Seasoned entrepreneurs and CEOs will agree: taking a company from an idea, to a product market concept, to $25 million in revenue is one thing. Making that $25 million dollar company a $100 million dollar company is something else entirely. As corporate strategist and author Jim Collins shares in his book Good to Great, a good company becoming a great company requires an expert mix of leadership, strategy, culture, and discipline.
Taking a small company to middle-market or enterprise levels is a conversation of scaling—whether that means international expansion, technology, capital, or all the above. That’s why, at this stage, owners and CEOs often consider a private equity (PE) firm as the next step.
A PE firm can inject the expertise, investment, and resources that can take a business to the next tier. But what makes a private equity firm interested in buying?
What are private equity firms looking for?
Above all, private equity firms are focused on scalability. A target company is one with the potential to grow significantly with access to the right resources—whether that’s capital, talent, strategic connections, or new opportunities. Typically, PE firms invest in profitable and cash flow positive companies, often financing the deal with debt leverage to create big returns with less capital. But there are additional factors that will place a business on the radar of a PE firm:
Growth potential
Private equity firms target companies with a clear potential to scale, particularly in terms of revenue. More specifically, they seek opportunities where they can generate significant growth and strong returns within a shorter time frame—around four to seven years. Leveraging their capital, expertise, and strategic guidance, they’re looking to turn a $25 million company into a $100 million or even $150 million company. As they determine growth potential, external factors like untapped markets or emerging demand are also considered.
In addition, PE firms consider whether the growth trajectory could lead to a viable IPO in the near future. The possibility of taking a company public is a particularly attractive outcome, giving the firm another reason to consider the investment.
Industry alignment
PE firms are rarely generic in their approach to growth opportunities, and will instead maintain a thesis surrounding their funds. For example, a firm might raise a $500 million fund to acquire a number of businesses in a specific industry—like SaaS, AI, or biotech. The firm may even have multiple theses, depending on its size.
It’s also possible that a firm already operates with leadership and a portfolio of companies upholding a general thesis. They may allocate their funds toward a specific industry, like environmental science or climate tech or healthcare. It’s not unusual to see a firm with a focus on a market vertical, which will naturally influence how a firm strategizes future investments.
Portfolio synergy
Similar to industry alignment, private equity firms may also assess how a target company fits within their existing portfolio. Firms often leverage synergies that exist between a target company and their other holdings, identifying opportunities for cross-collaboration and shared resources. In this way, a PE firm has the ability to unlock opportunities that a CEO or founder wouldn’t have envisioned for their company.
Leadership opportunity
A PE firm brings more than capital to the table. These firms are also looking for ways in which new leadership could take a company to scale. PE firms often bring experienced leaders who’ve grown companies to middle-market or enterprise levels before, helping to fill gaps in expertise and ensure the leadership team can execute on strategic goals.
Red flags: Signs a company may not be ready for PE investment
Turning an idea into a company with $25 million in revenue is a big success. But in the eyes of a private equity firm, that win doesn’t guarantee scalability within the ideal timeframe. What red flags might give PE firms pause when evaluating potential investments?
Red Flag #1: Growth potential
Private equity firms deal in growth potential, which means there’s little room for question here. PE firms need to see a clear strategic path where their deployment of money and assets can generate a return on investment in the near term. And the return they’re expecting is high: anywhere between 50-200% within the 3-7 year window. It’s important that a target company can demonstrate this level of market opportunity.
Flag #2: Market concerns
PE firms are going to assess market opportunity as a potential limitation on scalability. If the company is operating in a saturated market, and there’s no immediate opportunity for an acquisition or merger, it’s unlikely to spark interest. Similarly, highly volatile markets can pose challenges, making growth unpredictable. (On the flip side, emerging or innovative markets may signal long-term potential, so this factor can depend on timing and positioning.)
