What is Growth Equity?
Growth Equity is an investment strategy oriented around acquiring minority stakes in late-stage companies exhibiting high growth with significant upside potential in expansion, in an effort to fund their plans for continued expansion.
Often referred to as “growth capital” or “expansion capital”, growth equity firms seek to invest in companies with established business models and repeatable customer acquisition strategies.
Growth Equity: Quick Primer
Growth equity is intended to provide expansion capital for companies exhibiting positive growth trends.
For the most part, all early-stage companies, at some point in their development process, eventually need assistance either in the form of an equity investment or operational guidance.
Growth equity firms invest in companies that have already obtained traction in their respective markets but still need additional capital to reach the next level.
These targeted companies have moved past the early-stage classification, yet retain substantial upside potential in terms of “top-line” revenue growth, obtainable market share, and scalability.
The reluctance to accept external guidance or capital can prevent a company from realizing its full potential or capitalizing on opportunities that lie ahead.
With a growth equity investment, growth-stage companies can sustain or accelerate their growth trends by further disrupting and establishing defensible market positions.
Growth Equity Firms: Investing Strategy (Step-by-Step)
First and foremost, at the growth equity stage, the target company has already proven its value proposition as well as the existence of a product-market fit.
Growth equity firms invest in companies with proven business models that need the capital to fund a specified expansion strategy as outlined in their business plan.
Similar to early-stage start-ups, these high-growth companies are in the process of disrupting existing products/services in established markets. The difference is that the product/service has already been determined to be potentially feasible, the target market has been identified, and a business plan has been formulated – albeit there remains much room for improvement.
Conceptually, growth equity firms prioritize future growth and expansion potential, above all else.
- Validation of Product-Market Fit
- Proven Business Model
- Pathway Towards Profitability
- Target Market and Customer Profile Identified
Because the company has raised capital (and can raise more if deemed necessary), the priority tends to become growth and capturing market share, often at the expense of profitability. By further cleaning up its business model, the company should be able to achieve profitability if it were to focus its efforts on the bottom line (profits) instead of just the top line (sales).
Companies that do not necessarily “require” the growth capital to continue operating (and thus the decision to accept the investment was discretionary) are ideal targets.
This signifies that the company has enough funding and/or cash flows to finance its expansion strategy. If a company requires more capital to survive, the rate at which it is burning through cash could be a negative signal that the market demand is not there or management might be misallocating the funds, i.e. sub-optimal strategy.
Growth Equity: Investment Criteria
The type of company well-suited for a growth equity investment will have the following attributes:
- Planned Usage of Cash Proceeds
- Repeatable, Scalable Customer Acquisition Strategy
- “Untapped” Market Opportunity
Commercialization Stage: Business Model Lifecycle
The commercialization stage represents a developmental inflection point, where the value proposition and potential for product-market fit are validated, so the next step is to focus on execution, namely growth.
Otherwise known as the growth stage, the products/services of companies at this stage have begun to gain widespread adoption and their branding is starting to receive more recognition in their markets.
Generally, revenue tends to climb and operating margins begin to expand with increased scale; however, the company is still likely far from being net cash flow positive (i.e. the “bottom line” has yet to turn a profit).
In theory, companies should have made tangible progress toward profitability. While most late-stage companies do indeed achieve decent levels of profitability, the competitive nature of certain industries often forces companies to continue to spend aggressively (i.e. on sales and marketing), thus keeping profitability levels low.
The unsustainable cash burn of growth-stage companies can frequently be attributed to their single-minded focus on revenue growth and capturing market share, as these companies usually have high capital expenditure requirements and working capital spending needs to sustain their growth and market share – therefore, minimal FCFs remain at the end of each period.
For these companies with unsustainable cash burn rates and significant re-investment needs, growth capital proceeds could be used to fund:
- Market Expansion: Expansion into new markets to reach new customers and demographics
- Product Development (R&D): Internal development of existing product/service offerings (or adding on new features)
- Back Office Support: Hiring more client engagement representatives and related back-office functions to support the sales team and those in client-facing roles.
- Sales and Marketing (S&M): Spending more on sales and marketing, as well as advertising campaigns.
At the commercialization stage, one of the top priorities is to establish the business model, which governs how the company will generate revenue. For instance, deciding how products will be priced, the branding and marketing strategy going forward, and how its offerings will be differentiated from its competitors are all topics that must be addressed.
Growth Stage Investing: Financial Profile and Stages
Once a company passes the proof-of-concept stage, the focus will soon center on sustaining growth, improving unit economics, and becoming more profitable.
Companies at the commercialization stage attempt to refine their product or service offering mix, expand sales and marketing functions, and correct operational inefficiencies.
But in reality, the shift towards focusing on profitability is not nearly as quick or efficient as one might assume.
For instance, one of the most important key performance indicators (“KPIs”) for software companies, the LTV/CAC ratio, should gradually normalize to a level around 3.0x-5.0x – which implies the business model is repeatable and enough profits are being derived from customers to justify the sales and marketing spending.
The LTV/CAC ratio, assuming it is deemed sustainable over the long run, is often considered a green light for continued efforts to scale, i.e. validation that the current plan and growth strategies are working as intended.
However, for saturated industries, companies (and the news headlines) tend to remain focused on revenue growth and metrics related to new user count, as opposed to profit margins.
Revenue growth in the commercialization stage will normally be around 10% to 20% (exceptional start-ups will exhibit even higher growth – i.e., “unicorns”).
In an effort to make their revenue more recurring and establish reliable sources of income, the process of improving a company’s business model could include:
- Targeting Larger-Sized Customers with More Spending Power
- Securing Multi-Year Customer Contracts (and Long-Term Recurring Revenue)
- Implementing Upselling and Cross-Selling Initiatives