’Tis but a flesh wound! (Monty Python & The Holy Grail, 1975)

What happens when private equity buys your competitor?

If you were on Twitter Wednesday morning, you may have witnessed a humorous exchange between Marc Andreessen and danprimack regarding the private equity takeout of Ping Identity:

Marc’s obviously an investor in Okta, which provides identity management software for enterprises and competes with Ping. Presumably, he’s happy because Ping will be easier to compete with under private equity ownership.

To understand why, it’s worth discussing briefly how venture capital firms like Andreessen Horowitz (and my firm, Lightspeed, for that matter) invest in tech companies, compared to our colleagues in the private equity world.

How VC and PE differ

First, a disclaimer — I’m taking a broad brush here. Venture capital (VC) and private equity (PE) do overlap from time to time. VC firms occasionally do PE deals (e.g. AH and Index buying Skype from eBay alongside PE firm Silver Lake), and PE firms occasionally do VC deals (e.g. TCV backing Rent the Runway). Like most generalizations, the below do not universally apply.

That said, VC and PE deals tend to differ in several key ways:

1. Ownership/Control. VC’s are individually minority shareholders. For lead investors, that often means 20–30% initial ownership. PE investors often, but not always, hold majority “control” positions in the companies they purchase. Moreover, PE investors often buy out controlling shareholders, including founders, thereby lowering founders’ incentives to stay involved with the business post-transaction.
2. Company profile. VC’s typically invest early and care little about net profits or free cash flow at the time of investment. PE firms typically invest late, ideally after the business generates significant free cash flow. Free cash flow allows PE firms to buy companies with debt in order to minimize their equity commitment and achieve “leverage.” Moreover, PE firms love predictable cash flows, which give them confidence to increase debt capacity and leverage ratios even further.
3. Structure. VC’s typically buy preferred stock with a liquidation preference, but are generally in favor of simpler capital structures. PE investors love structure, and some invest at multiple layers of the cap table: senior debt, subordinate debt, preferred stock, and common stock. They often employ creative tactics to achieve a guaranteed minimum return and aren’t averse to dividends or “deal fees” as a way of monetizing their stake in a cash generating business that isn’t yet ready to exit.
4. Return expectations. VC’s expect to lose some capital on roughly half their deals. These losses are offset by the top 2–3 companies in a given fund, which normally account for the majority of that fund’s total profits. PE firms seek returns that are more normally distributed — they rarely lose capital, but also rarely hit home runs. The goal is to underwrite a certain IRR, and hit that IRR target, plus or minus a margin of error.
5. Approach. VC’s think of themselves as “partners” to the founders. PE investors tend to think of themselves as “owners” of the business.

How PE ownership changes your ability to compete

Given the above characteristics of a PE-backed business, a VC-backed competitor has a few key advantages:

1. Founder control. Founders are special people who somehow glimpse a vision of the future that few others understand, and then go build it. In consumer technology, especially, there are very few success stories that don’t involve at least one founder in an active role. When PE removes or disincentivizes early employees, the company often loses the visionary edge that made it a market leader in the first place.
2. Flexible capital structure. Without the constraint of debt, VC-backed companies can take every marginal dollar generated and invest in future growth or R&D. While debt can juice up equity returns, it can also restrict uses of cash and encourage short-term thinking. PE-backed companies are often caught in the middle of this struggle.
3. Skewed outcomes. Good VCs know that middling outcomes don’t drive overall returns, so they encourage founders to swing for fences and invest for the future. PE investors are more likely to promote a path of steady, incremental growth, which is antithetical to long-term market leadership in technology. Ping Identity, for instance, disclosed a 40% annual growth rate in its acquisition announcement. That’s below the average growth rate for a 9 year old public SaaS company, according to Tom Tunguz’s SaaS blog. Qlik Software, which also announced a “take private” transaction this week, is growing even more slowly at 15% quarter-over-quarter, despite generating $65M of annualized operating cash flow.

So, while your competitor may be far from deceased…

…there is some reason to rejoice when a private equity firm buys your rival. You are indeed better positioned for success as a result!

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