Selling to a Financial Buyer

January 1st, 2005

Here’s an option to consider when you’re selling a business: investment companies and financial institutions in the private equity market are looking for good values. Most business owners who want to sell their company can come up with a ready list of potential buyers. After all, any business that establishes a presence in the market will develop a pool of likely suspects, including family members, partners, employees, and competitors who know the seller’s business.

The problem is that many owners begin and end their search with such strategic buyers, generally defined as those who already "know" the company or operate in its industry. As a result, these owners overlook another camp of prospects called financial buyers, who typically acquire or invest in a business with the goal of increasing shareholder value and reselling their stake in the future. By failing to consider the full universe of players early in the game, an owner may miss out on the best buyer for the business.

In fact, the competition for good businesses is keen among financial buyers. More than 1,000 investment firms and financial institutions (such as the investment arms of banks and insurance companies) are organized to acquire interests in existing companies. These buyers have a huge pool of funds at their disposal, which they raise from pension plans, wealthy families, foundations, employee stock ownership plans and similar sources.

While the lion’s share of this money goes to investments in the public market, many of these fund managers now recognize that good values can be found among private businesses with sales of $10 million or more. In recent years, investments in the private equity market have produced good returns for these funds, leading many managers to invest a larger portion of their total funds than before in private companies.

To be sure, selling to a financial buyer has its share of good and had points. Every transaction involves some trade-offs, and you must evaluate financial buyers in terms of the primary goals you’ve set for selling all or a portion of the business. At the same time, your company must offer the elements these buyers look for in their private investments. As always, a successful transaction comes down to finding the right fit.

Here are some key points to consider:

Your company’s growth potential.
Unlike strategic buyers who generally integrate acquisitions into their core business, financial buyers often have a clear exit strategy in mind. They buy an equity stake in the company, focus on boosting shareholder value, and then cash out in five to seven years by selling the business to another company or taking it public.

Therefore, financial buyers look for companies with the potential to expand in a growing industry and especially one with good gross margins.

They generally acquire companies with sales of $10 million or more, since their earnings should be large enough to attract financing from banks, subordinated lenders, or other investors. With this infusion of capital and the buyer’s management oversight the company then focuses on boosting its earnings and shareholder value through definable growth.

It was a financial buyer, for example, who helped make "Famous Amos" so famous. In 1989, the owner of the Famous Amos Chocolate Chip Cookie Corp., who had acquired the company from the Amos family, sold a majority interest to an investment company for $3 million. At the time, Famous Amos was an under-performing company with sales of less than $6 million. Over the next few years, the owner cashed out and the company continued to grow to sales of about $76 million. In 1992, Famous Amos was sold to the President Baking Co. of Atlanta, Georgia, for $60.6 million.

Your financial and retirement goals.
While financial buyers can assist in a company’s growth, they don’t have the expertise to run the day-to-day business and ensure an increase in profitability. As a result, the viability of the deal is greatly enhanced if you agree to continue running the business after the purchase. Owners who do want to sell out and retire must, at the very least, have experienced senior managers in place.

If you remain on board, the sale will allow you to liquidate a portion of your ownership interest and achieve some degree of financial independence. In one example, a thirty something business owner built his company to sales of about $10 million, but the business needed more capital to continue its growth. The owner knew that if he committed more of his own funds, he would put at risk the value he had already created for himself.

Instead, he opted to sell 60% of the business to a private investment group for $5 million. The owner increased his liquidity and minimized his personal risk and the company got the financing it needed to sustain growth from a non-bank lender. Although he won’t own 100% of the bigger company, assuming it reaches its growth projections, the 40% he does own will be worth considerably more than the 60% previously sold if the company goes public or is sold to a larger firm.

Another option is to sell to a financial buyer as part of a management buyout. In this case, the buyer would become a co-investor with senior managers who want to acquire an ownership interest. For family businesses, the sale could be used to make the transition to a new generation of ownership.

That was the case at one manufacturing company where the parents wanted to pass daily operating control of the business to their children. So they transferred part of the ownership to their children and sold the remainder to a financial buyer. The result: the retiring owners got the liquidity they needed to create financial security in retirement and meet their estate-planning goals, while the company’s identity as a family business was preserved.

The pricing of the deal.
Buyers consider the industry, the company’s growth potential, and the size of the investment in pricing a transaction. But in most cases, the price falls in the range of four to seven times operating income, which the buyer will adjust to reflect the true economic benefit of ownership.

The reconstructed income usually is detailed as income before interest, taxes, and expenses that will not continue after the purchase, such as a high level of owner compensation or the cost of a lawsuit settlement. Any such nonrecurring or non-operational expenses are added back to income, thus increasing the base for the purchase price. Often, what appears to be a marginal company can, after adjustments, be a very profitable one.

There are no hard-and-fast rules about whether you’ll get a better price from a financial buyer than a strategic buyer. But in some cases, a financial buyer may pay more because it looks at a company’s total value. A competitor, by contrast, may be interested in one aspect of your business, such as its customer base. If so, the competitor will pay according to that aspect’s value to him, ignoring the business’s overall worth.

If you continue to run the business after it’s sold to a financial buyer, you’ll also have a chance to take a "second bite of the apple" when the stock is later resold to another company or public investors. Generally, the original owner sells his remaining interest when the buyer cashes out. In fact, financial buyers tend to be more hands-off than their strategic counterparts. A financial buyer’s primary influence will be in financial oversight and certain strategic decisions, such as whether to acquire a new plant to facilitate expansion. But he or she is not likely to get involved in daily operating decisions.

In the end, the most important point is to explore all your options when selling your business. Many companies get sold to strategic buyers by default, simply because the owners are not aware of the financial buyer option.

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