What Entrepreneurs need to know about Selling to a Private Equity Firm

As an entrepreneur, you work hard to build your business, but at some point the opportunity appears to sell your business. Maybe you own a thriving company but all your net worth is tied up in it, or people started contacting you to see if you’d sell and it’s finally piqued your interest or perhaps you have a more aggressive vision but want a partner to help you achieve it. Regardless, you’re ready to think bigger, but the right path forward isn’t clear.

Private Equity (PE) firms offer a variety of liquidity options and growth opportunities, but many entrepreneurs have only heard scary stories of PE firms. In the Exit & Acquisition’s 2019 Entrepreneur Selling a Company Survey, entrepreneurs ranked PE Firms with a negative 49 Net Promoter Score (NPS), which measures consumer experience. Translation? Most entrepreneurs won’t recommend this type of sale to a friend or colleague.

Chart: How likely is it that you would recommend selling their company to a Private Equity Group to a friend or colleague?

Why do entrepreneurs have a negative view of Private Equity?

Horror stories circulate about companies bought out through high leverage buyouts, under-distress and potentially dismantled. In the Selling a Company survey, 24.57% of entrepreneurs said they were Highly Concerned about a negative impact to their culture post-sale. But not all PE firms dismantle the company, and there are scenarios where entrepreneurs experience far more upside partnering with PE firms. So it is important as an entrepreneur that you know the type of deals you would or would not do as part of selling.

Not all private equity deals are created equally

Not all private equity strategies are the same, and the key to success is finding a private equity firm that can implement the right strategy for your business. If you haven’t considered a private equity deal in the past, there are many pros and cons to consider, much of which we’ll detail here.

For instance, sometimes a private equity firm buys a company outright. The owner might stay on with the business, or maybe they don’t. Equally important, we’ll explain what to expect from a private equity deal, and how you can use this avenue to achieve your business goals. Here are a few of the situations that could be a good fit for a PE-backed deal, including:

Growth Equity. Growth Equity is a good option for fast growing companies looking for capital but only selling a minority position versus Private Equity which usually will want to buy a ‘controlling interest’ or over 50 percent. In this scenario owners often delay taking capital out of the business for a later, hopefully bigger exit. Again, this is not Venture Capital, which many people confuse, it is growth equity to put fuel on the fire of companies ready for rapid growth.

There is a big difference between Venture Capital and Private Equity. People often confuse these two, yet both have vastly different investment strategies and expectations of return. VC’s fund early stage start-ups but PE firms typically look for established, profitable companies.

Management Buyout (MBO). The management of the company may decide to buy an equity stake with the help of a PE firm. This is a great option for business owners who want their employees to buy the company or for management teams who believe they can better create value than the current company ownership.

Distressed/Restructure. Some situations lend themselves best to a restructure. For example, is your investment partner becoming a challenge, or are the original investors ready for a payout? Or perhaps the business is losing momentum and needs a serious cash infusion or overhaul. A private equity deal can use a distressed or restructure approach to solve these challenges. The PE firm comes to the table with new ideas to assist with giving your company a chance to move forward but usually at a high cost.

Leveraged buyouts (LBO). An LBO involves acquiring a company using borrowed money to meet the cost of acquisition. Typically the assets of the company being acquired are used as collateral for the loan, along with the assets of the acquiring company. The purpose of this type of deal is to allow companies to meet their goals without committing a large amount of assets upfront. Think about it like taking out a mortgage. A mortgage allows you to purchase a larger value asset with a small down payment. In a similar fashion, the PE firm borrows money from the bank to buy the company, then uses company profits to pay down that debt over time.

Full or Majority Exit (Recapitalization). Tapping into additional funds allows entrepreneurs to meet their goals. For instance, the owner of a company might have a growth mindset, but be stuck in how to achieve the goals. Private equity firms provide the solution that aligns the right strategy to the specific goal.

Is Private Equity an option for you? It depends on your size. Most firms do not invest in smaller companies. Often unless your company is worth $50M or more, you may be too small. There are an increasing number of firms that are starting to look for companies around $20M in value with an even smaller percentage willing to invest below this.

Is Your Exit as an Add-on or a Platform — and what’s the difference?

A couple paths that fit with a full or majority exit include being an add-ons and platform deals. These terms describe how your deal fits into the PE firm’s strategic plans and may affect the value of the deal.

PE firms typically have two different strategies. The first is that they acquire a company in an entirely new industry, which is called a “platform investment.” This means that the company has the chance to consolidate their market and buy competitors. The second type of strategy is called an “add-on” deal. With these, the PE firm owns similar companies and purchases the new company to complement its existing deals.

If you can become the Platform Company, you can be the one to consolidate your market. Entrepreneurs who do use this platform strategy can achieve outsized valuation outcomes often 4–5x the value of their company.

