Private equity (PE) is a major funding source for SaaS and AI companies, but many founders misinterpret how these firms operate and their motivations. This disconnect often leads to frustration and misaligned expectations. Here’s what you need to know:
- Private Equity Basics: PE firms invest in established companies, aiming for growth and profitable exits within 7-10 years. They focus on maximizing returns through management fees and carried interest.
- Key Incentives: PE firms prioritize short-term growth and exit strategies, often conflicting with founders’ long-term visions for sustainable growth.
- Fund Structure: PE funds are set up as limited partnerships, with profits distributed through a waterfall structure. General partners (GPs) earn most of their income from carried interest, incentivizing large exits.
- Common Misunderstandings: Founders often assume PE firms share their goals, but fund timelines and profit models drive decisions that may not align with the founder’s vision.
- How to Work with PE: Align your goals with their timelines, negotiate clear terms, retain ownership, and plan for exit scenarios from the start.
Founders who understand PE incentives can negotiate smarter deals and build stronger partnerships, ensuring mutual success.
What is Private Equity? Structure, Strategy, and How PE Funds Make Money | M&A Masterclass Moment
How Private Equity Funds Are Structured
In the United States, private equity funds are typically set up as limited partnerships. This setup allows the income generated by the fund to flow directly to investors, bypassing taxation at the fund level. Additionally, these funds benefit from regulatory exemptions - like those outlined in the Investment Company Act of 1940 - which provide more freedom in how they operate and design their investment strategies. These exemptions also reduce the amount of disclosure required compared to public funds, giving private equity funds a distinct advantage in maintaining flexibility and privacy[1].
How Private Equity Funds Make Money
Private equity funds generate income primarily through management fees and performance-based carried interest. For founders, understanding this structure is key, as it shapes how private equity firms approach investments, manage timelines, and plan exits. Let’s break down the mechanics behind these incentives.
Capital Commitments and Investment Cycles
Private equity funds don’t receive all their funding upfront. Instead, they operate using capital commitments, where investors pledge a certain amount and contribute funds only when the firm "calls" the capital for investments. This process typically spans a 3-5 year investment period.
When a fund completes its fundraising, limited partners (LPs) sign agreements committing to invest specific amounts - anywhere from $1 million to $100 million per investor, depending on the fund’s size. The fund then has up to 10-12 years to invest the capital, oversee portfolio companies, and return profits to investors.
For example, a $500 million fund deploys its capital in stages over the investment period. This staggered approach helps limited partners manage their cash flow while allowing the fund to seize opportunities as they arise.
Management Fees and Carried Interest
Private equity firms earn money through two main channels: management fees and carried interest. These incentives often influence how firms operate, and founders may misinterpret their impact.
- Management Fees: These fees cover the fund's operational costs and typically range from 1.5% to 2.5% of committed capital annually. For a $500 million fund, this translates to $10-12.5 million per year. Management fees help pay for salaries, office expenses, due diligence, and other operational needs. However, these fees usually decrease after the initial investment period.
- Carried Interest: This is the fund’s share of profits, usually 20-30% of returns above a predetermined threshold known as the "hurdle rate." The hurdle rate is typically set at 6-8% annually, meaning LPs must first recoup their investment plus this minimum return before the fund earns any carried interest.
The structure of carried interest incentivizes private equity firms to focus on absolute dollar returns rather than percentage gains. For instance, a 10x return on a $5 million investment generates more carried interest than a 15x return on a $1 million investment. This dynamic often drives firms to prioritize larger exits.
How Profits Are Split in Private Equity
Once fees and performance incentives are accounted for, profits are distributed through a structured hierarchy known as the "waterfall" structure. This hierarchy heavily influences how private equity firms decide on investments and exit strategies.
| Distribution Priority | Recipient | Typical Percentage | Description |
|---|---|---|---|
| Return of Capital | Limited Partners | 100% | LPs receive their original investment back first. |
| Preferred Return | Limited Partners | 100% | LPs earn a 6-8% annual return on their invested capital. |
| Catch-up | General Partners | 80-100% | GPs receive profits until their carried interest reaches the agreed percentage. |
| Carried Interest Split | Both | LP: 70-80%, GP: 20-30% | Remaining profits are split based on the fund’s terms. |
For general partners (GPs), meaningful income from carried interest typically requires the fund to achieve 2-3x returns. This creates pressure to pursue larger exits, which can sometimes clash with founders’ preferences for steady, long-term growth.
While management fees provide a steady income throughout the fund’s life, the real financial rewards come from carried interest on successful exits. This explains why private equity firms often push for strategic sales or IPOs within 3-7 years, even when founders might prefer to continue building their businesses independently.
