If any of you are fans of HBO’s Silicon Valley - I am also. Besides the humor, believe it or not I actually learn a good chunk about PE’s and VC’s. Basically how private equity works is that there is this company called its WIS Company that need money. They schedule meetings with VC or PE firms who evaluate the business and submit offers. Usually the offer has 3 main parts - the bid, the ownership (%) and the valuation. So if a VC bids 50k for 10% they are effectively valuing your company at 500k. Now what is there are ten VC’s vying for that single company and the offer gets bids up. What happens then?

That is basically the nature of the private equity scene today- there is simply too much money or “dry powder” laying around and people are eager to take action. Does that mean firms are basically throwing money at every firm that asks for it? Not exactly, moreover its basically there is only one company wanting money and everyone throwing money at that one.

So what exactly is private equity and why is it so popular?

Private equity (PE) is basically the process where large investment firms (with lots of capital) extend capital and other resources to start-up or private companies in return for ownership. PE is very popular due to the outsized returns it can provide as the company grows and progresses through multiple equity financing rounds and ultimately goes public - usually this coincides with the exit of the PE firm.

How does PE provide outsized returns?

1st Round - Company WIS presents proposal PE firm buys stake 50K at 10%. = 500k valuation

2nd Round - Company WIS requires more capital and presents to other firms. PE firm 2 commits 50k for 5% = 1million valuation

3rd Round- Company WIS requires additional capital for infrastructure. PE firm 3 commits 100k for 5% - giving them a 2 million valuation

This process continues…

Tally

PE firm 1

Now holds a 10% of 2 million giving them a 200k equity position representing a four-fold increase

PE Firm 2

Holds a 5% position of 2million giving them a 100k equity position representing a two-fold increase.

Seems like a pretty good deal right?

The problem today well according to Chris Flood from the financial post magazine is that there is simply too much capital floating out there to generate the same kind of returns that PE investors have come to expect. With so much capital floating around and many people vying for the same deal - essentially this is driving the prices and valuation of companies up and reducing future returns. So although the money is being put to use its coming at a steep discount.

This is something to consider if you are investor banking on the PE boom to help you achieve your financial independence.

By Ali Chattoo