Types of Buyers

hen the owners of a business are interested in selling, a number of things need to be considered before starting the process. The first question that they should be asking is what is it we are trying to accomplish by selling?

• Do we want to recapitalize the business while taking some chips off the table?
• Is the current management team looking to get into an ownership position via a leveraged buyout?
• Is this a family business that is looking to transfer the business to new ownership?
• Are we looking for growth capital?
• Or are we looking to transition into retirement?
• If so, do we want to walk away after the sale, or stay on and potentially have an ownership position going forward?

The next questions that beg asking then are who, or what type of entity, will allow us as sellers to achieve our goals, and what type of buyer presents the best fit for the business going forward?

Generally speaking there are two types of buyers: strategic and financial, or private equity/investment groups (often referred to as “PIGs”). Each presents specific advantages and disadvantages to the seller. Let’s first define each type of buyer and then we’ll explore what each one has to offer the seller.

Strategic Buyer

A strategic buyer is the type of buyer that most business owners are familiar with, and as such we won’t delve too deeply in to their attributes. Strategic buyers are companies that in some way, shape or form, have something in common with the selling business. They can be a competitor, supplier or even a customer. They can also be a company that is not a direct competitor, but has a complementary product offering so that the selling company would represent a broadening or deepening of their product offering or expand the industries or markets served. In sum, there is some synergistic relationship between the two organizations.

Strategic buyers generally have a good track record of running businesses and have deep industry knowledge. They may or may not have any experience in buying businesses, structuring the transaction, or in integrating a new business into their existing infrastructure.

Generally, strategic buyers structure a transaction so that they are buying 100% of the business in an all cash transaction.

What strategic buyers are usually most interested in is what the selling company does and how that fits in with what the buyer’s business model. The quality and make up of the selling company’s management team may or may not be of any significant interest to the buyer.

Post transaction, the buying company looks to consolidate the two businesses around their business systems, controls and management structure. For a seller that is looking to exit the business post-transaction, this may not be of concern.

However, for a seller who is looking to stay on post-transaction, this can prove problematic. Generally what we see happen in a very high percentage of transactions is that there are conflicts between the way the seller’s and buyer’s companies are run. Both companies are used to, and have been successful doing things “their way”. Unfortunately, they are seldom the same way. Inevitably, these differences lead to conflicts and the sellers find themselves unhappy and unwilling to continue working in this environment. Given these inherent difficulties, seldom do we see sellers still working for the company 18 months after the sale.

Financial Buyer, or Private Equity Group

What are they?

Financial buyers, or private equity groups (“PIGs”), are companies whose business model is to buy good businesses at a fair price, build them over a specific timeframe, and then look to resell the business for a profit at some time in the future. Generally, private equity groups have guidelines that define what types of businesses they invest in. These guidelines include attributes such as size, industry, geography, hold period and target returns. Because many business owners are less familiar with private equity groups than they are with strategic buyers, we will go into detail on what they are, how they work, and what they look for when buying a business.

How Do They Work?

PIGs raise the capital needed to buy businesses from a variety of sources that include: partners in the firm, high net worth individuals, insurance companies, pension funds and other types of investment vehicles. They are able to raise these funds because their business model is predicated on generating a very handsome compounded annual return on their capital. A minimum 25% compounded annual return is typical for the industry. This may sound like an unrealistically high number, but as we will see in a later example, it can actually be achieved fairly easily and is in fact routinely exceeded.

Private equity groups are very, very good at doing a number of things such as:

• Determining which businesses to buy and which businesses not to buy
• What the value of the business is, given their particular outlook for the future.
• How to structure a transaction that includes equity from their fund, debt from different sources, and a potential equity stake for the current owners or their management team. The goal is to create a structure that simultaneously maximizes the return they get on their investment while at the same time avoids over burdening the business with debt. The last thing that a private equity group wants to create is a situation where the company’s debt burden is so large that it limits its ability to grow or potentially endangers the business should it experience a downturn in performance.
• Working with the existing management team in determining how to grow the business, what resources will be needed and how to procure those resources.

What they are not very good at is actually running a business. If a private equity group ends up running the day to day operations of a company that they have acquired, in most cases, they have made a big mistake in buying that business in the first place.

What do they look for?

Transactions with private equity groups tend to fall into two main categories, and what they look for in a company differs depending upon which type of acquisition is being contemplated. Generally there are two main types of acquisitions that private equity groups entertain.

• Platform companies
• Add-on companies

Platform Acquisitions:

“Platform companies” are companies that represent the first transaction for a particular private equity group in a particular area and act as a platform on which to build upon. Potential platform companies need to possess a number of attributes including: a strong management team, a minimum size threshold, growth strategies and a viable exit strategy.

For a company to be considered a “platform”, from a size standpoint it generally needs to be above $10M in revenue and above $2M EBITDA. Please keep in mind that these thresholds act as general guidelines and are not absolute size levels. (As mentioned earlier, each private equity group has their own investment criteria and some will consider platform companies as small as $5M in revenue and $1M in EBITDA).

In addition to size, another very important attribute that PIGs look for in a platform company is a strong management team that the private equity group can back and partner with. Said another way, PIGs look to back a strong senior management team that has produced consistently positive results, and the company is the vehicle that allows this to happen.

Ideal potential platform companies also have produced consistent growth and profitability over the last 3-5 years and have a readily achievable strategy for growth going forward. That strategy may or may not include future acquisitions.

