What to Know Before Accepting Private Equity

Puneet Mehta, an Atlanta entrepreneur, remembers how eager he was to take the money. When investors courted him, he felt “razzle-dazzled,” enchanted by their promises to help him build the online marketing business he had founded in 2006.

“Our goal was to expand rapidly with , put in a bunch of sales teams, get some distribution networks going,” Mr. Mehta explained. He ended up with $1.5 million in private equity growth investments and venture capital. “But I realized after we had raised the money that there were so many clauses that came with it that I had lost complete control of the company,” he said.

Mr. Mehta quickly grew upset with his new bosses, who, he said, handed control to “finance guys who had no idea what marketing was,” moved operations into exorbitantly expensive office space, installed a board above him and hired a new president and chief financial officer with hefty salaries. “Every day was torture to go in there, being an employee at the company I started,” he said.

One morning, he arrived at the office to learn that a beloved colleague had been fired. And so Mr. Mehta quit. The company's revenue dropped to zero, he said; today, it exists only on paper.

Especially since Mitt Romney's résumé became presidential campaign fodder, there has been much debate about the merits of private equity, which is known for its focus on short-term gains. Private equity investors typically use a mix of debt and equity to buy a large stake in underperforming companies, then re-engineer their financial, managerial and operational structures, with the goal of selling them at a profit within five years.

Thanks to horror stories like Mr. Mehta's and attack ads against Mr. Romney, the industry's reputation has taken some hits. But private equity remains a tempting option for some small-business owners. After all, bank credit has been hard to come by and other financing options can be extremely expensive. And with capital gains taxes expected to rise next year, some owners may be motivated to sell sooner rather than later.

Private equity firms in what is known as the lower-middle market typically seek out undervalued but scalable enterprises with more than $10 million in annual revenue and $3 million in Ebitda, or earnings before interest, taxes, depreciation and amortization. So should growth-minded owners like Mr. Mehta consider selling to private equity?

Interviews with a dozen small-business owners and investors revealed a common theme: Go slowly. Here are some things to consider before taking the money.

KNOW YOUR INVESTORS Private equity firms are not sentimental. They have an ironclad imperative: buy low, sell high. They usually purchase a controlling share in a company, bring in a combination of debt and equity, and manage the company in a way meant to increase its worth. Ideally, everyone profits when the company is sold, including the former owner, who gets a slice that is worth more than the original pie.

“Most private equity investors are looking to make, at minimum, about two times their money and be in the deal for three to five years,” said Daphne J. Dufresne, a managing director at RLJ Equity Partners. “So if your plan was to pass your company down to your firstborn, then private equity is probably not a good fit.”

KNOW WHAT YOU WANT “Starting with the end in mind is key,” said Justin Redfearn McLain, managing member of Duart Mull, the investment management arm of a family trust in Atlanta. “What do you want? Are you trying to get capital for growth or for yourself but continue in the day-to-day operations? Or do you just want out entirely?”

Owners who hope to stay involved should remember that most private equity firms want a controlling stake. For some founders, becoming employees of the companies they created is fine, if that's what it takes to grow. For others, it's intolerable.

“It's not my experience that private equity companies care about long-term value, because they're not in it for the long term, so it just wasn't in my nature to stay on,” said Alan Newman, who started Seventh Generation, a distributor of household and personal care products, in 1988 and helped found Magic Hat, a beer company, in 1994.

He walked away from Magic Hat when his partners sold it to a private equity firm in 2010. For Mr. Newman, Magic Hat had never been entirely about profit. “My vision was always creating this really cool, interesting company where people really liked work and we had an impact on our community,” he said.

John Warrillow, a serial entrepreneur and the author of “Built to Sell,” put it in blunter terms. “Provided your goals are aligned with theirs and you go into it with your eyes wide open, that is fine,” he said, “but they are not going to care about the soul of your company.”

DO YOUR HOMEWORK When considering a deal, entrepreneurs should run background checks, call a private equity firm's former clients and speak to members of corporate boards where the firm's investors are active. “I'm doing diligence on you, you should do diligence on me,” said Michael A. Smart, the managing partner of CSW, a private equity firm in New York.

A private equity partner should bring deep industry expertise, fresh connections and experience in tapping new markets: in short, more than just money. Troy D. Templeton, managing partner at Trivest, a firm in Coral Gables, Fla., that invests in founder- and family-owned businesses, said smart business owners should ask the following kinds of questions: Do the investors add value? Can they do things I could not do - introduce me to new markets, help me source products from different areas, help me with online lead generation, bring me into the digital age?

For an entrepreneur who finds the rare match of capital, talent and cooperation, the benefits of private equity can be considerable. “They've got so many insights you can't even pay for,” said Ryan Eleuteri, owner of the Charleston Beverage Company, which sells premium bloody mary mix.

Last fall, Mr. Eleuteri teamed up with Duart Mull, Mr. McLain's firm, which brought capital to the company - both equity and debt - and now owns 30 percent of it.

With $50,000 in revenue for all of 2010, Charleston Beverage was an unusually small candidate for private equity. Duart Mull “generally seeks companies that have a developed product and customer base,” Mr. McLain explained. “Albeit small, Charleston Beverage met these requirements.”

As for his decision to purchase a minority stake, he said, “We are doing this, in part, so Ryan and the other founders can retain majority ownership, because we want them to be motivated and incentivized to grow the company versus feeling like they are working for the investors.”

Mr. Eleuteri said his new partners helped him expand distribution. He now expects $250,000 to $300,000 in sales for 2012.

“I get to operate my business every day as a small-business owner, but if an issue arises, they've got a vested interest in my success,” Mr. Eleuteri said of his partners. “It's almost like having a big brother watching out for you. You get in a schoolyard fight and it's like, ‘Do you really want to do this? I've got my 6-foot-4 linebacker brother behind me.'”

But for Mr. Mehta, the entrepreneur who said he was burned by private equity, there is no going back. He swore off outside financing altogether in his current endeavor, a start-up called Local Marketing Inc., which he said was profitable and generating several million dollars a year in revenue.

“Now we basically get approached by a bank or a company every month to give us money,” he said, “but we don't need it.”