A business owner usually has all or most of the owner’s wealth tied to the business. At some point the owner will want to turn the wealth into cash. One willing and increasingly common source of cash is investors who like the business’s prospects and want to profit from the growth. These buyers may form various types of buying groups, which for convenience can be labeled private equity (PE). PE tends to have relatively common approaches to buying and operating a business, and business owners who understand the PE approach will increase their success in selling to PE.
This is the first in a two-part series of tips for business owners who are negotiating a sale of their business to a PE buyer. These suggestions are based on our experience, and are not universal rules. This first installment provides advice for sellers of ownership interests. The second installment, which we will publish next month, provides guidance for management that will survive the transaction and run the company for the buyer.
Financial Buyer: PE is a financial buyer. A financial buyer purchases a business as an investment, and is solely concerned about investment returns. This has several consequences:
- The other benefits of the business are largely irrelevant. For example, PE will not pay a premium for synergy.
- The purchase price will be driven by financial performance and ratios, such as return on investment or internal rates of return.
- PE will simultaneously analyze investments in different businesses, and will take the best deal.
- To enhance the financial ratios, the PE buyer may use uncommon deal terms, such as requiring seller financing with unusual repayment schedules (e.g., no principal and interest payments for a period of time), and requiring management to roll-over any proceeds obtained from the deal.
Due Diligence on PE Firm: As part of negotiating the sale, the sellers should conduct due diligence on each PE firm that makes an offer. The PE firm will have a portfolio of companies, and each was purchased from someone – a seller can learn from the prior sellers’ experiences.
PE Adds Capital, Needs Management: A business needs three things – idea, capital and management. PE provides the capital and buys the idea and management. An operating enterprise with existing quality management is within the target zone for PE because PE can add the third element of capital. PE will rarely pay extra for good management; it simply will not purchase an enterprise without good management. In a minority of circumstances, PE will pay for an idea and then hire new managers or provide managers from within the PE firm’s stable of managers; however, this approach is more common for venture capital investors.
Investment Criteria: PE usually invests through a fund that is formed by many investors pooling money to be invested by the PE firm. To raise money, the PE firm makes certain representations to the investors in the fund’s prospectus. Common representations include (i) the types of industries in which the fund will invest; (ii) the size of the companies in which the fund will invest (e.g., $1 to $5 million annual revenues, or $15 to $50 million EBITDA, or some other criteria); (iii) the amount of equity and debt to be used in making the investment; (iv) the return promised to the investors, such as 2 times the investment, or 3 times the investment; and (v) the duration of the fund, which is usually 10 years. If possible, a seller should obtain a copy of the PE fund’s prospectus because the PE firm usually has little flexibility to vary from the prospectus.
Leverage: To obtain promised returns, PE firms almost always use bank and seller debt, and many times use significant amounts of bank and seller debt. Thus a PE buyer’s ability to purchase without seller financing may be very limited. The need for the seller to finance part of the transaction increases the seller’s risk.
Call: PE funds rarely require investors to fund their investments in advance. Instead, investors contribute cash only when the PE firm “calls” for funding. While negotiating with the PE firm, the seller should ask whether the PE firm has the cash on hand or needs to call for investors to fund. The need for the seller to wait for the PE firm to collect the cash increases the seller’s risk.
Investor Approval: Some PE firms make the call mandatory. Other PE firms make the call discretionary – that is, once the PE firm calls for the money, the investors have the option to invest or not invest depending on the company being purchased. While negotiating with the PE firm, the seller should determine whether the call is mandatory or discretionary. The right of individual investors in the PE fund to decline to fund increases the seller’s risk.
Fund Cycle: PE funds typically have a 10 year duration. In addition, the fund usually has other, internal deadlines. The PE fund’s life cycle has a powerful effect on the motivations of the PE firm. If, for example, the fund must make all its investments in the first 5 years, and the fund is in year 4.5, then the fund must complete making all its investments in the next 6 months or it loses the right to invest. Since the PE firm is paid for making and managing investments, failure to invest means a financial loss to the PE firm. As a result, the PE firm is motivated to make a deal. In contrast, if the PE fund is in year 1, the fund has time to shop deals and stall.
Reputation: PE firms closely guard their reputation. PE firms survive by doing deals, and PE firms do not want anything to soil their reputation so that the PE firm is snubbed by other PE firms, banks, or sellers on the next deal. Thus, in negotiating with the PE firm, keep in mind that the PE firm will be very sensitive regarding its reputation.
Escrows and Holdbacks: PE firms will almost always require an escrow or holdback to repay the PE firm for a breach of the representations and warranties in the agreement to purchase the business. While the escrow or holdback is expected, the terms that permit the PE firm to recover money from the escrow or holdback are heavily negotiated.
Earn-Outs: PE firms often propose earn-outs in which the PE firm pays additional amounts to the sellers if the business performs well in the future. While earn-outs have the potential of increasing the amount received by the sellers, earn-outs are also very complex and disputes are common. Earn-outs increase the seller’s risk, but also may increase the proceeds from the sale.
Next month our corporate e-newsletter will provide tips for business owners who sell their business and continue to operate the business as employees of the new PE owner.
For more information about this or other PE matters, please contact a member of our Business Group or call 208.344.6000.