Selling Your Business vs. Selling Your Soul

There are approximately 200,000 U.S. businesses, with revenues between $10-$150 million per year, representing one-third of private sector GDP and employing around 48 million people. Additionally, the U.S. is home to 34.8 million “small businesses”, accounting for 45.9% of employment. Within these two groups, 22.8% of business owners are aged 65 or older, indicating a significant number are approaching retirement.

These statistics have been prevalent in lower middle market private equity fundraising decks over the past few years. They not only serve as compelling points for raising capital but also highlight a genuine opportunity for private equity funds, independent sponsors, searchers, and family offices. There is gold in these hills!

What Does This Mean for Sellers?

If you're considering selling your business, the influx of buyers is advantageous. Increased competition can drive up pricing, offer better terms, and provide more sophisticated options in brokers and investment bankers to maximize your returns. If you've built something of value, this could be an opportune time to exit, and enjoy the fruits of your labor.

However, if you're deeply connected to your work, care about your team, have longstanding vendor relationships, and value your customers, your considerations extend beyond just the financial. In such cases, your screening process for potential buyers needs to encompass more than just pricing and certainty of close.

There is nothing wrong with selling a business to a traditional PE firm, you can take chips off the table, they can execute a well worn path company streamlining and growth, their investors can make a great return in the process. This path isn’t for everyone, and definitely not good for every company. The below is a look under the hood of how these transactions typically work, and what drives decision making.

Key Considerations for Sellers

Funding Sources

Understanding where the money is coming from when someone is buying your business is crucial. Buyers funded by external investors are often driven by the terms of their fundraising, which may not align with the fundamentals of your business.

Sources of funds with financial buyers, are what ultimately drive management decisions. If you’ve never had outside investors, or debt in your company it is hard to understand this, but people that are not in the day to day of a company, and are driven by spreadsheets and legal documents see things differently.

Capital Deployment

Funds are typically motivated to deploy capital quickly, often within a 2-5 year investment period. If the capital isn't deployed, they risk losing management fees and potential gains from future sales. This urgency can lead to pressure to close deals, sometimes at the expense of thorough due diligence, and disciplined pricing.

Near-Term Business Plans

Post-investment, the clock starts ticking for funds to realize returns, usually aiming to sell businesses within 5-7 years. This often results in strategies focused on rapid revenue growth and cost-cutting to maximize EBITDA, which may not be sustainable long-term. Often businesses need a little of both, but in a lot of cases the push for growth, while cutting expenses are taken to the limits.

Exiting

If these initiatives take hold, there's typically a short period to maximize trailing 12-month EBITDA before selling to the next owner. The quicker this sale happens, the better for the sponsor's internal rate of return (IRR) and track record. Since most funds are judged, and promotes paid, based on IRR metrics, rapid success is a key incentive for these buyers.

Added Debt

Sponsors often add debt to transactions to reduce the equity they need to invest, and boost IRRs. In the lower middle market, it's common to see debt levels of 3-4x trailing 12-month EBITDA. While this can boost returns for investors, it also means more of the company's cash flow goes toward debt service, potentially limiting reinvestment in the business, and lenders often have covenants that may restrict long term thinking.

Actual Payout

In the lower middle market, structured payouts are standard. For instance, selling your company for $5 million might result in $3-$4 million in cash at closing, with the remaining $1-$2 million coming over subsequent years through earnouts or equity rollovers. While these structures can align interests, they also carry risks. I’ve heard that only 20% of rollovers actually pan out.

Plans for the Future

It's essential to ask potential buyers about their plans for the business. In the lower middle market, your company might be designated as a "platform" or a "bolt-on." As a "platform," the buyer aims to build around your team and operations. As a "bolt-on," your business might be absorbed into another, potentially leading to significant changes or even dissolution over time. If you’re hoping for a lasting legacy with your business it is important to understand which category you fall into.

What Happens to Your Team

The future of your team post-sale is a critical consideration. Understanding the buyer's intentions regarding employee retention, culture, and operations can help ensure that your team's interests are protected. Is the plan to promote from within, bring in outside management, or shed most of the team as sales gets absorbed into another organization. In truth, a lot of this is likely unknown at, or before, closing, but the answer is at least telling of how your team is being viewed.

A Self-Serving Alternative

As a family office with no outside investors, we have the flexibility to invest differently. Our capital doesn't have to be deployed immediately, and we aren't pressured to sell companies within a specific timeframe. This allows us to invest in businesses with a long-term perspective, focusing on sustainable growth and preserving the culture and values that made the business successful.

We aim to maximize financial returns over a generation, not just a few years. By investing in good businesses and keeping them great for the long haul, we believe we can create lasting value for all stakeholders involved.

Financially this translates to disciplined pricing upfront, we may not be the highest bidder, but we’ll be in the ballpark. We also don’t use leverage, so there is a high degree of certainty in closing, without restraints. We do have earnouts, and rollovers, at the seller’s request, but they are also tied maintaining revenue levels, not aggressive growth targets that are out of the seller’s control.

From my experience 80% of the time, sellers are not interested in the non financials of how we invest. The lower middle market is a well established investment class, with a lot of seasoned players, that have a ton of money. There is a reason why most businesses sell to these types of buyers. For those 20% that are looking for investors to carry their legacy forward, enhancing their business, not changing it, there are alternatives.

Final Thought

We invest in some private equity funds, where we know the principals, have long standing relationships and understand their management playbook. So, I won’t say that PE and sponsors are bad, I used to be one too. I’m just saying that finding the right buyer for your business, can be more than searching for the highest bidder.