Q: What should I expect when private equity starts sniffing around my company?
A: Expect to get put through the ringer. Selling to a private equity group (PEG) may be a great exit strategy for an owner who wants or needs to get substantial liquidity out of the business but wants to remain in operational control. Typically, PEGs will look to buy 80 percent of your firm’s equity; the rest stays with you. When the PEG sells the company five to seven years later, your stake can be worth as much as what the PEG originally paid. (We call this the “second bite at the apple.”)
Sounds nice, doesn’t it? Well, read on.
The first approach
After a friendly meeting or two, the PEG will ask for preliminary information, both financial and operational. Before you provide it, get a nondisclosure agreement in place. (This is the first of many times in this process that you’ll need an experienced transaction attorney.) If the PEG likes what it sees, it will give you a letter of intent (LOI). You should understand that this is a nonbinding offer—I refer to it as a hunting license.
This offer will be based on the investment value of your company, calculated as an industry-standard multiple of the adjusted EBITDA, or free cash flow. This number is always going to be lower than what’s called the “synergy value,” or the number a competitor or strategic buyer in a related industry might be enticed to pay—i.e., the price the PEG wants to get for your company when selling it.
If you agree to the LOI, it’s time for due diligence. The PEG and its hired guns are entitled to review every conceivable aspect of your business, using anything negative they find to negotiate reductions in the purchase price as stated in the LOI. (At one company where I was CFO, the PEG demanded an $11 million price reduction because it disagreed with the spreadsheet we used to track deferred revenue on customer software contracts. We were able to win that fight, but it cost us countless hours of management time and tens of thousands of dollars in CPA fees.)
This gets to the biggest danger of due diligence: It can distract you and your management team for months. This may result in your business falling off, which can further reduce the price of the deal—or scuttle it completely. The only way to avoid this is to get an expert deal-maker and outside advisors to manage the due-diligence process. It’s likely neither you nor your CFO (if you have one) has this experience, but you can bet everyone on the PEG side does.
Make no mistake: The transaction will be complex and maintained in a multitude of dense legal documents. There will be various classes of stock, voting provisions, liquidation preferences, shareholder rights and limitations, as well as an alphabet soup of terms and conditions that can be treacherous to navigate without adequate legal, accounting and tax advisors by your side.
Life after the deal
Usually you’ll be offered a generous multiyear employment contract to remain in your management position, tied to the results the PEG expects to see. Sounds easy, but understand that PEGs pay for these transactions through highly leveraged “senior” (secured) bank loans and perhaps even “mezzanine” (unsecured) financing, and they put these debts on your company’s balance sheet. They will also charge you generous management fees, which, in addition to debt service, put heavy pressure on profitability and cash flow. If you can’t meet those responsibilities, changes will come fast—often in the form of layoffs and other draconian cost-cutting measures. Ultimately, it could mean the loss of the company and its culture as you know it.