Selling to a Financial Buyer

This is the final article in the series identifying the different types of buyers.  In our prior two, we discussed the profile and nuances of working with individuals buying themselves a job and strategic buyer looking to expand the scope of their existing company.  Here, we will focus on the background of the financial buyer and the opportunities and challenges that may arise from working with this type of buyer. 

Financial buyers represent a group who don’t want to actively operate the business.  Instead, they acquire the company and want the existing management to stay on and handle the day to day business.  The goal is to see a return on investment by growing the company and exiting at a later date.  Most commonly, as owners, they will use their expertise and relationships at the board level to assist in the process.  When we think of financial buyers, it is typically private equity groups looking for companies generating over $10 million in revenue and $1 million in EBITDA.  Family offices would fall into this category as well. 

Private equity group acquisitions can fall into the category of platform companies and add-ons.  A platform company would represent a company that falls into a new industry or marketplace in the portfolio.  An add-on would be the acquisition of a company that may be folded into an existing platform company.  Since add-ons are similar to strategic buyers, we are reserving this discussion for the acquisition of platform companies. 

Private equity players are typically looking for businesses that have at least some of these characteristics: recurring revenue, high rates of revenue growth, high gross margins, low capital expenditure, superior product or service, growth industries, disruptive products or technologies, stable companies in industries that are geography specific and can be rolled up.   Since the businesses have to be able to stand on their own, they need to have infrastructure in place in the form of systems, processes, and technologies that streamline the operation and can scale.  They require a strong management team, sales and marketing strategy, high quality of earnings, and legal compliance.   

Selling to private equity can be a great option for a business owner who isn’t ready to retire but wants to create some liquidity.  It also works well for companies that have endless growth opportunities but need more resources to pursue them.  Deals often allow the seller to retain equity with the hope that the smaller percentage ownership retained can create an equal or greater liquidity event down the road than the first due to the sale of a much larger business. 

Private equity may also provide the greatest flexibility for creative deal structuring.  Over the course of operating the business, an owner may find they have inadvertently created potential tax problems or transition issues that can be solved with appropriate use of the tax code, capital structure, and employment/incentive agreements.  As the financial buyer’s primary business is in acquiring and divesting companies, the appetite to explore scenarios that work for all parties can be more robust than a strategic buyer who doesn’t regularly assemble such deals.   Since financial buyers are typically well capitalized, there may also be fewer restrictions from additional debt or equity partners.  Although we would be remiss not to point out that there is a segment of the private equity industry that is unfunded and does need a second layer of underwriting to raise capital after finding a busines to acquire. 

Challenges can also arise in selling to private equity buyers or setting the business up for a deal.  Assembling the infrastructure necessary for the business to scale and be attractive to PE is expensive and owners may find they can make the same income at lower levels of sales without the incremental risk and investment.  In industries where strategic buyers may not need the seller’s infrastructure because they already have existing software platforms, equipment, and systems, a seller may find a path to attractive deals without taking on the additional fixed cost and operational risk.

Additionally, despite staying on to manage the business, the seller is usually a minority shareholder and beholden to the decisions of the controlling interest.  For an entrepreneur used to following their visions, the cultural issues of potentially needing to follow another party’s vision should not be ignored.  

Lastly, many business owners have heard horror stories about others being tied up in a deal for months only to have the price cut dramatically immediately prior to closing.  While we don’t believe financial buyers typically have ill intentions going into a deal, the nature of the financial buyer is to maximize return on investment while balancing risk.  Should their due diligence show more risk than was initially believed, this cohort may be more likely to rebalance the risk reward more aggressively than others.