Private Equity and Small Business

In the small business acquisition world, deals where a seller keeps some equity for a future round of merger or acquisition activity is generally known as getting a “second bite of the apple.” Private Equity Groups (PEG), of which some 5,000 currently operate in the US, specializes in these two-stage deals.

Generally, the motivation for a small business owner is to secure part of his or her equity value now, and keep some skin in the game for a bigger payoff later.

On the face of it, these deals can offer the best of both worlds. An owner can monetize a substantial portion of ownership, alleviating the risk to family security that often accompanies an owner’s concentration of wealth in the company. With the capital and connections of professional investors bringing new opportunities, the company grows bigger and faster, making the ownership percentage kept by the founder worth more in a few years than the whole business was at the time of the original deal.

What is there not to like? You reduce the risk of a major downturn in your business by securing part of your investment now, and keep an ownership interest in a big upside. An infusion of new capital allows the company to expand and you enjoy additional connections to markets and strategic partners.

In an ideal transaction, that’s exactly what happens. In the real world, however, there are some issues surrounding supply and demand.

First, a private equity investor needs some scale to leverage that is commonly pegged at a minimum of $1 million in pretax cash flow (or profits, for some analysts). Statistics on the number of privately held companies that generate that level of profitability vary widely, but most estimates put it between 15,000 and 20,000 companies in the $10 million to $100 million revenue bracket. Among the 28 million privately held businesses in the US, that is about one half of a percent.

Chasing these small businesses (even assuming they were all for sale) are the approximate 5,000 private equity funds. Even if each did one transaction a year, they would run out of candidate companies in pretty short order.

The reality of the private equity marketplace is a little more muddled. The last few years of private equity activity has been about two-thirds add-on transactions. That is, smaller companies being acquired to grow a core acquisition in the original target range.

On the other end of the pipeline are the issues of acquisition strategy and “dry powder” in the PEG. Some have funds available from investors, the uncommitted portion of which (dry powder) are available for investment. Others merely claim to know where to find money if a good deal comes along.Similarly, acquisition strategies range those targeted on a single industry, to those with seemingly no strategy at all. In between are funds that claim a suspiciously broad range of expertise (One claims “specializing in health care, manufacturing and high technology.”) and those who claim no expertise. (“We will consider any company with $XX in annual cash flow.”) It’s usually not clear how those investors will provide the contacts and expertise to help a business grow to a whole new level.

Let’s assume you’ve been approached by an equity group that knows your industry, has a track record of success and can show real investment money in the bank. Aside from price, what other considerations should impact your decision whether or not to talk seriously?

A rational look at the number of “funds” active in the market, measured against the number of legitimate candidates for investment or acquisition, paints a clear view of why so many small companies are receiving calls from interested investors. There simply aren’t enough profitable, growing companies to buy.

I put “funds” in quotes because not all Private Equity Groups are funds. There is a big difference between “We have money” and “We can get money.” Your first questions to any purported acquirer should be about the source and condition of their funds.

Some will say they have investors ready to fund. Walk away. You don’t have the time or energy to let your company be used as a beauty contestant for someone who is little more than a broker.

Others will say they have “dry powder.” That’s the PEG term for an actual bank account in which their investors have deposited real money. “Dry powder” is the amount they have available to invest. Ideally it should be sufficient to purchase your business for cash. But that might not be how things eventually wind up.

For many of my clients who are approached, the next questions disqualify most of the remaining prospects. The conversation goes something like this:

Q: What related acquisitions in our industry are currently in your portfolio?
A: We have over $400 million dollars to invest
Q: What is your strategy for our industry, and why do you find it attractive?
A: We have over $400 million dollars to invest

That’s an oversimplification, but not by much. Money is only money, and merely having it is no guarantee of success. You should remember that the average PEG has promised a target level of return to its investors, and most have a deadline for investing the money. If they fail to do so, the money reverts to its original owners, usually less the PEG’s costs of operations. That (not surprisingly) greatly diminishes the PEGs chance of raising more from those folks next time around. If that deadline is approaching, some funds get much looser about how and where they find deals.

Let’s say you find a fund that is already focused in your industry and has a strong plan for growing their investment. That is usually either by adding more companies like yours, or by using their relationships to generate a lot of new revenue. Whether you should give up control (and you are always giving up control) of the business depends largely on your personal objectives.

Family Financial Security: You want to take enough money off the table to eliminate the risks your family has lived with since you started the business. You still enjoy working, but would like to have more of a safety net.
Executive Expertise: As hard as it may be to admit, you’ve taken the company as far as you can. It has a lot of upside potential, but you know that you aren’t the one to take it there.

Capital Investment: You’ve identified substantial opportunity if you had the equipment or network to pursue it, and the investors agree with you.

Two Bites: You see the investment partner as bringing the ability to make the minority share you retain worth more than the majority you are selling now.

Exit Strategy: Your new partners understand and agree on a time frame and method to let you move on to the next stage of your life.

I recently had a client who was offered a substantial 8-figure sum for his company. He is well under 40 years old. He decided that the company was (and the investors agreed) positioned for a period of very rapid growth, and he would rather make that run as a sole owner. Those members of his peer board who were over 50 years old strongly advised that he take the money and start another business if he had that much appetite for risk.

Age and attitude govern what is or isn’t a good deal. First you have to know what you want, but even then professional investors can’t read your mind. Unless you tell them what your objectives are (and you will have to eventually), they can only talk about their investment, and money is only money.