Growth Equity Primer

What is a Growth Equity Firm’s Investment Criteria?

The type of company well-suited for a growth equity investment will have the following attributes:

• Planned Usage of Cash Proceeds
• Repeatable, Scalable Customer Acquisition Strategy
• “Untapped” Market Opportunity

Commercialization Stage: Business Model Lifecycle

The commercialization stage represents a developmental inflection point, where the value proposition and potential for product-market fit are validated.

Afterward, the subsequent step is to focus on execution, namely around growth.

Otherwise known as the growth stage, the products/services of companies at this stage have begun to gain widespread adoption, and their branding is starting to receive more recognition in their markets.

Generally, revenue tends to climb, and operating margins start to expand with increased scale.

The company at this stage, however, is likely far from being net cash flow positive (i.e. the “bottom line” has yet to turn a profit).

In theory, companies must make tangible progress toward profitability at some point; otherwise, the business model is not sustainable.

While most late-stage companies achieve decent profitability, the competitive nature of certain industries often forces companies to continue to spend aggressively (i.e. on sales and marketing), thus keeping profitability levels low.

The unsustainable cash burn of growth-stage companies can often be attributed to their single-minded focus on revenue growth and capturing market share, as these companies usually have high capital expenditure requirements and working capital spending needs to sustain their growth and market share.

Therefore, minimal free cash flows (FCFs) remain at the end of each period.

For these companies with unsustainable cash burn rates and significant re-investment needs, growth capital proceeds could be used to fund:

• Market Expansion: Expansion into new markets to reach new customers and demographics
• Product Development (R&D): Internal development of existing product/service offerings (or adding on new features)
• Back Office Support: Hiring more client engagement representatives and related back-office functions to support the sales team and those in client-facing roles.
• Sales and Marketing (S&M): Spending more on sales and marketing, as well as advertising campaigns.

At the commercialization stage, one of the top priorities is to establish the business model, which governs how the company will generate revenue. For instance, deciding how products will be priced, the branding and marketing strategy going forward, and how its offerings will be differentiated from its competitors are all topics that must be addressed.

Growth Stage Investing: Financial Profile and Stages

Once a company passes the proof-of-concept stage, the focus will soon center on sustaining growth, improving unit economics, and becoming more profitable.

Companies at the commercialization stage attempt to refine their product or service offering mix, expand sales and marketing functions, and correct operational inefficiencies.

But in reality, the shift towards profitability is not nearly as quick or efficient as one might assume.

For instance, one of the most important key performance indicators (“KPIs”) for software companies, the LTV/CAC ratio, should gradually normalize to a level around 3.0x-5.0x – which implies the business model is repeatable, and enough profits are being derived from customers to justify sales and marketing spending.

The LTV/CAC ratio, assuming the current metric is sustainable over the long run, is often considered a green light for continued efforts to scale, i.e. validation that the current plan and growth strategies are working as intended.

However, for saturated industries, companies (and the news headlines) tend to focus on revenue growth and metrics related to new user count, rather than profit margins.

Revenue growth in the commercialization stage will normally be around 10% to 20% (exceptional start-ups will exhibit even higher growth – i.e., “unicorns”).

In an effort to make their revenue more recurring and establish reliable sources of income, the process of improving a company’s business model could include:

• Targeting Larger-Sized Customers with More Spending Power
• Securing Multi-Year Customer Contracts (and Long-Term Recurring Revenue)
• Implementing Upselling and Cross-Selling Initiatives

Growth Equity Investment Strategy: Minority Interest

Since the growth equity firm does not typically hold a majority stake, the investor holds less influence over the strategic and operational direction of the portfolio company.

As a result, the three components below are critical for the investor to ensure positive investment outcomes:

Growth Equity Partnership Structure: Management Team

A critical difference between growth equity and traditional buyouts is the active role retained by the management team, as well as the prevalence of other investors who invested in earlier funding rounds. Unlike buyouts, strategic and operational decisions remain primarily with management.

Once a growth equity firm has completed an investment, it now owns a minority stake in the company in the form of newly issued shares (or existing shares of prior shareholders who viewed the growth capital investment as an exit strategy).

Growth equity funds invest predominantly in late-stage VC-backed companies – meaning the founders have already given up a significant portion of their equity and governance rights in earlier funding rounds (e.g., liquidation preference).

Given the absence of a majority stake, a partnership based on trust is required to ensure the management team can be relied upon to take the company to the next stage of growth.

Due to the structure of growth equity investments, the growth equity firm cannot take matters into their own hands if the direction of the company or decision-making of management differs from their opinions.

Growth Equity Investor: Value-Add Opportunities

The more value a growth equity firm can contribute to the portfolio company, the more weight its suggestions carry in board meeting discussions.

At the commercialization stage, expansion capital is not the only thing these companies need.

Just as important is access to a full suite of operational resources to help scale efficiently and navigate inevitable obstacles at this critical inflection point.

The differentiating factor that can make a growth equity firm stand out is its capacity to be more than just a capital provider along for the ride.

