Not A Bad Outcome For Our Business Owner

Business, Financing.

Private equity may be your best business exit strategy - i must admit that i have had a bias against my clients selling their businesses to private equity firms until i discovered that there are some situations where it might be the best exit strategy. Because the valuation multiples in these industries can get a little rich, they do not normally fit the more conservative EBITDA models of the private equity industry.

Our firm represents business sellers primarily in the information technology and healthcare industries. - we normally achieve a better initial valuation from industry strategic buyers that build other synergy factors into their purchase valuation models. We will also present, as one of my colleagues calls it, the" mathamagic" of a good private equity acquisition. In this article we will present some situations where the private equity model is a superior solution for the business seller. Below are four scenarios where private equity may be the best solution. A company where one partner wants to retire and sell and the other partner wants to continue to run the business for several more years.

A company in need of growth capital. - a business owner that has 85% or more of his net worth tied up in the business and is" business poor" the business owner that is nearing retirement and wants to take some chips off the table from a position of strength. Leading market share or Rapidly Growing Market. Before we explore these in greater detail, below are the general investment criteria for most private equity buyers: Strong Management. Established brands and/ or strong customer relationships. Platforms with potential for expansion into new products, services and technologies.

Strong sales and distribution capabilities. - a minimum ebitda level( private equity firm specific) - small$ 2 million to$ 5 million, medium$ 5 million to$ 10 million, and large greater than$ 10 million. A hypothetical transaction: The business owner is 50 years old and has reached a crossroads point in his company. A minimum transaction size and equity investment level( private equity firm specific) Management teams interested in retaining an ownership stake. The business is doing$ 25 million in revenue and producing an EBITDA of$ 3 million. However, he is at the point where he should be diversifying his assets and not plowing an even greater percentage of his net worth back into his business. The owner is considering taking the company to the next level with either a major capital expenditure or a major expansion of his sales effort.

He loves his business and is not ready to retire. - for this example, let' s say that he can get$ 25 million from an industry strategic buyer. If he sells to a strategic buyer, he may get, for example a higher initial price. A private equity firm that specializes in his industry offers him a company valuation of$ 21 million and wants him to invest some of that equity back into the company and have he and his team remain on board to run the company. Total debt used to fund the transaction( 65% )$165 mil. The" mathamagic" is as follows: Sale price$ 21 million.

Total equity investment required$ 35 million. - owner reinvestment portion( 30% )$205 million. Private equit firm portion( 70% ) $145 million. The beauty of this model for the owner is that the private equity firm welcomes the equity reinvestment by the seller at the same leverage that the PE firm employs. Because the PE firm relies on debt leverage, the owner gets to reinvest with his ownership equity on a par with the PE firm. You might think that if the owner invested$ 205 million into a company valued at$ 21 million that his ownership percentage would be 15% ($205 million divided by$ 21 million) . Therefore, his$ 205 million represents 30% of the equity in this company and he now owns 30% of a$ 21 million company.

The economics of the initial transaction are: Company selling price$ 21 million. - one could argue that he really owns 30% of a$ 25 million company based on the strategic company valuation. Owner equity reinvestment$ 205 million. Owner value creation. Owner pre tax cash proceeds$ 1795 million. Value of 30% interest in$ 25 mil company$ 5 mil.

Total post sale value$ 2295 mil. - add cash proceeds from the sale$ 1795 mil. Now let' s look at how this can get really exciting. He still gets to run his company. First, the owner has secured his family' s financial future by taking the majority of his company value in cash allowing him to greatly diversify his asset portfolio. He receives an industry standard compensation package with bonuses as an employee CEO.

He now has a deep pockets partner to actively pursue his growth strategy. - he gets to retire in another five years, which was his original schedule, when the pe firm exits from their investment. With a private equity firm that specializes in his industry, this is very smart money. They actively pursue tuck in acquisitions to add to the organic growth that they help orchestrate. They leverage their industry contacts and industry expertise to expand markets and distribution. For purposes of this example, we will assume that the PE group invites the previous owner to invest in these tuck in acquisitions at the same leverage so that his ownership is not diluted. The total equity requirement is$ 2 million.

