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What Type of Buyer/Investor Is Best for Me?

Three types, each with their own pros and cons.

by Chad Burnett (May2, 2005)

(Note: Chad is employed by IndustryPro, an international investment banking firm facilitating business mergers, acquisitions, divestitures, buy-outs and valuations.)

Every business owner has unique needs and desires when it comes time to sell a business or take on an investment partner. However, most owners are not aware of many of the options available to them.

Many years ago, the liquidity opportunities accessible to private business owners were generally limited to the sale of the entire business and went something like this: obtain maximum value by selling to a competitor, achieve a lower value by selling to a high net worth individual, or as a last resort, finance the sale of the business to employees.

Fortunately, today’s private business owners can now choose from several more options. Owners can re-capitalize the business with a private equity group, retain a significant ownership position, and realize a "second bite of the apple" several years down the road. They can choose to sell all of their company to a strategic buyer. They can retire immediately or continue working for a salary. They can maximize value by accepting deferred payments or earn-outs, or they can trade some value and receive all cash up front. They can sell to an industry knowledgeable competitor (higher confidentiality risk), or sell to a financially motivated individual, strategic buyer, or private equity group with little or no experience in their industry.

In the universe of potential buyers/investors of established privately held businesses, there are three basic types: Individuals, Strategic, and Private Equity Groups. Each of these groups has different needs and can offer different benefits to business owners.

Individuals.

The individual buyer is often a medium to high net worth person that is looking to "buy a job." Generally speaking, the size of transaction that an individual can handle is much smaller than what industry buyers or private equity groups can complete. Individuals usually do not do transactions that are much greater than $5MM in transaction size, and they often need the owner to finance part of the purchase. These buyers are sometimes overly emotional about the transaction. However, individuals can often replace owners that are looking to leave the business. Also, sometimes an individual may be willing to make a minority investment in a company where other investors are not. Individual buyers are sometimes the only liquidity option if the company is not big enough to get the attention of strategic or private equity investors.

Strategic.

Strategic acquirers pursue companies for synergistic reasons. Strategic buyers can be direct competitors looking to expand market share or they may be outside of the industry but share things like common distribution channels or customers.

Strategic investors are often either the highest or lowest paying buyers. They sometimes will pay a premium value because they can greatly increase revenues, can consolidate and decrease costs, or they anticipate other synergistic benefits. Other times they will review a company and either not make an offer, or throw out a low ball offer because they think that they can "do it themselves."

Confidentiality risks with strategic buyers can be higher than the confidentiality risks associated with other buyers because of the disclosure of sensitive financial and other proprietary data to potential or direct competitors.

Strategic buyers will usually want to buy 100% of the owner’s company and usually do not offer much up-side potential to owners.

If an owner wants to quickly transition away from the business then a strategic buyer may be a good choice because they can sometimes replace the owner with someone within their own organization. However, some owners may not want to work with strategic buyers because they may move the business and/or eliminate loyal employees.

Strategic buyers look at companies of almost any size. However, like private equity groups, most prefer to do larger rather than smaller deals ($5MM to $100MM+ transaction size).

Private Equity Groups.

Private Equity Groups, or PEGs, are perhaps the least understood of potential buyers/investors. Most private equity groups are formed by business professionals (often former Fortune 500 executives), that raise a pool of equity capital from institutional sources such as pension funds, high net worth individuals, and school endowments. The size of funds raised generally range from about $50MM to a couple of billion dollars in size. Rather than investing in public companies or things like real estate, these groups invest in privately held companies in hopes of achieving above-average rates of return. The number of PEGs has increased from about 30 in 1980 to about 2000 today.

The variety and flexibility of transaction structures that a PEG can offer is much greater than other buyer types. However, the primary investment tool that private equity groups utilize is the Financial Recapitalization. A Recapitalization (recap) is the sale of a majority ownership position of a private company to a financial partner as a means of achieving liquidity.

However, under a recap, the owner also maintains a significant equity position going forward. A transaction with a PEG is much more of a "partnership" than an outright sale of the company. As a rule of thumb, an owner can usually take about 80% of the current market value of the company off of the table yet retain about a 35-40% equity position going forward.

Then, about 3-7 years down the road, the owner is able to take a "second bite of the apple" when another liquidity event takes place. This "second bite of the apple" could be even bigger than the first when the company is sold to a larger strategic buyer, goes public, or is acquired by another private equity group. Thus, a recapitalization can be the best structure for an owner that desires to stay with the company and maintain significant up-side benefits.

Most PEGs do not want to have anything to do with the day-to-day operations of a business. Rather, they are looking to back the owner or professional management team in the growth of the business. Most PEGs will not be interested in doing an acquisition if the owner wants to transition away quickly and there is not a professional management team in place.

A PEG will have representatives on the Board of Directors and assume an advisory role. Because PEGs are run by professional business people, they can act as a great sounding-board to the owner or management team. They can help fill in the blanks and help find talent where there are gaps in management or where the owner is wearing too many hats. They can provide additional growth capital and assist in strategic and M&A decisions. Therefore, although a PEG may have ownership control of a business, they usually leave operational control with the owner or management team. PEGs are sensitive to employees and the surrounding community and will always ensure that the management team is rewarded with incentives for the value they create while managing the company.

Also, owners do not need to be as concerned about confidentiality issues when working with PEGs because they are not operators, are private in nature, and do not have any mandates for public disclosure even after a transaction is complete.

Most PEGs have minimum profitability and other requirements regarding new platform companies that they will invest in. Candidates must be well established, have strong market positions, proven management teams, positive cash flows, a history of growth and good prospects for future growth. While a few PEGs will consider potential platform companies that have pre-tax profits as low as $1MM, most PEGs will only consider companies that have $5MM, $10MM, or even $25MM+ of pre-tax earnings. Of course, PEGs will consider add-on acquisitions of almost any size once they have a platform company. Thus, many PEGs are also Strategic buyers once they have a platform company or have gained experience in a particular industry.

Besides the diversification of an owner’s estate, companies can partner with private equity groups to retire inactive shareholders, complete a succession from one generation to the next, or facilitate a management buyout. Nevertheless, very few PEGs will purchase a minority equity position.

Conclusion.

Most owners will choose to approach different buyer types when looking to sell their businesses. However, a business owner who is particularly concerned about maintaining confidentiality, or has a desire to maintain significant up-side potential may choose only to talk to PEGs. On the other hand, a company that may have the potential of offering significant value beyond current financial results may choose only to approach a few strategic buyers. A good mergers and acquisitions intermediary that is knowledgeable about the industry can help an owner determine which buyer types are best for their unique characteristics and desires.

(Note: At the moment Chad is working with four scrapbook/craft companies for sale. Revenues range from $160,000 to $6 million. For more info, call him at 801-838-7708 or email cburnett@zirkle.com. To read previous Business-Wise columns, click on the titles in the right-hand column.)

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