Ridgefield Partners

Most business owners or CEOs have at some point been contacted by someone representing a private equity firm (PE firm) or a company owned by a PE firm, often referred to as a “portfolio company.” They call asking about your business and attempting to gauge interest in a potential transaction. For most average business owners, the world of private equity is, well, very private. The popular perception is that PE firms are only located in big cities like New York or Chicago with fancy buildings filled with Ivy League whiz kids backed by mysterious large pools of money. While some of those stereotypes are true, I believe that PE firms play an important role in our economy. I have seen how these firms can create jobs and opportunity, and wealth to small and medium size business owners. So, what are these people looking for when they come calling on you? What specific aspects of your business do they value most?

There are hundreds, if not thousands, of PE firms of varying sizes. All with differing strategies, industry preferences, ownership structures, financing options and investment criteria. Depending on those preferences, different firms will weigh aspects of any given business uniquely. I’ll stick with the mainstream and focus on the most important aspects of valuation in general terms.

1) Continuity of Management

As an in-house M&A professional, I used to tell owners all the time that we had the money to buy warehouses, trucks, inventory, etc. The one thing we could not buy were those relationships and the people behind those relationships that make that business great. When I say relationships, I don’t only mean customer relationships. Relationships with staff, vendors, industry, and potential customers are vital when it comes to valuing your business. If the management team or any part of it walks out the door after the sale, so goes the potential value of the business. The issue is that the value lost with people leaving is difficult to predict and that creates significant risk. With risk comes a valuation discount to a buyer. That isn’t a concept unique to PE firms. Any smart buyer with the money to write a big check for your business understands this and will act accordingly.

Many owners wait until they are ready to hang up their spurs and retire before selling. That may be fine if you have a team in place ready to stay in place managing the business for the buyer. Even still, it’s best to have a long transition plan for the owner. Owners, especially founders of the business, tell me all the time that their team is so good that they aren’t really needed in the business. That may be true in some situations. However, the connections within the business and industry directly tied to the owners to be critical. In my experience, something is almost always lost when that owner leaves, even with the best management team in place.

To get the most value for your business, plan on staying in place or in some active role, for at least two to three years. Don’t wait until you’re ready to go fishing when it comes to selling your business.

2) A Clean Business

“We are not in the business of buying problems.” I have heard this many times in my career. Keeping the business clean is much more than just sweeping the warehouse or cleaning out the fridge in the break room. I think it goes without saying that any buyer of substance, let alone a PE firm or one of its portfolio companies, will do extensive financial due diligence. Once a Letter of Intent (LOI) is signed by both parties, professional buyers will hire an accounting firm to prepare what is known as a Quality of Earnings report (Q of E).  Sometimes this is done by an in-house team from the portfolio company, but the process will be the same or very similar. As you can imagine, the accountants will request numerous reports, data, bank statements, payroll records, tax returns and will ask a cornucopia of questions about all of them. Keeping your accounting accurate is critical to getting through this process along with a healthy dose of patience. The invasive nature of this work can be very frustrating to business owners. The good news is that regardless of the outcome of the transaction, the buyer customarily pays for this and you as the owner or CEO will likely learn something about your business through the process.

Oftentimes in privately held businesses, the lines between the business needs and the personal needs of the owners or their families can get a bit blurry. There is nothing wrong with owners legally getting non-cash economic benefits from the business to save on taxes. It’s why many folks get into business to begin with, and professional buyers understand this. However, keep it legitimate, legal and carefully document everything. For the purposes of valuing the business, those items are called “owner addbacks.” The addbacks or discretionary expense items that wouldn’t carry over to a buyer, should be added back to the bottom line. There is certainly nothing wrong with a reasonable number of these. However, too many, or improperly explained addbacks, can hurt the value of the business or even scare off a buyer depending on the amounts and perceived legitimacy of the expenses.

Equally important once the LOI is signed, will be legal diligence. The lawyers assigned to this portion of the transaction will ask about all litigation (past and present), compliance with environmental regulations, employment law, OSHA standards, local and federal tax regulations, just to name a few. All will be carefully examined. Some of these issues are serious risks to buyers that could flow through to a buyer regardless of an asset or stock purchase. At some point, most businesses have had legal issues, everyone understands that. The key is to be transparent about how those past or present issues were or currently are being handled. In the worst-case scenario, if it is a deal killer for the buyer, it is best to break that news early in the process, preserving the chance to work with that company or firm in the future. Perhaps the deal will be delayed until the pending litigation is settled. However, if it is intentionally not disclosed it will throw up major red flags and the buyer is likely to walk away and not look back. With transparency, chances are that the issue can be remediated in the transaction successfully. The name of the game is to keep it clean, keep it legal and keep it real.

3) Size is Important

There are many ways to value a business and if you speak with ten different PE groups, you may get ten different answers. Many books have been written on the subject so I will stay out of the weeds here, except to say that generally, businesses are valued based on a multiple of their earnings. For the purposes of this article, I will exclude businesses with proprietary intellectual property or technology. My comments on valuation are directed at small to mid-size companies in transportation, industrial distribution, services, retail, or light manufacturing. For these types of businesses, in most cases, bigger is better in terms of multiples of earnings paid. The idea is that there is less risk associated with a bigger business, established management teams, bigger or less concentrated customer lists, etc.  This is not to say that PE firms do not buy small businesses, because they do. These smaller deals are often called “add-on” or “bolt-on” transactions. In most cases, those smaller deals can offer additional geographic coverage, market penetration, new potential customer relationships or a new product or service offering, to name a few. However, there is still the issue of size and the risks associated with a smaller transaction. Therefore, expect a discount on the multiple paid. Professional buyers do not pay a premium for potential. The most successful buyers of companies are the ones that are best able to quantify risk and pay accordingly. That is very hard to do on most small deals. Ultimately, beauty, or in this case value, is in the eye of the beholder. Hence, PE firms approach different markets with different strategies. What may be valuable to one, may be worthless to another.

Of course, I am leaving out critical factors like growth rates, margins, customer concentration, market share, geography, etc. However, without jumping over the basic hurdles first, those more detailed discussions of valuation won’t matter.

I love the adage, “dig your well, before you’re thirsty.” So, when those calls come, take them even if you are not ready to sell. Develop relationships with folks in the private equity community. You don’t have to give out confidential information, nor should you. Legitimate professionals won’t ask for detailed information without an NDA in place and most know that you’re probably not in the market to sell when they call. They are also trying to develop relationships and it must start somewhere. Do your homework on the firm or banker calling. They should have a website that lists the names of the professionals, its investment criteria and industry interests. Most of them will also list their current and past investments.

Over the years, my experience working with private equity professionals by and large has been very positive and rewarding. I think you will generally find a variety of high-quality firms with good people looking to buy great businesses.

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