A common exit strategy for business owners is to sell to private equity (PE). Last month we provided suggestions for business owners when negotiating a sale to PE. This month we examine a sale to PE from the perspective of owners who remain with the business as employees and continue to manage the business after the sale. The continuity of management is usually an essential part of the PE’s purchase. Owner-managers who understand PE will be better positioned to negotiate more favorable terms in the acquisition agreement, and to adjust their management style to succeed in the PE environment.
Negotiating with PE
- Management’s Bargaining Power: PE supplies capital and buys management, so management’s bargaining power will ebb and flow. Before management commits to the deal, management has strong bargaining power because PE needs management. After management commits to the PE deal, but before the PE invests its money at closing, the bargaining power shifts to the PE, because the PE can refuse to close. Once the deal closes and the PE invests the capital, power shifts back to management because the PE cannot extract its capital without selling the business at a profit, which requires management.
- Skin-in-the-Game: PE almost always requires that the CEO, and frequently other key managers, invest in the company simultaneously with the PE. Managers can finance their investment (i) by reinvesting in the company any money the managers received from the sale of the company to the PE, or (ii) from other sources (such as refinancing a house or borrowing from a retirement fund). PE’s interest in keeping management’s “skin-in-the-game” also affects the amount PE will pay to purchase the company. PE will want to reduce the amount paid to the continuing manager at the time of the initial sale, and increase the amount the PE pays to the continuing manager in the form of future equity incentives.
- Follow-on Equity: For a business to achieve the growth typically demanded by PE, the business will usually require further capital investments, often called the “follow-on investment” or “follow-on equity.” Most PE expressly reserve some equity for the follow-on investment rounds. Management needs to confirm that the PE can supply follow-on equity because, without it, the company’s growth will be limited and one of the key reasons for management to continue with the business disappears.
- Due Diligence with Management of Portfolio Companies: The PE buyer will have multiple companies in its current portfolio and companies that were previously in its portfolio and subsequently sold. As part of the due diligence, management that will continue with the PE should identify the present and past companies in the PE’s portfolio, and contact the CEOs of the various portfolio companies to learn about the CEO’s experiences with the PE as an owner, including how the PE compensated management.
PE Involvement with Business Strategy and Operations
- Growth: PE makes money by purchasing a business, growing the business either organically or by further acquisitions, and then selling the business at a profit. Management will be required to grow the business to meet the PE’s growth goals.
- Financial and Not Business Targets: PE firms are financial businesses that base business plans on financial targets and use financial targets as the foundation for management’s incentive compensation. The financial targets are usually based on the PE’s promises to investors. As a result, the financial targets may have only a marginal relationship to the performance of the actual business, and may force business decisions that the company would not otherwise make.
- Managements’ Relations with PE: PE (i) may or may not have expertise or background in the business, (ii) may or may not trust management to operate the business, and (iii) may or may not provide management with the proper resources. PE will likely make demands on management for new financial reports that have financial but not business uses, and these demands will likely increase the time and effort required by the business to furnish the financial reporting, which can increase costs. In addition, PE may station a person at the business to work with management, monitor the business performance, and provide continuous oversight.
- Management Team: PE will evaluate each member of the management team individually and replace managers deemed weak or add managers to increase the management depth. In particular, PE will want high quality financial reporting, including budgeting, cash flow management, GAAP compliance, and related financial matters. Accordingly, PE routinely either replaces the existing, or adds a new, person to handle accounting and finance.
- Management and Fund Cycles: Once a PE invests, the PE will be marking the time until it must liquidate the investment to meet promises made to investors. If the PE’s fund has a 10 year cycle, and makes the investment in year 5, then the PE will be planning to exit the investment in years 8 or 9 of the fund so it can distribute the proceeds in year 10 of the fund. This means that the PE will require the business to plan and achieve short-term growth so the PE can realize its investment goals within 4 years. In contrast, if the fund has a 10 year cycle, and makes the investment in year 1, then the PE will have a 9 year horizon, and be much more willing to support long-term growth plans. The need for the fund to exit at a certain time will mean that managers who cannot produce within that cycle will quickly be replaced. The result is that management will manage the company based on the PE fund cycle and not the market dynamics.
PE Approaches to Management Compensation
- Performance-Based Compensation: PE wants performance. As a result, PE prefers to offer management lower base salary and fewer benefits, but higher compensation based on performance.
- Financially Driven Compensation: As financial investors, PE understands finance and not the company’s business. Thus, performance compensation will usually be based on financial and not business targets. Management should be prepared to work with the narrow financial focus of PE.
- Equity Used in Management Incentives: PE will usually provide management with a form of performance-based equity incentives that enjoy limited governance or financial rights. For example, PE will often (i) reserve the right to make key decisions for the business or (ii) establish multiple ownership classes and relegate management to the lower equity class that can then be diluted by additional investments, eliminated if the business performs poorly, or forfeited if the management departs early or does not perform. Ideally, the equity used in management’s incentives should be exactly the same equity as issued to the PE, should be protected from dilution in follow-on rounds of investment, and should be protected from elimination, but these protections are rare.
- Structure of PE’s Investment Affects Compensation: In addition to equity, PE frequently fund the company with significant amounts of debt to fuel growth, capital improvements, and investor dividends. To the extent that management compensation is based on company performance and profits, the debt service will lower company performance and profits and, by extension, management compensation.
- PE Fees Affect Compensation: PE charges the company fees, and these fees will be high. The fees may include (i) investment fees charged when PE purchases the company, and (ii) annual fees for management services that can be in the range of 2-5% of revenue or profits. The company pays these fees from company cash, which reduces the company’s ability to operate and grow. To the extent that management compensation is tied to company performance, the fees will affect management compensation. Management needs to confirm the amount and payment schedule of the fees, and negotiate, if possible, to reduce the fees and base the management’s compensation on the performance of the company prior to the accrual and payment of the fees. The annual cash demands to pay the fees can place a significant burden on the company and pressure on management to perform.
- Repayment of PE Equity Affects Compensation: PE will sometimes accelerate the repayment of their investment in the company by loading the company with debt and using the proceeds of the debt and any available cash to pay an extraordinary dividend or distribution to the company’s owners, which is mainly the PE. These payments are in addition to the fees discussed above. This process essentially converts part of the PE investment from equity to debt, and (i) will affect ability of management to successfully operate the company and achieve the compensation targets, and (ii) can result in the company having so much debt that the company cannot handle the debt service, and then slides into insolvency.
For more information about this or other PE matters, please contact a member of our Business Group or call 208.344.6000.