Add-on Acquisitions:

Add-on acquisitions are acquisitions to existing platform companies. Add-on acquisitions can be either a stand alone acquisition or a “tuck-in” acquisition. A stand alone acquisition is one in which the company continues to operate as a branch in their existing facility. A “tuck in” acquisition is one in which the selling company’s location will be closed down post transaction and “tucked into” the buying company’s facility.

Potential add-on acquisitions often look more like strategic acquisitions from an attributes standpoint. The buyer is generally more interested in how the company fits in with its business model rather than in what their management team looks like, or what size they are. This is especially true for tuck-in acquisitions.

Private Equity Group Transaction Structures

In private equity group acquisitions, the structure of the transaction is often much more complex than what you typically see with strategic acquisitions. This is driven by the results that they need to produce for their investors, as well as their partnership arrangement with the existing management team.

In order to achieve the minimum 25% compounded annual returns that they have promised their investors, PIGs need to use leverage, or debt, as a part of the purchase capital. This debt can come from a variety of sources but usually falls into two main categories: senior debt and junior debt, or mezzanine debt. Senior debt is the same type of debt that a business owner would use for capital expansion needs. It usually comes from a bank, has a five year time horizon, and is paid off in monthly principle and interest payments. It carries an interest rate based on an index, such as the prime rate or the LIBOR rate, plus some additional percentage. It is backed by assets, but carries no personal guarantees. Mezzanine debt has the advantage of being completely unsecured, but carries very high interest rates currently in the range of 14-19%. As part of its feature of being completely unsecured, mezzanine debt requires no personal guarantees, and is usually structured as a 5 year note with quarterly interest-only payments.

Especially for platform companies, private equity groups have a strong preference for the management team to have a meaningful equity position in the company post-transaction. This stems from two primary reasons. First, as mentioned earlier, private equity groups are good at running companies, and they need to insure that the existing management team stays in place and doesn’t leave after the sale. Second, they need to make sure that the company is being run in the best interest of the shareholders. By having management hold a significant equity position, they accomplish both goals. To encourage management teams to purchase an ownership stake, PIGs make it a very attractive proposition. The mechanism that allows this to happen is called “parri passu” participation. In essence, management is allowed to buy their ownership interest at the same basis that the private equity group is buying theirs. Let’s look at an example to illustrate the concept:

The owners of company “A”, which has $2M in interest-bearing debt, have determined that they are looking for a tiered retirement strategy and have decided to take their company to market and entertain offers from private equity groups. As a result of this process, they have received several offers and have accepted one that values the company at $10M. The private equity group has raised a fund of $250M, so they could easily write a check for the $10M purchase price. However, if they did so, it would be very difficult for them to get the 25% compounded annual rate of return that they have promised their investors. So, as mentioned above, to achieve this, they use leverage, or debt.

The private equity group’s capital structure for the purchase of fictitious company “A” is as follows:

• $10M total purchase price
• $4M in equity from their fund
• $2M in senior debt financing secured by company A’s hard assets
• $4M in mezzanine debt

Without any type of equity participation going forward the transaction would look like this to the sellers:

• $10M in gross proceeds
• Less $2M to retire outstanding interest bearing debt
• Net of $8M to sellers, before taxes and transaction costs

Now let’s assume that the management team wanted to own 30% of the company post sale. We know that at the value company “A” sold for this would be worth $3M (30% of $10M). However with a pari passu buy in, the management team could buy 30% of the company for 30% of the equity going into the sale, or in this case 30% of $4M (that the private equity group is putting into the transaction from their fund). This equates to $1.2M. Now the transaction looks like this:

• $10M in gross proceeds
• Less $2M to retire outstanding interest bearing debt
• Less $1.2M to purchase 30% of the company
• Net of $6.8M to sellers, before taxes and transaction costs, plus a 30% equity stake.

Now, for example sake, let’s assume that the company grows in value by $1M in the first year after the sale. The company is now worth $11M. If the private equity group had paid the $10M purchase price by taking all $10M out of their fund, they would only be receiving a 10% return on their investment ($1M increase on a $10M investment). But because they used leverage, they are actually receiving their required 25% return ($1M increase on their $4M investment). Combine this type of increase with a pay down of the a majority of the $6M in debt, and one can see how a 25% compounded rate of return is readily achievable in the normal course of business.

Let’s take this one step further, assuming that the company does indeed achieve the minimum required 25% compounded annual return for 5 years, and the private equity group sells the company. A 25% compounded annual return multiplied out for the 5 year period of time, results in a tripling the investment. The management team’s investment of $1.2M five years ago has turned into $3.6M. This “second bite at the apple” is often what prompts business owners to seriously consider this exit strategy when selling their business.

As you can see, when it is time to consider selling your business, there are a lot of things to consider and many available options. Determining which options apply to your particular situation and which ones are right for you can be a complicated and confusing task. We at Aspen Mergers are here to help guide you through this process and insure that not only do you receive the best possible offers, but -just as importantly- are able to complete the sales process and enjoy the fruits of your hard work!

Robert Vogl
Vice President

About Aspen M&A

Aspen Mergers and Acquisitions, Inc. are specialists in deal making with over 80 years of aggregate experience, serving clients nationwide through our offices in Los Angeles, Atlanta, Vail and Boston. Our mission is to enable middle market business owners to capitalize on their business value through transactions resulting in liquid equity. We offer a full range of professional services including contact with acquirers founded on our long standing buyer relationships. Please contact us for a free consultation. We charge no up-front fees and only get rewarded if a transaction closes. We are results driven and we would welcome having a private and confidential discussion with you.