Saturday, April 26, 2008

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. Our firm represents business sellers primarily in the information technology and healthcare industries. 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.

We normally achieve a better initial valuation from industry strategic buyers that build other synergy factors into their purchase valuation models. In this article we will present some situations where the private equity model is a superior solution for the business seller. We will also present, as one of my colleagues calls it, the "mathamagic" of a good private equity acquisition. Below are four scenarios where private equity may be the best solution.

A company in need of growth 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

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

Before we explore these in greater detail, below are the general investment criteria for most private equity buyers:

Strong Management
Leading market share or Rapidly Growing Market
Established brands and/or strong customer relationships
Strong sales and distribution capabilities
Platforms with potential for expansion into new products, services and technologies
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 minimum transaction size and equity investment level (private equity firm specific)
Management teams interested in retaining an ownership stake

A hypothetical transaction:

The business owner is 50 years old and has reached a crossroads point in his company. The business is doing $25 million in revenue and producing an EBITDA of $3 million. 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. 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. He loves his business and is not ready to retire.

If he sells to a strategic buyer, for example, he may get a higher initial price. For this example, let's say that he can get $25 million from an industry strategic buyer. 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. The "mathamagic" is as follows:

Sale price $21 million
Total debt used to fund the transaction (65%) $13.65 million
Total equity investment required $7.35 million
Private equity firm portion (70%) $5.145 million
Owner reinvestment portion (30%) $2.205 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. You might think that if the owner invested $2.205 million into a company valued at $21 million that his ownership percentage would be 10.5% ($2.205 million divided by $21 million). Because the PE firm relies on debt leverage, the owner gets to reinvest with his ownership equity on a par with the PE firm. Therefore, his $2.205 million represents 30% of the equity in this company and he now owns 30% of a $21 million company. One could argue that he really owns 30% of a $25 million company based on the strategic company valuation. The economics of the initial transaction are:

Company selling price $21 million
Owner equity reinvestment $2.205 million
Owner pre tax cash proceeds $18.795 million

Owner value creation
Value of 30% interest in $25 million company $7.5 million
Add cash proceeds from the sale $18.795 million

Total post sale value $26.295 million

Now let's look at how this can get really exciting. 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 still gets to run his company. He receives an industry standard compensation package with bonuses as an employee CEO.

He gets to retire in another five years, which was his original schedule, when the PE firm exits from their investment. Finally, he now has a deep pockets partner to actively pursue his growth strategy. With a private equity firm that specializes in his industry, this is very smart money. They leverage their industry contacts and industry expertise to expand markets and distribution.

They actively pursue tuck in acquisitions to add to the organic growth that they help orchestrate. 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. Over the next 3 years they make several small acquisitions totaling $12 million and they employ the same 65% debt. The total equity requirement is $4.2 million. The previous owner reinvests $1.26 million to retain his 30% position.

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. The PE firm sells the company for $225 million. Our owner's final cash out is valued at $67.5 million. Not a bad outcome for our business owner. 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. 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. He determines that having a deep pockets partner with industry presence and momentum provides him a superior risk reward profile.

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. 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 senior partner decides that he wants to retire and wants the junior partner to buy him out. The junior partner does not have access to the capital required. 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. 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.

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. 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. 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 conversation might be something like, "You keep telling me we are wealthy, so where is the vacation, the new house, the spending money we should have?" It just might be the right time to recognize your life's priorities.

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. You are 60 years old and you want to retire in five years. Your company is doing great and you still have the energy and desire to run your business. Why would you sell now? There are several compelling reasons.

This strategy requires the business owner to view the business sale and their retirement as separate, contingent events. One answer is to move up your sale time frame, but not necessarily your exit time frame. While this scenario may be difficult to envision at first, it can be very advantageous. 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. 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.

An additional, unsettling factor for business owners contemplating retirement are potential changes to the tax code. Democratic party leaders, including the major presidential contenders, have put forward proposals to change the current tax structure. Business owners and other "wealthy" citizens should pay close attention. Most of the proposals would increase personal income tax rates and other forms of taxation.

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 2006. However, in 2011 this lower rate will revert to the rates in effect before 2003, which were generally 20%. It could potentially go higher, if the federal budget deficit worsens and Congress adopts a "tax the wealthy" philosophy. The 2 democratic candidates are in favor of a 25% or higher capital gains tax rate.

Finally, the baby boomer retirement issue presents another compelling reason to sell now and retire later. Experts project a doubling in the number of businesses that will hit the market looking for a buyer by 2009. According to the Federal Reserve, in 2001 50,000 businesses changed hands. That number rose to 350,000 in 2005 and is projected to increase to 750,000 by 2009.

As the overall population ages and sellers outnumber buyers, the laws of supply and demand point to an erosion in valuations for business sellers. At this point, the trend looks to be gradual. 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.

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. I am now enlightened and can more objectively view the potential outcomes for the business owner that encompass the owner's retirement time frames and risk reward profile. 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.