Selling your business can be a time-consuming and onerous process, even under the best circumstances. But with the right professional guidance and preparation, it can be one of the most rewarding and lucrative lifetime events, resulting in the best possible outcome for you, your company, and your employees.
In order to maximize your proceeds and ensure the best possible outcome, it is critical that you understand thoroughly – and well in advance of your exit – the differences between financial buyers, strategic buyers, and employee stock ownership plans (ESOPs), and perhaps more importantly, the key business characteristics that each buyer group looks for in a company. Listed below are some motivating factors of each buyer group. We excel at helping business owners understand the best exit strategy when it comes time to sell their business, while working with them to position their company in the most favorable light depending on the buyer.
What is a Financial Buyer Looking for in a Company?
Financial buyers generally refer to private equity firms, family investment offices, venture capital funds, hedge funds, and high net worth individuals, among others. These firms are in the business of investing in companies (typically with the use of leverage) and realizing a return on their investment. Their primary goal is to invest capital in private companies with strong growth prospects or other attractive business characteristics and realize a return on their investment through a subsequent sale or IPO. Typically, these buyers are not heavily motivated by potential synergies that other buyers may be able to realize, and are looking for incumbent management to continue to run the business for some period post acquisition. Listed below are key characteristics of a strong acquisition target from a financial buyer’s perspective, based on our experience advising both buyers and sellers in the acquisition process.
Stable & Recurring Cash Flows
Financial buyers seek companies with stable and recurring cash flows so they can service post-transaction debt requirements, as substantial leverage is typically used to finance acquisitions. This motivates financial buyers to invest in businesses with little exposure to seasonal fluctuations in cash flows, as well as low sensitivity to cyclical factors (i.e. commodity prices, economic cycles, etc.). Financial buyers carefully examine whether a business has generated consistent cash flow in the past, as well as the trajectory of future cash flows. These buyers will determine a business’s true earning capacity by identifying any one-time/non-recurring events (i.e. severance, lawsuit settlements, insurance proceeds, etc.), personal or owner related expenses, out-of-market salaries, or other items expenses that are not expected to recur post transaction.
Favorable Industry Environment / Trends
Financial buyers are attracted to companies that are well-positioned within a favorable industry environment, which can be classified as an industry with robust growth prospects, low levels of competition, minimal risk factors, or favorable (suppressed) valuations. Private equity groups and venture capital firms spend significant time and resources researching and identifying attractive industries to invest in. That said, in the event you’ve been approached by a financial buyer, chances are they are somewhat knowledgeable of your industry and may even know where your company stands within the marketplace. By participating in industry trade associations and reading industry periodicals, business owners can stay informed of potential and active buyers to better understand their motivations.
While industry leading companies are generally perceived as attractive acquisition targets to most financial buyers, a business doesn’t need to be a market leader to be considered a viable acquisition target. Some financial buyers specialize in acquiring underperforming businesses and implement numerous strategic initiatives (i.e. make operational improvements, sell non-core assets, etc.) to “close” the valuation gap.
Strong Management Team
A financial buyer’s investment horizon – the length of time from which a business is bought and sold – typically ranges between four to seven years. From a financial buyer’s perspective, this relatively brief investment period is what motivates, among other reasons, the need for a talented management team. Every day of operation counts and even the most trivial managerial mishap can impact the return on investment. While members of financial buyer groups often hold board seats and provide strategic guidance to the company, they almost exclusively rely on management to execute their operating strategy. Conversely, holes in the management team, or an unwillingness of key managers to sign employment agreements can evoke hesitancy among financial buyers, making it increasingly challenging, if not impossible, to finalize a deal.
Strong Customer Base
A financial buyer will put a considerable amount of time and resources into assessing the overall viability of a company’s customer relationships. A financial buyer will typically request extensive documentation on customer concentration, customer attrition/retention, historical and projected renewal rates, payment options, and perhaps most importantly, will request discussions with key managers or employees who maintain the customer relationships. A financial buyer may also request to conduct client meetings to obtain more direct feedback and to discuss any challenges that may result from new ownership. Financial buyers, as well as every other buyer group, want to be sure that customers will remain with the company post-acquisition.