Estimates vary, but add-on deals are estimated to constitute about 40 to 50 percent of PE buyout activity. However, it’s important to note that being the “platform” is far more desirable. A platform company serves as the foundation of a consolidation of multiple companies acquired often from the same industry. The platform company accelerates its growth through the acquisition of new customers, offerings and channels and scales through the integration of new systems, resources, and processes.

Typically, any good market will experience consolidation. The question usually is, do you want to be consolidated or be the one who consolidates? Understanding the differences between these deals can assist with better understanding the potential value of your company. And this brings us to the next point: What a PE firm is looking for when evaluating a business. Let’s take a closer look.

A glimpse into the mind of PE firms

You’ve decided to take the plunge and explore a private equity deal. You want more freedom and/or a breakthrough for your company, and you’re ready to take business to the next level. Now what? What do PE firms look for when considering a purchase? Every firm is different, but here are a few general items to consider.

• An excellent management team. The quality of the people in the company, specifically the managers, is an important factor for PE firms. The PE firm won’t be involved in the daily running of the company, so they’ll depend on the people already there to execute the strategy put into place. The PE firm wants to understand your people, their situations, what’s important to them, and their motivations, so they can understand how those things impact the company’s culture.
• A market segment with high growth potential. Private equity firms are all about increasing your growth. And it’s one of the primary reasons why entrepreneurs are interested in this type of deal. In some instances, PE firms also want to grow market share, which is why it’s important that your company is positioned well in your sector.
• Low volatility. PE firms prefer companies that operate in a non-cyclical industry. Since a PE firm will own a company only for a short period of time, they like to buy companies with minimal volatility.
• Steady cash flow. PE firms need to have reliable cash flow to meet their required interest payments. If a PE firm misses debt payments, they could lose ownership in the company, which could seriously affect their business.
• Low capital expenditures. PE firms prefer to purchase companies that require little additional investment. For example, let’s say you’re buying a house, and you find one that is clearly falling apart and in need of repair. This house is not a “PE friendly” investment.
• A clear exist strategy. A PE firm is plotting out potential exit strategies before they step foot in your company. And that’s a good thing, because it’s critical to the long-term success of your business. They are looking for a company with a clear and executable strategy.

Private Equity buyers look at your business from a mathematical perspective. As you present your business in addition to having a clear understanding of their investment thesis, present yours and support it with a clear mathematical case. (read why Math Wins from my Blackjack card counting experience.)

Making the right exit — understanding PE exit strategies

A PE firm isn’t a long-term partner. Typically within 3 to 5 years, the firm will execute an exit strategy, and there are many options that allow your company to continue to thrive in the future. In 2017 alone, PE firms completed 2,475 exits. Understanding the potential exit options beforehand helps to better understand potential scenarios.

• Initial public offering (IPO). Some private equity firms will design a strategy that includes an IPO, where they sell shares to the public. This type of exit is not common and typically used for larger companies since the cost of an IPO is high and not the best fit for many companies.
• Strategic acquisition. A PE firm might deploy a strategic acquisition or “trade sale,” where the company is sold to another suitable company and you take your shares from the sale value. This is one of the more popular routes for private equity funds.
• Secondary sale. In this type of sale, the private investors sell a stake in their business to another private equity firm. A couple reasons this exit strategy would be viable is that the business requires more money or reached a stage that the existing PE investors wanted to reach, and another equity investor wants to take over the growth from that point.

The exit strategy is a critical last step of the PE investment process and is important to businesses wanting to better understand their company’s future. Speak with PE firms and ask about typical exit strategies and what they envision for your company.

Alignment is Key to Achieving Your Desired Outcome

The best strategy for speaking with PE firms is to be totally transparent. PE firms are experts in bringing your company to the next level of growth and achieving your goals. But it’s only through complete transparency that they can truly understand your company and figure out the strategy that will get your business to where you want in the future. A PE firm can generate customized solutions that allow the owner to take some of their “chips” off the table, but this option only works if it’s perfectly aligned with the owner’s goal. Additionally, at some point, the PE firm will execute an exit strategy, and not all strategies are the same. Having the right partner is key to understanding the design of the long-term plan.

Summary: Not all Private Equity is created equal, so it’s critical to know what type of deal you need and when to consider bringing in private equity.

Business owners are constantly looking for their next step, asking, “What is going to help my company achieve success in the future?” Sometimes that next step feels just out of reach, and you need help getting there. Private Equity has increasingly become a viable option for any situation, as the number of PE firms has grown from the dozens to thousands Further, a good PE firm can leverage its experience and resources to help you accomplish your goals in a fraction of the time. Whether it’s to spur additional growth, infuse capital to achieve goals, or to exit the company, a PE firm provides additional options to consider.

Want to learn more? Check out current Platform Strategy and learn if this could be the right exit strategy for your business.