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VOICES FROM THE INDUSTRY: Selling your company? Welcome to the jungle

May 5, 2008

If you're thinking about selling your company, you'll get no further than typing your first Google search when the term "private equity" pops up and maybe to a fifth Google search when the term "strategic buyer" appears.

Private equity firms seem to be everywhere these days. These funds are growing larger, going public and making (or failing to make) ever larger acquisitions. With the increased visibility, the reputations of private equity firms are still based largely on stereotypes. Think unfair tax advantages, slick pinstripe-clad doubletalkers and excessive fees. In truth, private equity firms have gotten a bad rap-these firms have generally had success in improving their portfolio companies' financial performance.

Strategic buyers

In the deal world, a "strategic" buyer is a buyer who wants to enhance its business by acquiring another business. A strategic buyer may be a competitor, a customer or vendor or another business that has significant synergies with your business.

Deciding between a private equity firm or a strategic buyer is based largely on the owner's goals. In general, private equity is probably not the best choice if the seller wants to maintain the executive staff and if the corporate culture is generally progressive and demonstrative. A strategic buyer probably isn't a good fit, either, if your goals include retention of the existing employees and an easy transition.

In addition to understanding a seller's goals, it is also useful to understand the buyer's intent. A private equity firm's primary concern, for example, is its investors.

This emphasis on profit generally means management is closely monitored, particularly with respect to controlling costs. When a private equity firm acquires a company, it is generally very hands-on and will look to streamline business systems and processes and establish a new operating plan. The plan will contain specific metrics to monitor financial performance.

While the planning process and stringent, possibly daily, monitoring from a private equity firm may result in some late nights, early mornings and management eye-rolling, private equity's strict focus on the bottom line is likely to result in improved financial performance.

Conversely, strategic buyers will generally focus on the long-term health of the business and not strictly on the short-term financial performance. As a result, most strategic buyers will immediately look to manage complicated integration issues, such as combining accounting systems and payroll systems.

Differences are also apparent in how buyers look to leverage a company. Private equity firms generally increase a company's leverage (the ratio of debt to equity) by borrowing against the company's assets in order to implement the new operating plan. The private equity firm wants to return cash to its investors, not leave it on the balance sheet.

Combine the high-risk business model of the private equity industry with a tendency to borrow heavily, and you may get increased costs of capital in the form of higher interest rates.

Strategic buyers may also increase a company's leverage but are less likely to do so on a long-term basis. If the acquisition is financed by debt secured by the company's assets, leverage will increase. On a going-forward basis, though, strategic buyers are often less willing to incur significant debt. This may be due in part to lower pressure to return cash to investors.

Retention philosophies

Finally, private equity firms and strategic buyers are philosophically different in their approach to retention. Private equity firms are likely to retain most of the existing management team. After all, they decided to buy the company based, in part, on their confidence in management. On the other hand, companies in the same or similar lines of business will have employees doing the same jobs, so a strategic buyer will often eliminate positions to prevent redundancy and increase efficiency.

Private equity firms attempt to improve returns to their investors by closely tying management's compensation to the company's performance. Strategic buyers are less likely to offer management significant equity stakes.

Recent research has shown that companies owned by the largest private equity firms have significantly outperformed the S&P 500 in terms of return to investors over the past 20 years while companies owned by all private equity firms (regardless of size) have slightly underperformed the S&P 500. With the current rise in interest rates and related repricing of risk, private equity firms may not continue to be as active or as successful in "flipping" companies.

If the ongoing strength of the business enterprise is high on your list, you should consider the track record of the private equity firm you are dealing with.

Often, the biggest plus on the strategic buyer side of the ledger is a larger purchase price. Generally, strategic buyers see significant benefits to the deal that motivate them to pay more than would be paid by a firm concerned primarily with relatively short-term financial performance. Don't get too excited, though. The additional purchase price may take the form of a promissory note or an "earn-out"-an agreement by the buyer to pay additional money over time if the company meets certain financial targets.

For all sellers the message is simple-explore all your options. Think about what is important to you and rely on trusted advisors. Finally, establish clear understandings and written agreements that will protect what's important to you.

And good luck - it's a jungle out there.



Wilken is a partner in the Private Equity/Venture Services Department at Indianapolis law firm Ice Miller LLP. Views expressed here are the writer's.
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