Over the next 3 years they make several small acquisitions totaling$ 12 million and they employ the same 65% debt. - the previous owner reinvests$ 26 million to retain his 30% position. The PE firm sells the company for$ 225 million. Fast forward 2 more years( typically 5 year holding period) and the company is now at$ 100 million in revenue and is a valued target of a big strategic industry player. Our owner' s final cash out is valued at$ 65 million. Below is a more in depth look at the situations that this strategy can be successfully employed: A company in need of growth capital - This is a cross roads decision for an owner. Not a bad outcome for our business owner.

He recognizes the potential in his market, but in order to capture it, he must make a substantial investment back into the business either in the form of debt or his own capital. - a company where one partner wants to retire and sell and the other partner wants to continue to run the business for several more years - often a successful business is run by two partners with a meaningful difference in age. He determines that having a deep pockets partner with industry presence and momentum provides him a superior risk reward profile. One may be 65 years old and is a 70% owner in the business and the junior partner is 50 years old and a 30% owner. The junior partner does not have access to the capital required. The senior partner decides that he wants to retire and wants the junior partner to buy him out. Now he is faced with the company being sold to an industry buyer and he looses his desired management control and his normal retirement timeframe.

A business owner that has 85% or more of his net worth tied up in the business and is" business poor" - This is a fairly common situation and sometimes for marital harmony, the business owner decides to unlock the liquid wealth in his business. - this is an ideal situation for a pe group to acquire the senior partner' s equity and retain the rest of the management to run and grow the business. The spouse is often in competition for her mate' s time with the mistress - translation the business that occupies 60 plus hours of his time per week and much of his thought outside of business hours. The conversation might be something like, "You keep telling me we are wealthy, so where is the vacation, the spending money, the new house we should have? " It just might be the right time to recognize your life' s priorities. That is bad enough, but when every spare dollar is plowed back into the business to support his growth goals, that can be the breaking point. The business owner that is nearing retirement and wants to take some chips off the table from a position of strength - I can not stress enough how important this can be to your family' s financial future. Your company is doing great and you still have the energy and desire to run your business.

You are 60 years old and you want to retire in five years. - why would you sell now? This strategy requires the business owner to view the business sale and their retirement as separate, contingent events. There are several compelling reasons. One answer is to move up your sale timeframe, but not necessarily your exit timeframe. Too many owners wait too long and end up selling because of a negative event like a health issue, loss of a major account, a shift in the competitive landscape, or family demands.

While this scenario may be difficult to envision at first, it can be very advantageous. - so, the best decision is to sell your company to a pe group 5 years before you plan to retire, put the bulk of your net worth into a diversified portfolio of financial assets, and agree to run the company for the pe firm for five years. Democratic party leaders, including the major presidential contenders, have put forward proposals to change the current tax structure. An additional, unsettling factor for business owners contemplating retirement are potential changes to the tax code. Business owners and other wealthy citizens should pay close attention. For example, the current 15% tax rate on capital gains, previously scheduled to expire in 2008, has been extended through 2010 as a result of the Tax Reconciliation Act signed into law by President Bush in 200However, in 2011 this lower rate will revert to the rates in effect before 2003, which were generally 20% .

Most of the proposals would increase personal income tax rates and other forms of taxation. - it could potentially go higher, if the federal budget deficit worsens and congress adopts a tax the wealthy philosophy. Finally, the baby boomer retirement issue presents another compelling reason to sell now and retire later. The 2 democratic candidates are in favor of a 25% or higher capital gains tax rate. Experts project a doubling in the number of businesses that will hit the market looking for a buyer by 200According to the Federal Reserve, 000 businesses changed, in 2001 50 hands. At this point, the trend looks to be gradual. That number rose to 350, 000 in 2005 and is projected to increase to 750, 000 by 200 As the overall population ages and sellers outnumber buyers, the laws of supply and demand point to an erosion in valuations for business sellers.

However, as we have seen recently in the prices of certain stocks and debt obligations, a rush to the exits can precipitate a sudden, calamitous drop in prices. - i am now enlightened and can more objectively view the potential outcomes for the business owner that encompass the owner' s retirement timeframes and risk reward profile. As I said at the beginning, I had a somewhat narrow view on selling businesses to private equity groups based strictly on the initial company valuation compared to potential strategic buyers. A private equity firm can provide an initial - secure your family' s future - cash out. An industry specialized PE firm with a track record can provide, not just the first bite, but often a very exciting second bite of the apple when you exit together in five years.