Exploring the Key Differences Between Types of Buyers Available to Lower Middle Market Companies

In today’s market there are various types of buyers which are interested in acquiring in or making an investment in lower middle market companies, which we are defining for purposes of this article as having revenue ranging from $10M to $100M. Companies of this size are generally owned by a family or a few partners (“Owners”). The most common buyers in this market segment are strategics, private equity firms and family offices, each with their own distinct characteristics and objectives.

For the purpose of this article, and to simplify the differences between the types of buyers, we will focus on those sellers who are interested in a complete sale of their company. In another article we will focus on companies who are looking to sell only part of their business and the differences between the buyer types in those types of transaction.

Owners interested in selling all of their company usually have 4 key areas of interest when it comes to an acquisition: (1) purchase price and deal structure, (2) post-transaction Owner role, (3) post-transaction employee impact and (4) what will happen to the company culture or brand that I have built.

In order to identify potential buyers that best align with Owner objectives and to make informed decisions on which types of buyers to target in the first place, we explore how each type of buyer approaches these the first 3 key areas. The 4th being the survival of the company or culture or brand, is more complex, is not as tied to the type of buyer and will not be covered here.

1. Strategic Buyer.

A strategic buyer is typically a larger company (public or private) that operates in the same or a related industry as the company to be acquired and may even be a competitor. While competitors may make the most sense, there are obvious risks to approaching a competitor and the pros and cons should be considered. The main motivations of a strategic acquisition are usually to expand market share and customer base faster than can be done organically, access new products or technology, enter new geographies, vertically integrate, increase profitability, and acquire additional talent.

Purchase Price and Deal Structure.

A strategic buyer will usually want to acquire 100% of the company to be acquired as owner motivation is not necessarily a future subsequent exit as may be the case with the others. If the strategic is public, acquisitions may help to increase the buyers short or long-term profitability, and therefore increase share price. Valuations and purchase prices tend to be rational and tied to a market multiple of adjusted EBITDA, with most or all of the purchase price paid at closing, except for escrowed amounts. In addition to the profit generated by the seller’s business itself, the strategic buyers often focus on synergies and the value the acquired business has to them. At times, a portion of this additional value can translate into an increased purchase price paid to the seller, or a contingent portion of paid as an earn out based upon certain synergies being achieved.

Post-Transaction Owner Role.

Since a strategic will already have a senior management team in place, this is good news for an owner looking to exit or change their roles. An owner should be able to exit the business during a shorter transition period, perhaps 6-12 months (or shorter) depending on the buyer profile, the plan for the acquired business and what type of management team is in place at the sellers. However, if an Owner was interested, there could be opportunity to stay on longer in a different role, such as identifying and approaching other potential acquisition targets.

Post-Transaction Employee Impact.

Acquisition by a larger company can give employees more opportunities, better benefits, and a wider career path, but since it is highly likely there will be redundancies, especially in the G&A areas (which were part of the strategics financial calculations) there is also the risk of layoffs.

2. Private Equity Firms.

Private equity firms are investment entities that pool capital from private investors, institutions, and other funds to acquire and manage companies. Their primary goal is to generate returns for their investors, often within a defined investment period, frequently 5 – 7 years. This is accomplished by selling the acquired company at a higher valuation than when purchased. This is achieved by increasing revenue/earnings both organically and through acquisition. Private equity firms commonly follow a “roll-up” strategy which involves acquiring a “platform” company in a particular market sector and then acquiring other smaller companies as “add-ons”, and subsequently selling the resulting entity when it reaches a certain valuation and return.

Purchase Price and Deal Structure.

By contrast with a strategic buyer, a private equity firm will almost never want to acquire 100% of a company, especially with respect to a platform, as they view an Owner maintaining an equity position as insurance that the Owner will have financial incentive to assist with the transition and that the Owner has confidence in the growth which was projected. For a platform investment, PE firms will typically want Owners to keep at least 15% in “rollover equity”, sometimes up to 35% or more, as a PE firm will always want to hold the majority. For add-ons, the rollover equity requirement can range from 0 – 20%.

This rollover equity is referred as to the Owner receiving a “second bite of the apple”, meaning that the Owner will have a second exit, which has the potential to be larger than the first depending upon the circumstances. Obviously, there is risk for the Owner in not cashing out completely the first time.

Private equity firms will almost always place leverage (debt) on the company to finance part of the purchase price. This allows them to increase their return on invested equity. As interest rates rise from historic lows, this has slightly impacted the purchase price, particularly on larger deals where the debt is an important component of financing the transaction.

Valuations and purchase prices from private equity firms can be larger than those offered by strategics because of the leverage their use and the opportunity for the Owner to have a second exit, getting benefit on the value creation that the private equity firm hopes to achieve in the future.

Post-Transaction Owner Role.

For a platform acquisition, private equity firms will usually want an operating Owner to stay on for between 1 and 3 years, unless there is a second in command who can take over, such as the CFO, and as stated above, they may want the Owner to maintain something in the range of 15% - 35%. However, some PE firms may have already identified a new CEO and potentially other executives, in which case a transition period of 6 -12 months may only be required, and with a reduced rollover requirement.

As an add-on by definition means that there is a larger platform company already in place, presumably already with a CEO and a management team, there is less opportunity for an Owner to continue, but there could be certain available roles akin to when the buyer is strategic.

Since the private equity buyer will have a controlling interest in the business, they will be active in the day-to-day management and will usually require an increase in the financial reporting and controls.

Post-Transaction Employee Impact.

Whether the acquisition is a platform or add-on also has implications for the employee base. Since a platform is first-time entry into a particular market sector, then the employees will generally be expected to continue, but as with the Owner, if it is an add-on acquisition, then some percentage of layoffs should be anticipated where there is a duplication of positions.

3. Family Offices

Family offices are private wealth management entities established to manage the financial affairs and investments of high-net-worth families. They often seek diversification by investing in various asset classes, including operating companies. In the past, family offices were more likely to invest in companies indirectly through their investment in private equity firms. However, this has changed, and rather than pay fees to PE firms, many family offices now also make direct investments themselves.

While family offices are open to selling a portfolio company if the price is right, they have no specific time mandate like a private equity buyer does and are generally more concerned with preserving wealth for future generations and are less focused on short-term financial gains. Cultural fit is also important given the longer-term relationship expectation.

Purchase Price and Deal Structure.

There is a wide range of differences between each family office, with some requiring majority interest and taking an active role in managing the acquired company, and others which are comfortable with a minority interest and take a more passive approach, providing capital and strategic guidance.

Since there is no pressure for a subsequent exit, Owners should be comfortable with cash at closing and try to negotiate for the right to sell their stock at some point, referred to as a “put option”.

Post-Transaction Owner Role.

Family offices, especially for a platform company and if they hold a minority interest, will want the Owner to stay on for a three to five-year period. As with respect to the other scenarios, an Owner staying on for an add-on acquisition beyond a suitable transition period is less important.

Post-Transaction Employee Impact.

The platform or add-on difference yields similar results with family offices, but since there is less pressure on short-term performance and more value is placed on cultural fit and alignment, there is greater chance that more employees will be retained even for an add-on.

CONCLUSION

When considering the sale of a company, the choice of buyer type can significantly impact the outcome of the transaction in many key respects, including the purchase price and deal structure, whether the Owner will be required to stay on after the closing, and how a sale may impact the seller’s employees. For what is usually the single largest transaction of their lives, Owners should engage advisors who have experience dealing with strategics, private equity firms and family offices, and are able to guide them through the complex process of defining their desired outcome and the sale of the business.