Despite only taking a minority stake, growth equity funds can still offer hands-on value to their portfolio companies. Each growth equity firm brings its unique specialization and business acumen to the table, but common examples include expertise in:

• Capital Structure Optimization (Debt and Equity Mixture)
• Mergers & Acquisitions (M&A)
• Initial Public Offerings (IPOs)
• Relationships with Institutional Investors, Lenders, Investment Bankers, etc.
• Business Development and Go-to-Market Strategy Planning
• Market Expansion and Customer Cohort Analysis
• Professionalization of Internal Processes (e.g., ERP, CRM)

Growth Equity Funds: Alignment of Interests

Growth equity investors come in at a time when the company has already accomplished a certain level of success.

Due to this timing, the investment sometimes is less meaningful to management since the market potential and product idea has already been validated.

Establishing trust from management and key stakeholders without a majority stake is the prime hurdle for growth equity funds.

Before obtaining a minority stake, a growth equity firm must gather information regarding the near-term and long-term goals of management (and influential shareholders with majority stakes).

Amongst the management team, the key stakeholders, and the growth equity investment firm, there must be an understanding and general consensus on:

• The portfolio company’s estimated market share that can be reasonably attained
• The pace of growth at which the company should attempt to expand
• The amount of capital required to fund the plans for growth, which dilute existing shares
• The planned, long-term exit strategy

The purpose of doing so is to ensure their objectives align with the investment thesis, which is oriented around continued expansion. To ensure an all-around beneficial outcome is structured, the firm needs to confirm the growth targets meet the growth equity fund’s threshold.

Growth Equity vs. Private Equity (PE): What is the Difference?

Growth equity firms can theoretically invest in any industry of their choosing, but the allocation of capital tends to be skewed towards mostly software and industries such as consumer discretionary and healthcare to a lesser degree.

Venture investments are made across nearly all industries, whereas control buyouts are restricted to mature, stable industries.

In terms of the risk/return profile, growth equity sits right in between venture capital and private equity (LBOs).

• Venture Capital (VC): The funds are intended to test for product-market fit (i.e., the viability of the idea) and product development. The majority of the portfolio is expected to fail, but the return from a “home run” can offset all those losses and enable the fund to achieve its targeted returns (i.e., tail-heavy distribution)
• Private Equity (LBO): The use of debt is one of the primary return drivers. Therefore, the fund attempts to minimize the required equity contribution. Differs from growth equity in that most, if not all, of the target’s equity is acquired post-LBO

Growth Equity vs. Venture Capital (VC): What is the Difference?

In most cases, venture capital represents the first injection of institutional capital to fund the market research, product development, and related projects of early-stage companies.

For a start-up attempting to reach the next stage of development, most face the common challenge of raising enough capital before running out of cash.

Once they have moved beyond the point of just needing enough cash, the focus at this growth stage shifts to establishing a niche and continuing the company’s top-line growth.

Here, common initiatives include refining the product or service offering, expanding the sales and marketing functions, filling in the missing pieces in the organization, and targeting large-scale customer acquisitions.

Early-stage companies usually see growth rates near or far above 30%, while growth-stage companies grow at a rate around 10% and 20%. The exponential growth seen at the onset gradually slows down. However, revenue growth is still a double-digit figure at this point.

Growth Equity vs. LBOs: What is the Difference?

The returns from a growth equity investment come predominantly from the growth of the equity itself. In contrast, a significant portion of the returns from leveraged buyouts is generated from financial engineering and the paydown of debt.

Thus, the most notable differentiation between growth equity and LBOs is that LBOs focus on the use of debt to achieve their required returns.

Growth equity firms, however, rarely use debt. If the capital structure has any leverage (most often in convertible notes), the amount is negligible compared to the amount utilized in LBOs.

Another important difference is that private equity firms acquire majority stakes in companies, and their investment thesis does not necessarily include rapid growth. PE firms often just need the portfolio company to perform in line with its historical performance to achieve its required returns.

Like venture capital, differentiation is a critical factor in growth equity, and both are centered around “winner-takes-all” industries that can be disrupted through products that are difficult to replicate and/or proprietary technology.

On the other hand, traditional LBO funds focus on the defensibility of the FCFs to ensure all debt obligations can be met on time, and confirm there is sufficient debt capacity to avoid breaching a debt covenant.

Thus, companies that generate steady, consistent cash flows while operating in established markets with minimal disruption risk tend to be perceived as higher-quality investments than high-growth, yet risky targets in the context of an LBO.

Unlike companies that undergo traditional buyouts, companies targeted by growth equity funds have neither a defensible market position nor a consistent track record of profitability.

What are the Risks in Growth Equity Investing?

• Product Risk: The central risk consideration in venture capital is product risk, which can come in the form of being unable to develop a product that meets the needs of its users, lack of market demand, non-functional products, the existence of an alternative with more utility, etc.
• Execution Risk: For growth equity, the concern shifts to execution risk, which refers to the failure of the plan to achieve the desired outcome. For example, this can be caused by losing out to close competitors offering similar products. Private equity (LBO) also has exposure to execution risk, but to a lesser degree. Instead, the main consideration is the credit default risk due to the amount of leverage used.
• Disruption Risk: Additionally, mature companies (as targeted by private equity / LBO firms) may be subject to increased market disruption risks and external competition (i.e., targeted by new entrants).