The Five Myths of Private Equity

As venture capital and private equity continue to make news headlines, some entrepreneurs may find it challenging to distinguish fact from fiction. Republican presidential candidate Mitt Romneyfailed to clarify what he did at Bain Capital and further obscured the reputation of venture capitalists and private equity investors alike.

Economic Warfare - Ziad K. Abdelnour
Economic Warfare - Ziad K. Abdelnour

In meeting face to face with an average of 500 entrepreneurs each year I keep hearing the same question again and again: Why is every private equity fund with which we meet trying to take advantage of us?

There are indeed some real predators out there looking for an opportunity to take advantage of someone in need of financial backing; however, I don’t believe there are as many sharks as the financial press would have you believe.

Misperceptions can prevent an entrepreneur from making rational, fact-based decisions. During my twenty-five years as an investor and financier, I have identified “The Five Myths of Private Equity.”

The first is that private equity is a win-lose game. In this scenario, investors win and entrepreneurs lose. This is the favorite myth of people who are looking for someone to blame for their bad choices.

They didn’t read the contract they signed, they were too lazy to do their due diligence, or some other negative outcome occurred that caused them to lose control of their enterprise. They’re understandably angry, hurt, and looking to place the blame on someone other than themselves. According to this myth, private investors somehow make off with the value of your company, perhaps buying at a low price and cutting you out of the eventual rewards that you’d earn from going public or selling to another company. The important fact to remember is that private equity investors make money only if the value of your company appreciates. It is also a fact that, in most cases, the entrepreneur retains a substantial interest in the business. After all, it’s in the investor’s best interest to help you grow your company and increase its value. If the investor wins, the entrepreneur wins.

The second myth is that valuations are the only consideration when you’re shopping the deal. Valuation is certainly an important consideration. You want to get a fair price when you sell your company; however, it’s equally important to partner with an investor who shares your goals and who will work with you to achieve them. When you focus exclusively on valuation, you risk ending up with a partner who doesn’t understand your company, your growth strategies, or your industry. For example, suppose you sell your company to an investor whose expectations for your business are unrealistically high. You may obtain a good price for your company, but that relationship is likely to sour as the business fails to meet the investor’s expectations. However, an investor with a more nuanced understanding of your company would work with you to increase its value in a realistic and sustainable way.

The third myth is that private equity investors don’t add value because they haven’t been in an operating role. This may be true in some cases but should be avoided as a generalization. Most financiers and professional investors I know have ample experience with operating issues. Also, though they don’t usually try to micromanage portfolio companies, they can look at the operation from an objective perspective and add value by challenging management to think outside the box. Investors who have backed many different companies at rapid growth stages can recognize patterns that may not be obvious to the management team. They may have a network of relationships that can also assist companies in recruiting talent at the board and management level.

The fourth myth is that the taking of venture capital or private equity money means you lose control of your company. This often refers to the sharks and other predators looking for a quick kill. It can also stem from a person who is so determined to get their idea to market that they will accept any terms offered. As an entrepreneur, you cannot abdicate your responsibility for the sake of expedience. Nobody is forcing you to take a deal and surrender control. The reality is that if you take on a minority investment, you can continue to control your company, make all operating decisions, and have the ultimate say over strategic issues. It is my experience that the majority of investors do not want to run your company. They are busy running their own. Selling less than half of your company leaves you in charge, while providing liquidity to you and other early shareholders.

The last myth—namely, that private equity investors are interested only in your exit strategy—is one that ignores some basic realities about investing. When a private equity firm invests in your company, they do expect to exit their investment within the next five to seven years. Since the firm has limited partners who expect liquidity at some point, they can’t hold their investment forever. However, this doesn’t mean that you will have to sell your company or take it public. Alternatives might include recapping the company with bank debt, swapping out one investor with a new private equity investor, or raising capital from a strategic partner. In any event, your private equity partner has a vested interest in growing your company over the next several years up to the exit event. Their goal during this period is the same as yours: to increase the value of your company by expanding the business.

Whether or not to take on private equity financing is a complex decision, requiring in-depth analysis of your personal and business goals, the market environment, and the financing options available.

Focusing on these important considerations and avoiding the more common misperceptions will help an entrepreneur make the right decision.

Ziad Abdelnour is President and CEO of Blackhawk Partners in New York and the author of "Economic Warfare: Secrets of Wealth Creation in the Age of Welfare Politics."

Email me at bullishonbooks@cnbc.comAnd follow me on Twitter @BullishonBooks