Selling A Business to Private Equity: Pros & Cons
If you’re the owner of a small to midsized business and have been approached by a private equity firm about selling, you’re probably curious what the process is really like. I’ve sold 5 businesses in the last two decades to both strategic buyers and private equity firms, so I have first-hand knowledge of the pros and cons of selling to private equity specifically.
I’ll begin with the context of what a private equity firm does as it relates to owners, then describe the deal structure you’re likely to be offered, and finally, discuss how it feels to be on the other side of selling your company to a private equity shop. In each section, I lay out the pros and cons of the experience.
What is a Private Equity Firm & What Does It Want?
A private equity (PE) firm is an investment vehicle run by individuals who are betting they can make your business more valuable by overhauling its operations and/or combining it with other businesses. A PE firm deploys cost-cutting measures, experienced managers, and economies of scale to increase revenue and profit margin. Its end goal is to get a higher return when it sells your business years later, usually as part of a combined entity.
If you’ve been contacted by a PE firm, that’s because its research team determined your business could make a good piece of a long term deal. For example, it might wish to purchase a majority stake in 6 regional firms, create synergy among them as a national brand, and sell the new entity to a public company at a valuation multiple much higher than what it paid the 6 individual companies.
Private equity may or may not be the right type of acquirer for you. The table below summarizes the pros and cons of selling to private equity. It’s based on my experience and and conversations with other owners who have sold to private equity, strategics, and employees, and in some cases, decided not to sell at all.
Pros and Cons of Selling to Private Equity
|PE firms can make a deal happen quickly because their business is structured around a carefully thought-out, long term acquisition plan, and they have investors to satisfy. Once they’ve selected your company as a target and gone through basic diligence to determine a price, there are relatively few unknowns.||PE firms are likely to give lower offers because they have carefully calculated financial plans and tend to be risk-averse; On the other hand, strategics tend to take more risk in their offer price, which can contemplate “brand building” and other vague, future-oriented goals.|
|PE firms tend to act aggressively, acquiring competitors and creating better conditions for your company’s growth than you could foster yourself.||There is greater potential for conflict in your relationship with a PE firms because of its express desire to overhaul the operations of the company.|
|PE firms give owners an opportunity for a much bigger payday down the road by structuring a deal that involves stock in a much larger entity.||Some PE firms charge their portfolio companies fees for management, recruiting, financial services, and HR management; Strategics rarely engage in this behavior.|
The Private Equity Offer & Deal Structure to Owners
The typical deal small to midsized business owners are offered by a private equity firm is the following:
- PE firm purchases a majority interest in the business
- Owners are paid in cash as well as stock in the new entity
- Owners and key managers continue working at the company during the transition, and for a set time period afterwards, under an earnout structure
There are plenty of variations in the offer type PE firms make to small to midsized company owners, but a common one is 75% cash, 25% stock, with a 3 year earnout. The earnout stipulates that the remainder of the stock will be earned, in increments, upon the completion of certain milestones in the company’s growth or profitability. There are also holdbacks (wherein part of the purchase price is held in escrow) that can last 1-2 years.
While that structure may sound straightforward, the definitions of “growth” “profitability” and other KPIs are where many inexperienced owners end up getting outfinessed by the PE firm. That risk is why nearly all owners who are in discussions with a PE firm retain an M&A advisory firm to negotiate on their behalf.
|Related: See our report on the Top M&A Adivsory Firms In The US.|
The following chart summarizes the pros and cons of selling to a private equity firm through the lens of its typical deal structure:
Pros and Cons of the Private Equity Deal Structure For Owners
|The PE firm is aligned with your interest in making the stock portion of your deal as valuable as possible.||The earnout structure is a minefield. For example, how are metrics such as Net Revenue defined? And what if the PE firm doesn’t do their part to help you achieve them, especially later in the agreement when they’re disincentivized to help you maximize earnings?|
|If you believe in the company you created and the PE firm performs, the earnout can increase the value of your stock substantially.||The PE firm could fail to manage the new entity well, making the stock portion of your deal worth little or nothing.|
|The earnout structure spreads out your tax burden because part of the income from the sale is realized years later.||If the PE firm utilizes debt financing, the business will have to service that debt from their cash flow.|
|If your business is struggling, the PE relationship could ensure you get far more value than you would have alone due to the PE firms’ fresh outlook, ability to roll up your firm with complementary businesses, and experienced managers.||The PE diligence process can become a significant time sink and distraction when you need to be focusing on your product and operations.|
What It Feels Like to Sell to a Private Equity Firm
As mentioned, a PE firm is a wealth creation vehicle for its founders and investors, and as such, those working at their portfolio companies will feel like they’re being pushed. For many business owners, it’s their first time having a boss. However, PE firm partners have widely divergent philosophies; some are former business owners and respect owners’ time and expertise; others, particularly the purely financial partners, constantly push for growth. In all cases, however, you will not feel the freedom of calling the shots anymore.
In my sample size of ~12 colleagues who have sold to PE, about two thirds found their years of working for the PE firm to be a grind, but worth it for the life-changing outcome of selling their business. The last third had an overall positive experience, feeling like they grew as entrepreneurs. 5 of the 12 made more money from the stock portion fo the deal than they did from the up-front cash (though these experiences occurred between 2012 and 2021, during boom times).
Overall, selling to the right PE firm is the key decision; however, it can be difficult to get unbiased information. During your initial discussions with partners, you’ll likely meet other owners who are now portfolio companies. While these owners are usually well-intentioned, keep in mind that they were selected to speak with you because of their positive experience with the private equity firm. You’ll also want to talk to people who have done business with the firm but aren’t references in order to get a range of experiences. You can find those folks through a high-end professional network like YPO or Tiger21 if you belong to one, or as mentioned earlier, by retaining an M&A advisory firm.
I’m also happy to chat with you if you’d like. Feel free to send me a note through this website.