Flag #3: Operations
Ultimately, a PE firm relies on management to execute their strategy. A team that lacks experience or has high turnover could raise a red flag. A firm will weigh the existing leadership and operations of a company and how that might uphold or detract from growth potential. Operational questions are also taken into consideration: Are reporting systems up to date? Are the operations unnecessarily complex, or subject to a high degree of regulatory scrutiny?
What financial metrics will a private equity firm analyze?
When evaluating a new investment, private equity firms carefully analyze a wide range of operational efficiency metrics to assess growth potential. They hone in on the metrics most relevant to the company’s industry. For example, if the firm has their sites on a SaaS business, they’ll examine metrics like the SaaS Magic Number, gross revenue retention, or customer retention.
Beyond industry specific metrics, private equity firms will always analyze the balance sheet, assessing the company’s assets, debt, leverage, and equity growth over time. Further, they want to see the company’s financial health in full:
Are the books in order?
Are there historical trends in terms of growth?
Are the drivers of that growth clear?
What is the market acceptance?
A target company must be able to articulate these answers, backed by data and reporting.
This is where the importance of an experienced and strategic CFO comes in. At Ascent CFO Solutions, we help provide Fractional CFO support for companies at this stage of growth. If a small business is considering a private equity strategy, they have to be able to demonstrate an unquestionable growth trajectory—why not work with a CFO who has done it all before?
Common misconceptions surrounding private equity investments
For small businesses looking to scale, it’s important to clear up a common misconception: the difference between a PE and venture capital (VC) firm. VC firms tend to be more hands-off, offering high-level guidance and support. In contrast, a PE firm will be much more prescriptive. PE firms are usually heavily involved, offering precise strategic direction to ensure the company meets critical targets within a specific timeframe.
If a company deviates from the growth trajectory, the PE firm will intervene. They may bring people in, or even make changes to the leadership team; whatever it takes to keep the business along the trajectory intended with the investment.
Also noteworthy is that the distinction between PE and VC firms has become less rigid over the last several years. Historically, PE firms are more likely to buy majority stakes (more than 50%) in later-stage companies, whereas VC firms invest minority stakes (less than 50%) in earlier-stage companies with the hopes that they grow. But some PE firms are starting to act more like VCs, taking minority interests in high-growth companies initially, making earlier bets. As the landscape evolves, PE firms may be looking to tap into growth without necessarily taking a controlling interest.
Ready for a private equity investment? What to do next.
If a small company feels viable for a private equity investment, preparation is of the essence. As mentioned, it’s imperative to articulate a detailed trajectory of growth to a PE firm that is incredibly adept at analyzing the financials and performance of a business. The house must be in order: clean financials, strong reporting, and a clear growth story. It’s okay to have weaknesses, but there should be a plan in place to address them.
Having a seasoned CFO can make all the difference at this stage of the growth journey to help prepare financials, track metrics, and shape the growth narrative. Beyond financials, an expert CFO should be able to advise across departments, ensuring the company is ready for the scrutiny PE firms bring.
You can read more about our strategic services here. If your company could benefit from the support of a fractional finance professional, reach out to our team!
But what if a PE firm isn’t the right fit?
A private equity investment isn’t the only strategy for scaling a company. Other strategies—such as organic growth, debt financing, venture capital funding, or strategic buyers—can also take a business to the next level. While private equity may be ideal for businesses ready to scale quickly and substantially, these alternatives may be a better fit for companies at different stages or with different objectives.
Consult a Fractional CFO to strategize and execute your best path forward.
About the Authors
Dan DeGolier is the founder of Ascent CFO Solutions and a Fractional CFO with nearly 30 years of experience. He is passionate about working alongside leaders of companies to help them “upward” to their highest potential. Read more
Mark Kearney is a seasoned executive with extensive experience in financial and operational leadership. Throughout his career, he has worked with organizations of varying sizes, from high-growth startups to large companies with over a billion in revenue with a proven track record of success in driving business growth and profitability. Read more