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Growth Equity Primer

Growth Equity Meaning & Strategy of Expansion Capital Explained

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Growth Equity Primer

Key Takeaways
  • What is the definition of growth equity?
  • Which types of companies are targeted by growth equity funds?
  • How does growth equity differ from venture investing and control buyouts?
  • What are the main return drivers of growth capital investments?

Growth Equity Defined

Growth equity is intended to provide expansion capital for companies exhibiting positive growth trends.

For the most part, all early-stage companies, at some point in their development process, eventually need assistance either in the form of an equity investment or operational guidance.

Growth equity firms invest in companies that have already obtained traction in their respective markets but still need additional capital to reach the next level.

These targeted companies have moved past the early-stage classification, yet retain substantial upside potential in terms of “top-line” revenue growth, obtainable market share, and scalability.

The reluctance to accept external guidance or capital can prevent a company from realizing its full potential or capitalizing on opportunities that lie ahead.

With a growth equity investment, growth-stage companies can sustain or accelerate their growth trends by further disrupting and establishing defensible market positions.

Growth Equity: Target Investment Criteria

Investment Attributes

First and foremost, at the growth equity stage, the target company has already proven its value proposition as well as the existence of a product-market fit.

Growth equity firms invest in companies with proven business models that need the capital to fund a specified expansion strategy as outlined in their business plan.

Similar to early-stage start-ups, these high-growth companies are in the process of disrupting existing products/services in established markets. The difference is that the product/service has already been determined to be potentially feasible, the target market has been identified, and a business plan has been formulated – albeit there remains much room for improvements.

Growth Equity Investment Target Characteristics

Because the company has raised capital (and can raise more if deemed necessary), the priority tends to become growth and capturing market share, often at the expense of profitability. By further cleaning up its business model, the company should be able to achieve profitability if it were to focus its efforts on the bottom line (profits) instead of just the top line (sales).

Companies that do not necessarily “require” the growth capital to continue operating (and thus the decision to accept the investment was discretionary) are ideal targets.

This signifies that the company has enough funding and/or cash flows to finance its expansion strategy. If a company requires the capital to survive, the rate at which it is burning through cash could be a negative signal that the market demand is just not there or management is misallocating the funds.

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

Growth Equity Target Ideal Attributes

Purpose of Growth Capital

Commercialization Stage

Companies at the commercialization stage are at a developmental inflection point: the value proposition and potential for product-market fit have been validated, so the next natural step is to focus on execution, namely 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 its markets.

Revenue tends to climb and operating margins begin to expand with increased scale; however, the company is still likely far from being net cash flow positive (i.e., the “bottom line” has yet to turn a profit).

In theory, companies should have made tangible progress toward profitability. While most late-stage companies do indeed achieve decent levels of 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 frequently 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 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:

  • Expansion into new markets to reach new customers and demographics
  • Developing existing products/services (or adding on new features)
  • Hiring more sales representatives and related back-office functions
  • Spending more on marketing and 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.

Product Lifecycle Stages

Financial Profile

Once a company passes the proof-of-concept stage, the focus will soon center around 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 focusing on 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 CLV/CAC ratio, should gradually normalize to a level around 3.0x-5.0x.

This suggests the business model is repeatable and enough profits are being derived from customers to justify the sales and marketing spending, which can be considered a green light for continued efforts to scale.

CLV/CAC Ratio

However, for saturated industries, companies (and the news headlines) tend to remain focused on revenue growth and metrics related to new user count, as opposed to 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 (i.e., More Spending Power)
  • Securing Long-Term Customer Contracts
  • Increased Upselling / Cross-Selling Efforts

Growth Equity: Investment Structure

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 in order to help ensure positive investment outcomes:

Growth Equity Minority Stake

Partnership in Growth Equity

A key difference between growth equity and buyouts is the active role retained by the management team, as well as the prevalence of other investors that invested in earlier funding rounds. Unlike buyouts, the 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 preferences).

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

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, money is not the only thing these companies need.

Just as important is being offered 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.

Growth Equity Investor: Value-Add Opportunities

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:

Growth Equity Aligned 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 proceeding with 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.

Summary Comparison Chart

Before we go into detail regarding the variances between growth equity and VC / LBOs, the following table provides a high-level summary of the differences:

GE vs. VC / LBOs Comparison

Growth Equity vs. Venture Capital / Buyouts

In terms of the risk/return profile, growth equity sits right in between:

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)
Leveraged Buyouts (LBOs)

 

  • 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)

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 past 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%, whereas growth-stage companies grow at a rate around 10% and 20%. The exponential growth seen at the onset gradually slows down; nevertheless, revenue growth is still a double-digit figure at this point.

Investment Stage Lifecycle

Growth Equity vs. Leveraged Buyouts (LBOs)

The returns from a growth equity investment come predominately 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 usage of debt in order to achieve its required returns.

Growth equity firms, however, rarely use debt. If the capital structure has any leverage at all (most often in the form of convertible notes), the amount is negligible in comparison 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 key 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 concentrate on the defensibility of the FCFs to ensure all debt obligations can be met on time, as well as making sure there is sufficient debt capacity to avoid breaching a debt covenant. As a result, steady, consistent, and defensible companies are valued more than high-growth companies in the context of an LBO.

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

Product, Execution & Default Risk Considerations

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.

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 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.

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).

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.

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