Tuesday, September 11, 2012

The Four Types of Business Buyers. Part 2: Financial Buyers

Financial buyers have been big news lately—one in particular—but not because of deals they are doing to buy moderate-sized, privately held companies (read: human owned). In fact, financial buyers have been relatively quiet in that respect. Politics, not business, has put the spotlight on them.

Private equity funds, such as those run by Republican presidential nominee Mitt Romney’s Bain Capital, are financial buyers. My focus is how they operate, not the taxes they pay, because barring some major legal changes, private equity buyers are here to stay and one could well be the buyer of your business. Upwards of one trillion dollars is purportedly sitting in private equity funds, awaiting deployment as investments in other companies.

A typical fund controls millions of dollars. Its managers are looking for industries with significant growth potential and companies that provide the opportunity to create value for the fund’s owners. The fund may invest as a minority owner in a business, but most often, and my subject today, the fund will buy a majority of a company typically using some of its own and a significant chunk of borrowed money secured by the assets of the company it just acquired.

The financial buyer’s objective is to improve the target company’s performance so that it can sell the business (to a strategic buyer or another financial buyer) or take it public, in either case at a significant profit in three to five years. This focus means that financial buyer must be able to see a clear path to that result, it will not be swayed by the long-term potential of your business, and it will be very careful not to overpay for your company. This usually means the financial buyers will drive a harder bargain than the strategic buyers discussed in my first post in the series. This does not, however, mean that a deal from a financial buyer will ultimately be less desirable than that from a strategic. It only means that you and your financial and legal team have to work that much harder to evaluate the different offers.

A financial buyer rarely buys 100% of a private company. In many cases, some or all of the original owners will stay on as minority owners and as part of their management team. So, as closely as a financial buyer is evaluating you, you need to evaluate them. The value of your retained interest and your sanity is at stake. I’ll illustrate my point with two stories of companies I helped sell to financial buyers.

In both cases, my client, the original owner retained about 30% of the company, in one case the retained interest was equity; in the other, the retained interest was a combination of equity and subordinated debt (meaning that my client was paid only after the commercial lenders to the buyer were paid). In both cases, my client stayed on as part of management, but in a role that answered to managers brought in by the private equity firm.

I hardly heard from the first client after the sale until a few years later when the private equity firm sold the business it had bought from him. He told me he was making more money selling the retained 30% than he had from the original 70%. That’s the kind of picture-perfect ending that the private equity guys pitch when they talk to sellers. My second client, however, wasn’t so lucky.

From almost immediately after closing, my second client struggled answering to a bunch of “wet behind the ears” MBAs whom he thought knew nothing about the relationships with customers and suppliers that made the business successful. He complained bitterly that his formerly debt-free company was struggling with the debt the buyer had loaded on it.

Some business owners don’t do well when they aren’t the boss, so they aren’t the best candidates for private equity deals, but maybe my client was also on to something, because the business performed poorly as part of this private equity portfolio. After a number of challenging years, which included disputes with his “partners” and a couple difficult refinancings of the commercial debt, my client parted ways with the company he founded, getting almost nothing for his retained interest.

The lesson I hope you learn here is two-fold. First, be sure your after-tax proceeds from the initial sale are sufficient to meet your minimum goals for a sale and don’t leave you overly reliant on the financial buyer’s management of your former company. Second, pick your financial buyer carefully. Follow the link to a good New York Times piece on the due diligence you need to do.

Monday, September 3, 2012

Labor Day, the Bittersweet, Confused Legal Holiday

Summer's over.  That's the bittersweet meaning most people put to this legal holiday.  The confused part comes from the word "Labor." Beyond the oxymoron of a day off to celebrate work, many still associate the day with unions, when the focus is much broader: the work and workers that are the engine that powers our economy.

The U.S. Department of Labor tells us that Labor Day “is dedicated to the social and economic achievements of American workers. It constitutes a yearly national tribute to the contributions workers have made to the strength, prosperity, and well-being of our country.” The DOL doesn’t tell us that Labor Day was rushed through Congress by President Grover Cleveland to appease America’s labor movement a mere six days after his controversial use of federal troops forcibly ended the bloody Pullman strike that paralyzed rail traffic, and thus the country, during the summer of 1894.

Cleveland’s gesture didn’t work for him—his Democratic party was slaughtered in the 1894 midterm election—or help the labor movement that much either. Many needed reforms, such as reasonable working hours and safe working conditions, now taken for granted, would not be enacted for decades--decades that would include the infamous Triangle Factory fire and Colorado’s own Ludlow Massacre.

