How you should build business plans to attract private equity funding

Away from the glamor of unicorns, there are thousands of leaders who are building businesses the old-fashioned way, diligently and profitably. In India, a large proportion of these are service businesses. Similarly, many serious private equity (PE) firms are ignoring the hype and looking for businesses that can grow quickly, but sustainably and profitably. This column describes how service businesses can build plans to attract PE investment.

While there are many areas that PEs evaluate, four are important: 1. Target Addressable Market (TAM) and competitive positioning, 2. Revenue model, 3. Excellent leadership and 4. Clarity on investment areas to drive growth.

PEs first focus on TAM and competitive positioning. The reason is probable: a general management can deliver excellent results in a fast-growing market with systematic competition. Even the best managers struggle to deliver results in a tough market. PEs bet on growth markets with systematic competition.

The TAM should be specific and reflect a deep understanding of the market structure. For example, for a standalone analytics player, saying that the analytics market is $150 billion is simply wrong. More than half of this market consists of hyper-scalers such as AWS (Amazon Web Services) and is not addressable. Similarly, if a business specializes in commercial data and analytics in pharma, the addressable market is proportionally smaller. And if this market includes licensing fees paid to third-party data partners, the actual TAM is a fraction of $150 billion.

To access this TAM, it is important to identify white spaces that can be protected. If the market position is not differentiated and gap-proof, growth will be neither sustainable nor profitable. Market structure, resulting TAM and competitive positioning are the correct first steps.

Next, the revenue model becomes important. PE leaders prefer predictable revenues for the next two to three years. They closely analyze sign-up revenue, pipeline, conversion rates and key customer relationships. PE leaders and their CDD (commercial due diligence) advisors spend half their time on revenue models. We have ways to independently verify the quality of key customer relationships and arrive at risk-adjusted revenue projections.

Because of this scrutiny, it is advisable to build revenue plans that are based on that. Hollow schemes, such as those showing stability for the past three years and magical growth after PE investment are easily identified and affect credibility.

Next, having a performance high top leadership is an enviable gap. We have observed investors willing to pay a 15-20% premium to access such leadership.

Superior leaders have three characteristics: One, a visionary understanding of market structure and competition, which leads to rapid identification of growth levers and related actions. Two, a track record of productive allocation of limited capital to sectors that yield the highest returns. Three, the ability to simplify and communicate strategy to a larger organization and deliver results through average middle management. Although these criteria are qualitative, I would say that such superior leaders are rare but not difficult to identify. And often, they are the company’s top salespeople.

Warning: We often see companies that have delivered great results in recent years by leveraging one or two top leaders. While this may seem like a positive, it is a red flag. High leadership is notoriously difficult to measure. Instead, the depth of leadership, and the ability to make the most of available resources, is what matters.

Finally, clarity about how PE money will be used is important. PEs want maximum returns, and it is encouraging if investment areas have already been identified. An analytics firm that recently raised a PE fund knew that hiring strong account managers for its key clients would accelerate growth. These customers had high NPS (Net Promoter Scores), but they were not cultivated enough. Conversely, it is a red flag if a significant proportion is allocated to paying existing shareholders. Process and quality are also important, but these are considered easy solutions. Of course, attracting and retaining talent can be a deal-breaker in hot markets and must be addressed.

It’s important to think like PEs when building business plans.

Abhishek Mukherjee is Co-Founder and Director of Octus Advisors

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