www.tonkabayequity.com Prepare for new partner A private equity investor will become a partner focused on helping your business succeed. Investors ask questions and request information. This may be time consuming, but in return you can expect some good advice and fresh ideas. Many small-business owners run their companies like it’s their own personal checkbook. These companies may have expensive cars, club memberships, and personal expenses run AS SEEN IN UPSIZE MINNESOTA, JUNE • JULY 2006 • reprinted with permission, all rights reserved 99