Different types of entrepreneurs and investors
Most small business owners will sell or attempt to sell their business. Lifestyle entrepreneurs eventually want to retire and serial entrepreneurs want to cash out and fund their next venture(s). There are many iterations to the types of deals that can be done to exit a business, but two major categories of buyers exist: strategic and financial.
Strategic buyers are companies in a similar, competing, or collaborative industry. They are buying a supply chain, distribution, intellectual property, a brand name, or another business function that will enhance their own business… or all of the above. Financial buyers are basically private equity firms that want free cash flow and profitability.
What category of buyers is right for you?
Much of the same processes and pressures exist with both types of buyers, but there are some trends that entrepreneurs will want to consider when determining what category of buyers is right for them.
Management: In both cases, it is likely that key management will be required to sign employment contracts for one or more years. With strategic purchases, the buyers often absorb the old company, and management along with employees end up working for the new company (in management’s case, this usually means in a reduced capacity). Financial buyers will usually bring in a new board of directors, and sometimes top executives, but the company will likely continue to operate as a stand alone entity with basically the same team. Management may be asked to roll over some or all of their financial gain into the new company when a private equity firm is the buyer. This can be good (with a large upside for the management team) but it also isn’t a true “exit” from the business.
Employees: When a strategic buyer comes in, the companies are usually merged and the buyer dominates. Redundant positions in the sold company may be eliminated. Financial buyers will look for efficiencies, but usually the staff will stay intact to preserve operations.
Lawyers: Be prepared for significant legal work in either scenario. There are a lot of liability issues which need to be accurately documented in addition to all the business issues, and remember that lawyers get paid hourly (and like to get paid) so it will not be a quick process. In financial buyer cases, the legal jockeying can be especially long and expensive. Sometimes in strategic deals, the buyer focuses primarily on business synergies, and the deal-making aspects aren’t such a priority, but this doesn’t mean the legal isn’t important and won’t be significant.
Purchase price: This is one of the major differences. While it varies by industry, most deals will be valued at some multiple of EBITDA (earnings before interest, taxes, depreciation and amortization). In most cases, strategic deals will command a larger multiple. For example, a financial buyer might offer a company 6 times EBITDA as a purchase price. With a strategic buyer, the same company might command 8 to 12 times EBITDA. This means that a small business making $5 million in annual profits might see its exit price grow from $30 million to $40-60 million, varying between financial and strategic buyers. This is not a “set-in-stone” rule by any means, but it is a well-established trend. While private equity firms are buying cash flow, strategic buyers get that same cash flow AND hope to achieve efficiency, expanded growth and/or added value with a merger. This explains the increased multiples.
Earn-out: With both buyer categories, a portion of the purchase price will likely be an earn-out. This means that either certain benchmarks must be met to get some of the money out of the deal, or that a portion of the money is tied as a percentage to revenue, profits or other metrics. In financial deals, the earn-out time period is usually shorter and is a smaller percentage of the total purchase price. Strategic deals often have a longer earn-out period (2 to 5 years is not uncommon), and the earn-out is often a larger percentage of the total deal value.
Financing: Strategic deals may or may not involve some sort of financing. Many deals these days do, but there are also a lot of cash-rich companies that will not use a bank to close their acquisitions. In nearly all private equity deals, there will be bank financing. This doesn’t have a significant impact on the end result exit, but it is an extra step in the process of a sale. It is also an additional hurdle (i.e. if the business has a hard time qualifying for the financing needed, the PE firm may walk away from the deal). Financial buyers put up their own capital in these deals, but only for a percentage of the total acquisition price. This mitigates risk for them, and it also increases their expected return on investment (if they put up less money, any gains on the deal are larger percentage-wise and look better for the buyer’s investors).
A major accomplishment
Any exit is a huge accomplishment for an entrepreneur. It is an important validation of work well done, and it is an open door for future projects. And yes, it is often a significant financial windfall. There is no right or wrong buyer in the strategic verses financial discussion, but it may be helpful to understand the nuances on both sides. The bottom line is that any exit can be a good exit, and all good exits should be celebrated!