In Part I of our saga, our outdoor-loving business owner decided that she would like to spend more time fishing and was constructing a strategy for maximizing the value of a sale of her company.
She familiarized herself with the differences between financial and strategic buyers and is now asking herself which kind of buyer will make her a higher offer for her business. She wants to know how big of a boat she should be shopping for . . .
Ignoring the topic of earn-outs, individual seller priorities, intangibles, and other value-adds that are not typically considered part of the bottom line purchase price for a business – all of which must go into the seller’s calculation of overall value - there are general rules of thumb regarding offers from a strategic buyer versus a financial buyer. The general rules come with the acknowledgment that there are so many industry and circumstantial variations, however, that at times a general rule has little applicability to a specific business. A savvy business owner will retain well-informed professional advisors who can guide the process of creating a successful exit strategy.
All other things being equal (although they seldom are), a strategic buyer is more likely to give the target company a higher valuation and thus offer a higher purchase price in a well-negotiated transaction than will a financial buyer or private equity firm. This is so because the strategic acquirer can begin extracting value from the acquired business much quicker. For example, it can immediately implement the cost synergies it may have identified in its due diligence review, or in other ways lower the business’s transaction costs, enjoy other economies of scale, and thus immediately increase cash flow and profits.
The greater the strategic alignment between the buyer and seller, the quicker and easier a strategic buyer can extract value from the acquired business, and thus, the greater the valuation the strategic buyer may attach to the transaction. The strategic seller may even be willing to place value on cost savings, synergies, and other benefits it sees as possible but not certain. This is particularly true if the potential strategic acquirer is competing with a competitor to acquire the strategic target business, or at least perceives that it is competing with a competitor.
The other benefit of selling to a strategic buyer is that strategic acquisitions tend to take place much quicker than financial or investment acquisitions. Because strategic buyers are more familiar with the seller’s industry they are usually able to perform due diligence quicker than can private equity buyers.
Also, because the strategic buyer’s value proposition stems from adding the acquired business to its own ongoing business, the strategic buyer is generally more motivated to move quickly and begin realizing value as soon as possible once it determines that the target acquisition is a good fit for its purposes. Strategic buyers want a quick return on their investment – which often starts with immediate post-closing cost-cutting and other decisive measures.
The financial buyer or private equity firm on the other hand must operate its acquisition for a period of time before it can sell the business and collect the projected profit on its investment. It cannot extract value from the seller as fast as can a strategic buyer who can simply merge its strategic acquisition into an ongoing company. The financial buyer will therefore typically evaluate the transaction as having a lower initial valuation than will a strategic buyer and will typically offer a lower amount for the purchase price.
Because the financial buyer must operate the seller’s business for at least some period of time, it will make sure it is buying a solid business, one it can operate smoothly for this interim period before it arranges its divestiture of the business. The financial buyer will therefore not only carefully analyze the financial statements of a company it is considering buying, it will also carefully examine the management, salespersons, and other employees of its potential strategic acquisition. Because the financial buyer will retain ownership and control of its strategic acquisition for so long, sellers do themselves a favor by stressing the quality and experience of their management team, salespersons, and so forth when negotiating with such a buyer.
This is not to say that there is no potential value upside to selling to a financial buyer or even to say that there are no situations where a financial buyer will make the higher offer. For example, a financial buyer may still put a significant value on a business that is not yet profitable in a growing or demand industry where a strategic buyer may not be willing to risk the capital on an unproven asset.
Since a financial buyer is more likely to need our outdoor-loving seller’s help post-closing, it may be willing to pay handsomely for his or her post-closing services. And, depending upon the designated exit strategy, may be willing to throw in significant additional bonus or equity incentives to motivate the seller to help grow the business in the way the purchaser needs for its own optimal exit strategy.
This is potentially a huge upside to a seller who is happy to work for a period of years before retiring, potentially earning more salary than he or she paid herself, with a possible equity sale windfall at the end of the rainbow; provided that the seller is prepared to ride out the typical three to seven-year period that it may take for the acquiror to prepare, develop and implement its own exit strategy.
These equity opportunities are more frequent with financial buyers who specialize in taking their investment purchases to the public market. Many acquisitions by private equity firms are framed as capital investments (most usually to update outdated infrastructure or equipment, or to expand in a key area) in exchange for a controlling ownership interest in the target company rather than an outright acquisition of the entire company. A significant part of the “market opportunity” offered to the sellers who retain ownership and to key employees who may be granted options in the newly financed entity is the upside potential of participating in a future sale or initial public offering of the company. These exit round earnings can far exceed the sale price an owner could have achieved on the date of the initial acquisition by the financial purchaser.
Granting contingent options that don’t cost the acquiror/grantor anything is easy to do and is highly motivating to owners and key employees who can envision an initial public offering making their options very valuable in the future.
These kinds of upside opportunities (particularly equity incentives) for owners selling to financial buyers are not as prevalent with financial purchasers whose intent is to resell the acquired business in another private offering. This is largely because the anticipated profit margin on a resale in another private offering tends to be more linear than a potential public offering of a business that the public market considers a hot commodity.
The true key to driving the best purchase price for a business is to manage the sale process and drive competition from multiple suitors. While this can happen spontaneously, it generally doesn’t, and leaving this to chance is a huge mistake made by far too many business owners.
All things being equal, the extent to which a seller takes deliberate measures to court multiple potential buyers is the single-most determinative factor in the final purchase price that a seller will receive. This fact simply cannot be overstated. Taking proactive control of the sales process pays significant dividends to the wise business seller. The first step in concluding a well-negotiated transaction is to set your sale up for success from the beginning.
So while strategic buyers generally offer higher valuations, experienced investment bankers and attorneys who represent sellers will do everything in their power to ensure that the seller is courting multiple potential buyers, regardless of whether they are strategic buyers or financial buyers. The process of selling a business is no different from the process of selling any product. The more potential investors the business owner can identify, the higher the perceived valuation, and thus the price, of the selling company.
Experienced investment bankers and attorneys will want to include both strategic and financial buyers in the process of selling the company in order to generate options and the highest possible valuation for a seller. Even if a seller ultimately does not wind up selling to a financial buyer that it has entered into negotiations with, entertaining conversations and preliminary negotiations with a financial buyer may be the perfect leverage for obtaining a superior offer from another buyer – whether a competing private equity buyer or a strategic buyer.
Ask your attorney what deliberate measures you should be taking to proactively control the marketing and sale of your business or reach out to Rose Law Firm with the same question. Our focus is to protect and maximize the value you have created in your business, regardless of the transaction or legal matter that you find yourself faced with.