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Where Founders Get Private Equity Incentives Wrong
Understanding the structure of private equity funds and how profits are generated is crucial for founders. Yet, many founders misinterpret the incentives at play, leading to mismatched expectations and potential friction. Let’s break down some common areas where founders often go astray in their understanding of private equity dynamics.
Growth vs. Exit Timeline Conflicts
Founders often dream of long-term, steady growth for their companies, while private equity funds operate on a much tighter timeline. These funds have a finite lifecycle, driven by the need to deliver returns to their investors. As a fund nears the end of its term, the pressure to generate returns intensifies, often resulting in accelerated exit schedules.
What founders might see as impatience is actually a reflection of these structural constraints. Private equity firms are simply working within the boundaries of their investment model, which prioritizes timely exits over extended growth periods.
Misunderstanding Carried Interest
Carried interest is another area where founders frequently misinterpret private equity incentives. While firms do take equity stakes, their real financial gains come from carried interest - profits earned only after investors receive their initial capital back, plus a preferred return. This structure pushes private equity firms to focus on maximizing absolute dollar returns.
As a result, firms may lean toward aggressive growth strategies or pursue acquisitions to scale quickly. For founders who prefer organic, gradual growth, this approach can feel misaligned with their vision for the company’s future.
Founder Expectations vs. Private Equity Reality
Misaligned expectations further complicate the relationship between founders and private equity partners. Founders often enter these partnerships with assumptions about how decisions will be made and how growth will be pursued. However, the operational realities of private equity can differ significantly from these assumptions, creating predictable friction points.
| What Founders Often Assume | Private Equity Reality |
|---|---|
| Partners will support long-term, sustainable growth. | Fund timelines may require earlier exits to meet return goals. |
| Growth strategies will prioritize sustainability. | Strategies often aim to maximize returns, even if they involve higher risks. |
| Decision-making will be collaborative and patient. | Decisions are driven by fund lifecycle pressures and investor demands. |
| Partners share the same level of risk tolerance as founders. | Partners are bound by fiduciary duties to their investors, not personal stakes. |
| Equity alignment means shared priorities. | Carried interest creates different priorities for private equity partners. |
| Strategic guidance will be based on operational expertise. | Guidance is often focused on optimizing the exit process. |
Founders may also overlook that while they interact with mid-level staff on a daily basis, major strategic decisions are made by senior partners focused on meeting investor return criteria. This can create a disconnect, especially when founders favor lower-risk, sustainable strategies while private equity firms are willing to take on higher risks to meet performance targets.
These differences don’t have to lead to conflict. Instead, they highlight the need for clear communication and alignment of expectations from the very beginning. By understanding how private equity incentives are shaped by fund structures, founders can better navigate these partnerships to achieve outcomes that work for both sides.
How SaaS & AI Founders Can Work Better with Private Equity
Let’s dive into some practical strategies to help SaaS and AI founders build stronger partnerships with private equity firms. Here's an eye-catching fact: founder-involved deals jumped from 31% to 44% of total deal value between 2020 and 2023. Even more striking, companies with active founder involvement performed three times better than those without in private equity-backed setups [4].
Aligning Your Goals with Private Equity Goals
Start by aligning your goals with the private equity firm's objectives. It’s essential to understand their investment timeline and expected returns before entering negotiations. Most private equity firms work within 4–7 year cycles, so your growth strategy needs to show how you’ll deliver measurable value within that timeframe [2].
Aim to retain at least 20–30% ownership in your company. This ensures you stay involved in strategic decisions, maintaining the founder-driven momentum that often leads to better performance.
Consider structuring your deal around performance milestones. For instance, set clear goals like increasing annual recurring revenue, improving customer acquisition costs, or achieving intellectual property milestones. These targets should align with the firm's exit strategy, making your partnership more seamless.
Another critical area is operational governance. Research indicates that 76% of successful founder-CEOs underinvest in this area [4]. Address this early by collaborating with your private equity partner to establish clear reporting structures, regular board meetings, and decision-making processes. This balance between your expertise and their fiduciary responsibilities is key to a productive partnership.
Due Diligence and Term Negotiation
When it comes to negotiations, preparation is your best friend. Dive deep into the private equity firm's investment strategy, their portfolio, and their history with founder-led companies. If they’ve worked with SaaS or AI businesses before, study those deals to uncover their priorities and negotiation tendencies [2].
The private equity landscape in 2025 has shifted toward longer investment periods, often exceeding the traditional three to five years [3]. Use this to your advantage by negotiating terms that give you the time needed to execute your vision while still meeting their return expectations.