What is a Strategic Buyer Looking for in a Company?
A strategic buyer is typically a company within the seller’s competitive landscape or value chain that acquires a company to capture synergies. Motivations in pursuing an acquisition may include the desire to eliminate competition, improve financial or operational weaknesses, expand geographic reach, achieve economies of scale, acquire valuable intellectual property, or enter a new product/service line. A strategic buyer typically has significant knowledge of a seller’s business and has the infrastructure to manage operations.
While strategic buyers generally seek the same characteristics as financial buyers, there are some notable differences.
Revenue, Cost & Financial Synergies
When considering growth through acquisition, strategic buyers spend considerable time and resources identifying and quantifying synergies. Synergies are achieved when a combined entity generates more sales, greater cost savings and/or more favorable financing arrangements than the two companies could as stand-alone entities. The achievement of target synergies can enhance the company’s financial position and more than offset the consideration paid for the acquisition. Synergies can be realized in countless ways, including utilizing an existing distribution network and sales force to increase sales of a newly acquired product, centralizing warehouse operations or other back-office functions to eliminate redundant costs, integrating supply chains and vendor relationships to obtain more favorable pricing, or combining assets to negotiate lower financing costs. Business owners can offer unique insight as to how their business can improve the strategic buyer’s operations if the target synergies are understood.
Cultural fit is often a key starting point for a buyer’s selection of a viable acquisition target, and vice versa. While strategic acquisitions can fail for a number of reasons, corporate development executives and other M&A professionals often point to misalignment of culture as a main contributor to many failed acquisitions. While increasingly difficult to vet, strategic buyers want assurance that a target company’s workforce will assimilate to a new corporate structure and processes and procedures, while simultaneously preserving its existing culture and workforce productivity.
What does an ESOP Look for in a Company?
An Employee Stock Ownership Plan, or ESOP, is an alternative exit strategy to a third-party sale. In short, an ESOP allows a business owner to sell the company on a tax-advantaged basis to its employees. The company stock is sold to a retirement trust that is overseen by a trustee who has a fiduciary responsibility to act in the best interests of the participants. Eligible employees are allocated shares of company stock in annual installments based on their respective compensation as a percentage of total payroll.
Listed below are key characteristics of a strong acquisition target from an ESOP’s perspective, based on our experience advising both trustees and selling shareholders in the ESOP acquisition process.
Consistent & Increasing Earnings
Selling your company to an ESOP can be viewed as a tax-advantaged alternative to a leveraged buyout (LBO), in which a buyer uses substantial leverage to finance an acquisition. As the ESOP is formed as part of the transaction, and employees don’t make contributions, the ESOP doesn’t possess any mechanism to finance its purchase as of the closing. As a result, the majority of ESOP transactions are leveraged, either through bank financing, seller financing, or both. For this reason, companies that generate consistent and/or increasing earnings are better suited for an ESOP relative to companies with volatile earnings or where cyclicality is significant.
Reasonable and Supportable Valuation Expectations
ESOPs are regulated by the Employment Retirement Income Security Act of 1974 (ERISA) and Internal Revenue Code (IRC) as an employee benefit plan. Under ERISA and IRC guidelines, ESOPs may acquire company stock provided they pay no more than fair market value, which is defined as:
…the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
ESOP trustees typically favor purchasing a business from a seller that is willing to negotiate a purchase price with reasonable expectations of value. While a business owner cannot always obtain a significant “strategic” premium in an ESOP, say as they might from certain buyers, they can still realize full fair market value, and often end up with more after tax proceeds than a strategic sale if the transaction is structured appropriately.
The Right Result
While many of the factors listed above are common across all categories of buyers, many nuances exist between them. Regardless of your goals, there are pros and cons to each strategy and getting sound advice is critical to ensuring that the path you take is consistent with your goals. Given the many possible outcomes when you sell your company, you need a trusted advisor like the experts at Acuity Advisors to help you navigate this journey and achieve the one right result.