Key insights
- Private equity firms seek to buy businesses with potential for growth and value generation
- Depending on your goals, you might opt for growth capital or a buyout
- PE firms may want you to stay involved in the business after selling
Private equity (PE) is a potential pathway for business owners considering an eventual sale. But what is private equity, and how does it work for small to mid-sized businesses?
Private equity is a type of investment where investors pool their funds to buy ownership stakes in a private company, aiming to improve the business and eventually sell it at a profit.
For business owners, understanding how PE works—and whether it’s the right fit—can be key to making well-informed decisions about the future of their companies.
In this guide, we’ll break down how PE works for business owners and what types of companies attract PE firms. We’ll also examine private equity versus other forms of business investment, such as selling to strategic buyers. You should gain a clearer understanding of how PE might play into your plans.
How private equity works for small and mid-sized businesses
PE firms typically raise capital from institutional investors and high-net-worth individuals, forming a fund that they use to invest in various businesses. They seek companies with growth potential and specific opportunities to generate value.
Here’s a straightforward overview of how PE works.
- Investment selection. Private equity firms carefully select businesses that align with their investment strategy.
With small and mid-sized businesses, PE firms often look for:
- Potential for growth or expansion
- Strong management teams
- Solid market positions within a niche
- Opportunities to reduce costs or enhance efficiencies
- Ownership acquisition. PE firms typically buy a majority stake in the company, though minority stakes are also common for growth-oriented investments. They might make direct purchases or combine their capital with borrowed funds (leveraged buyouts).
- Operational improvement. Once a business is acquired, PE firms work closely with the management team to implement changes that increase the company’s profitability and efficiency. This might mean introducing better financial controls, improving sales strategies, or even expanding into new markets.
- Exit strategy. After growing the company’s value, the PE firm aims to exit the investment. This could involve selling the business to another buyer, taking it public, or merging it with another company in the firm’s portfolio.
Private equity firms usually hold on to investments for three to seven years, aiming for a substantial return at the end. For business owners, this timeline typically involves growth and restructuring, followed by a clear exit plan.
Types of private equity deals: growth capital versus buyouts
Understanding the different types of PE deals can help you determine whether PE is right for your business. Two common deal types are growth capital and buyouts.
Growth capital
This PE investment strategy is aimed at funding the expansion of a business without taking full control. In this scenario, the PE firm provides money to help fund growth initiatives such as:
- Expanding to new locations
- Launching new products or services
- Enhancing sales or distribution channels
For a business owner, growth capital allows you to retain a degree of control while securing funds for expansion. It’s often an appealing choice if you’re looking to scale operations but aren’t ready for a full exit.
Buyouts
In a buyout, the PE firm acquires a majority, or even complete, stake in your company. There are two main types of buyouts:
- Management buyouts. Here, the company’s management team buys the company with the financial backing of a PE firm.
- Leveraged buyouts. In this case, the PE firm uses a mix of its own and borrowed capital to buy the business.
Buyouts tend to be more suitable if you’re ready for a full exit or don’t mind relinquishing control after years of hard work.
Growth capital lets you grow your business without a full exit, whereas a buyout is best for owners ready to sell.
What types of companies do private equity firms invest in?
Not every business is a prime candidate for PE investment. PE firms typically look for companies with specific characteristics, such as:
- Revenue and profitability. Although PE firms invest in a range of industries, they generally prefer businesses with consistent revenue and a clear path to profitability.
- Niche dominance. Companies often attract PE interest if they dominate a specific market segment, even if they’re not large.
- Scalability. Businesses with room to expand—whether through product lines, geographic markets, or customer base—are often preferred.
- Operational improvements. A business can be highly appealing to PE if it shows potential for improving efficiency or reducing costs.
Small to mid-sized companies with growth potential or operational inefficiencies are particularly attractive, because PE firms can implement changes to increase profitability.
Private equity firms prefer businesses with steady revenue, market niches, scalability, and operational improvement potential.
Private equity versus strategic buyers
If you’re considering selling your business, you might wonder how PE compares to selling to a strategic buyer. Both options have their pros and cons, and understanding the differences is essential for making the right choice.
1. Investment focus
- Private equity firms: Focus on financial returns through growth and operational efficiency
- Strategic buyers: Often competitors or businesses in related industries looking to acquire assets, customers, or technology to expand their operations
2. Control and involvement
- Private equity firms: Work with existing management and aim to grow the business over a set period; may encourage you to stay involved post-sale
- Strategic buyers: Often take over full control and integrate your business into their own, meaning your role may phase out quickly
3. Financial structure
- Private equity firms: Use a combination of capital and debt, often with a detailed growth plan
- Strategic buyers: Generally rely on their resources without requiring the same level of debt, potentially providing a simpler transaction process
4. Potential for future involvement
- Private equity firms: May keep you or your management team involved, making it a suitable choice if you’re not ready for a total departure
- Strategic buyers: Typically absorb your company into their existing structure, meaning a full exit may be inevitable
Private equity firms might let you stay involved, whereas a sale to a strategic buyer may lead to a quicker departure from the business.
How private equity evaluates your business
Valuation is a central factor in any PE deal. PE firms aim to invest at a fair value, with the potential for significant returns down the line. Here are the main factors they consider.
- Revenue: Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a key metric for evaluating profitability.
- Growth potential: PE firms look at your business’s potential for future revenue and margin growth.
- Market conditions: The broader market and industry trends play a role; PE firms assess how your business fits within these dynamics.
- Comparable sales: PE companies will look at recent sales in your industry to gauge a competitive valuation.
Working with an investment bank or other advisor can help you understand your business’s valuation range and increase the likelihood of a successful PE investment.
Timing your exit with private equity
We typically advise entrepreneurs to sell when their business is ready. Market conditions are a secondary concern because they’re so hard to predict—by the time a PE firm arrives at a final valuation, months will have gone by. Here are the factors to consider:
- Business readiness. Ensure your business is operating at peak performance. Addressing inefficiencies before engaging with PE can boost your valuation.
- Personal readiness. If you’re not ready to step away, growth capital can allow you to scale without a complete exit. If you’re set on an exit, a buyout might be a better fit.
- Market conditions. Strong economic conditions may lead to higher valuations, making some periods more favorable to sell. But we don’t recommend prioritizing market conditions as a precursor to selling.
Assess your personal goals and business readiness before deciding on a PE engagement, with market conditions as another possible factor.
Final thoughts
Understanding how PE works and weighing it against other options will help you make informed decisions that best align with your long-term goals. With the right partner, PE can be a powerful tool for taking your business—and your life—to the next stage of its journey.