Make sure to negotiate governance rights, deal structure, and exit timelines with equal focus. For SaaS and AI companies, protecting intellectual property is non-negotiable. Also, secure board positions - whether as an advisor or observer - to maintain some level of operational independence.
It’s equally important to establish clear boundaries on control. Studies show that 58% of successful founder-CEOs struggle with relinquishing control [4]. Be upfront about decision-making authority during negotiations. Clearly define which decisions require board approval and which remain under your control. Once these terms are locked in, you can shift your focus to crafting a solid exit strategy.
Planning for Exit Scenarios
Your exit strategy shouldn’t be an afterthought - it needs to be part of the initial investment discussions. Create a structured timeline with milestones that lead to a successful exit [2]. This approach reduces last-minute stress and ensures you stay in control of the process.
Be prepared for potential leadership changes. If you transition to a different role, such as executive chairman or a focus on product development, view it as an opportunity rather than a setback. Planning for these scenarios in advance can make the transition smoother.
Finally, start building relationships with potential acquirers early. Whether you’re aiming for a strategic sale or an IPO, maintaining connections with buyers or investment banks throughout the partnership can open up more opportunities when the time comes to exit.
The best founder–private equity partnerships thrive when both parties acknowledge their strengths and limitations from the start. By understanding the structural realities of private equity and negotiating terms that reflect these dynamics, you can create a partnership that blends your entrepreneurial vision with the operational expertise and growth capital private equity brings.
Key Takeaways for SaaS & AI Founders
Understanding the basics of private equity is key to creating a partnership strategy that works for both sides. When founders and investors are on the same page about how things are structured, the collaboration becomes much smoother.
Private equity firms follow strict timelines and profit models. To make the partnership worthwhile, align your growth strategy with their investment cycle. Set clear milestones within shorter timeframes that demonstrate progress and potential.
Another important aspect is staying actively involved as a founder. Your hands-on engagement can significantly impact performance. However, this doesn’t mean you need to control every detail. Striking a balance between your expertise and a structured governance framework ensures smooth operations and effective decision-making.
When it comes to growth strategies, keeping a stake in the company is essential. Retaining ownership gives you a say in major decisions while allowing your private equity partner the freedom to implement their strategies for creating value.
Lastly, start planning for an exit from day one. Build connections with potential buyers early on to keep your options open and maximize opportunities when the time comes.
FAQs
How can founders align their long-term vision with the growth priorities of private equity firms?
To ensure your long-term vision aligns with a private equity firm's growth priorities, start by clearly defining and sharing your strategic goals while gaining a solid understanding of the firm's objectives. Private equity firms typically aim for measurable growth within set timeframes, so identifying common ground where their short-term targets complement your broader vision is crucial.
Work together to create a shared roadmap that strikes a balance between immediate performance gains - like boosting revenue or improving operational efficiency - and investments that build sustainable long-term value. Maintaining open communication and transparency throughout the process is essential to keeping both sides aligned and ready to adapt as business needs evolve.
What strategies can SaaS and AI founders use to negotiate better terms with private equity firms?
To secure favorable terms with private equity firms, SaaS and AI founders need to focus on thorough preparation and ensuring their goals align with those of the firm. Understand what drives private equity firms. These firms are primarily looking for high returns within a set timeframe. If you can show how your business aligns with their objectives, you’ll be in a stronger position during negotiations.
Showcase your company’s strengths and growth potential. Use clear, concrete data like revenue trends, customer acquisition costs, and untapped market opportunities to back up your claims. While it’s important to acknowledge challenges, make sure to pair them with actionable strategies to overcome these hurdles. This approach not only demonstrates transparency but also builds trust.
Lastly, bring in experts who know the landscape. Financial advisors or legal professionals with experience in private equity deals can help you navigate complex terms. They’ll assist in protecting your interests by identifying key provisions like control rights, exit strategies, and performance benchmarks. By combining careful preparation, honest communication, and professional guidance, you’ll be better equipped to negotiate a deal that works for both sides.
What is the waterfall structure in private equity, and how does it influence decisions for founders and investors?
The waterfall structure in private equity outlines how profits are shared between investors (limited partners) and fund managers (general partners). Here's how it usually works: first, investors get back their initial capital. Next, they receive a preferred return - commonly set at 8%. After that, any remaining profits are divided based on a pre-agreed split, often 80/20, with the larger share going to investors.
For founders, grasping this structure is essential. It directly impacts how private equity firms balance returns and risk. For instance, investors may prioritize strategies that boost short-term profits to meet these distribution milestones, which might not always align with a founder's long-term goals. By setting clear expectations early on, founders can better manage these dynamics and foster stronger, more aligned partnerships.
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