The Labor Day holiday illustrates that while the pace can be slow our country does eventually do what needs to be done.  Election-year finger pointing aside, what if, instead, we focused on the changes We the People can create without the politicians?

There are over 30 million human-owned businesses in our America. If only five percent of us (that 5% includes you and me, right?) committed to hiring at least one new employee before New Year’s Eve, together we’ve created at least 1,500,000 new jobs. All those new jobs means more business for all of us. Then maybe the politicos and the rest of the country will get the message and follow along.

So enjoy a day off, and then get back to the labors that made America great. 

I close with my traditional photographic farewell to summer.

a blogger and his mom

Thursday, August 16, 2012

The Four Types of Business Buyers. Part 1: Strategic Buyers

News of a strategic buyer acquiring a string of Colorado businesses spurred me to end this blog’s summer break and to help human-owned businesses understand the distinctions among possible buyers of such companies.  Business buyers are often described as “strategic,” “financial,” or “entrepreneurial,” and the differences between the three result in important implications for prospective sellers.  This four-part series will explore these three profiles and one more, the related-party buyer.  This series draws heavily on some great thinking and advice my partner Ned Minor gives in his book “Deciding to Sell Your Business.”

You will jump through many hoops when you sell your business.  It helps to know which ones are important.

A “strategic buyer” comes from the pool of companies that conducts business, directly or indirectly, in your industry. Any business that sells goods or services to your industry, distributes your industry’s products, or provides financing to your industry is a possible strategic buyer. Of course, your direct competitors may be the most important group of strategic buyers.  

The strategy that drives a strategic buyer to acquire a particular business changes from buyer to buyer, deal to deal.  Here’s a list of some of the most common strategies:
  • Increase revenues;
  • Diversify revenues;
  • Reduce competition by acquiring a competitor;
  • Reduce competition by acquiring a business before a competitor can;
  • Increase market share;
  • Economies of scale;
  • Expand into a particular market segment;
  • Expand into a new geographic market;
  • Secure a specific location;
  • Open up strategic alliances;
  • Protect or enhance a supply chain; and
  • Enhance growth opportunities for employees.

Strategic buyers have dominated mergers and acquisitions, lately, since they often use their own cash to make acquisitions.  Financial and entrepreneurial buyers typically rely on the leverage of credit to make their deals happen. With the credit markets yet to recover fully from the Great Recession, in some markets, those buyers have been sidelined or put at a significant disadvantage relative to strategic buyers.  

More often than not, a strategic buyer will pay a higher purchase price than a financial or entrepreneurial buyer.  There are several reasons for this.  Strategic buyers compare the cost of purchasing your business to the cost of starting a business in your area and competing head to head against you. The strategic buyer knows your industry and may be willing to pay a premium because it understands the opportunities, dangers, pitfalls, market conditions, and trends in the industry.  Because strategic buyers understand the risks, they can also be more flexible when it comes to negotiating indemnifications in the sale transaction.

The potential for financial and operational synergies is another strong motivator for strategic buyers to pay more for your business than financial buyers, entrepreneurial buyers, or related parties. Strategic buyers can cut costs, eliminating areas of duplication. For example, once the post-closing transition phase is complete, your controller may be looking for a new job.  Most strategic buyers already have strong accounting/financial departments in their home offices. The strategic buyer may consolidate multiple locations, thus saving significant rental expense. Some strategic buyers may stop doing business with smaller, lower margin customers in order to improve their profits. 

You need to think carefully before talking about a deal with a competitor.  Antitrust laws may make add challenges and costs to closing the deal.  Confidentiality will be key, especially since industry rumor mills wreak havoc on employees, customers and suppliers by spreading premature, or downright false, information about negotiations.  But most critical of all, if the transaction fails to close, the competitor will know everything there is to know about you, giving it an unfair advantage.  A good transaction attorney can help minimize this risk with a well-crafted nondisclosure agreement, as well as carefully timed, and structured, responses to the buyer’s due diligence requests.  

One fundamental principle applies to all buyers, but especially to the strategic buyer. No matter how successful you are, your strategic buyer believes he is smarter than you, knows your industry better than you do, and can make more money running your business than you can. The challenge for you, and for your transaction attorney negotiating the sale, is to make that strategic buyer pay a premium for the opportunity to prove just how smart he really is.