Demystifying Types of Buyers

September 01, 2023

In this month’s newsletter Big Band’s CEO Kevin McArdle breaks down the various types of buyers that Founders might sell to. Let’s dive in!

DEMYSTIFYING TYPES OF BUYERS

TYPES OF BUYERS:

So you are thinking about selling your business. Where do you begin? Well, if you have been following me for any length of time you have heard me talk about Annual Exit Planning, so hopefully you’ve done that. If you have, then you’ve determined your objectives, aligned with co-owners or investors, and have organized your business for a potential sale with all necessary documentation in a data room. If that sounds like you, congratulations - you already know the different types of buyers and you’ve been building relationships with those buyers you might want to sell to. You have your advisory team lined up and you are ready to take the plunge.

If any of the above doesn’t match your situation then you need to carve out some time for your own Annual Exit Planning. Big Band is putting together a guide that we will share in the weeks to come. Subscribe to make sure you get it first! In the meantime, let’s dive into the nuances of different buyer types and the associated pros and cons.

Strategic Buyer:

A lot of people think this is the dream to sell to. Why? Because, in theory, they have the deepest pockets and are willing to overpay for your business because they desire the tech, the customers, your product fills a gap in their offering, etc. Think Facebook acquiring Instagram for $1B or Adobe’s bid to acquire Figma for $20B. Everybody laughs and thinks the deals are overpriced…except the shareholders in the acquired companies who laugh their way to the bank.

First, let’s get a bit more realistic and practical with a strategic acquisition for most companies. 

Competitive Strategic Buyer:

The acquiring company might be a larger competitor in your space. This is the company you put on the dart board in your office. You don’t like them and they don’t like you. They want you out of the way because they are sick of losing a few deals to you and having to answer questions in a board meeting. The general goal will be to buy your tech, move your customers onto their platform, shelve your brand and let go of your team. Problem solved. 

Collaborative Strategic Buyer:

The acquiring company might be an ‘adjacent competitor’ - someone who sells to the same customers as you, but they don’t have a competing product. This might be a partner who decides they think there is enough strategic fit that they’d rather have you in the company vs. just a partner. The story likely plays out the same as above except your product lives on because they need it. But you might see your brand folded into their branding and they are likely to ‘eliminate redundancies’ in the team (that’s the polite way to say they are letting go of a lot of people). Even if the buyer plans to keep your brand and team, the goal is probably to push your product to all of their customers as fast as possible. Good news: you get a bunch more customers. Bad news: they capture all of that upside and you are a line item for their sales team to sell and the strategy is no longer your own. 

Regardless of the strategy, as a Founder/owner, they are likely to lock you up for 2-3 years with an employment agreement, an earnout, and a non-compete. Basically, you work for them and they get to tell you what to do; and if you leave early, you are leaving a lot of that big payday on the table. This tends to not sit well with most entrepreneurs who (likely) started their business to control their own destiny.

Strategic Buyers in Summary:

Pros:

  • Potentially bigger exit value / enterprise value / paycheck

  • Work inside a bigger company with more resources

  • Quicker distribution of your product into their customer base

Cons:

  • Big checks come with big strings attached (earnout, 2-3 year work agreement, non-compete)

  • Work inside a bigger company with more bureaucracy (and a boss)

  • Your brand, team, culture are going to change (at best) and could go away

The overwhelming majority of businesses that sell, sell to a financial buyer. If you just look at your market and map out the strategic buyers (both competitive and collaborative) you might come up with 10? 20? For that deal to work out, the ‘fit’ has to be right. They need to convince themselves and their board of directors (they always have a board) that buying your company is a strategic priority amongst all of the other things they could be doing with their time and money. The ‘timing’ has to be right. Do they have the cash or could they access the right amount of debt? Do they have anything else on their plate that is as big or bigger than M&A (hint: they always do)? Have they ever done an acquisition and do they know WTF they are doing? For all of the reasons above - the biggest being just simple math - strategic acquisitions rarely happen. And rarely are they the fairy tale ending that the buyer and seller hope. That’s why Harvard Business Review famously says that 70-90% of acquisitions fail.

Financial Buyers:

So if a strategic acquisition isn’t possible or doesn’t sound appealing to you then your buyer is likely a “Financial Buyer.” They don’t have the competitive need or partnership opportunity to buy your business. Essentially, they like the pure financials of your business and/or they think they can sell it to someone else in the future for more than they will pay today. Good news…it ain’t complicated! Tougher news…they are going to be WAY more concerned and interested in the details of your company.

Let’s look at the sub-types of financial buyers to get a deeper understanding of what these acquisitions might look like.

Private Equity:

If you are running a successful business, you probably get messages like this quite regularly:

This kind fellow is trying to start an acquisition conversation with me but clearly has no clue who he is talking to. It’s a cut/paste of my name and the company name into a stock LinkedIn message with no context. A quick click on his profile reveals that he is a very junior level employee at a very big private equity firm. He is surely measured on how many of these messages he can send per week in hopes that even 1% will respond.

I am fortunate (or unfortunate, depending on your life outlook) to have seen hundreds of these messages and know the game that is being played. But if these messages are new to you, I can see how it would be exciting! Big firm wants to talk to me?!? And he says they want to be helpful?!? Awesome! In reality, their job as a firm is to try to see everything and build relationships before a business hits the market. Nothing wrong with that, but, as a Founder, don’t let it consume too much of your time. If now is not when you want to sell (and you know because you’ve been doing Annual Exit Planning), you can either ignore, send a polite “not interested at this time” message, or send them a teaser on your business if you think they might be a fit for you long-term. But play by your rules and timeline…not theirs.

So what does selling to Private Equity (PE) look like? Well, we need to break it down even further for big PE groups (I warned you that this was complicated). PE groups usually make either a platform buy or an add on (or tuck in) buy. Here are the differences.

Platform Buy: This is a big, important purchase for a PE group. They are spending a meaningful amount of a given fund (more on funds and why they matter later) to make a big purchase. If that’s you, they probably intend to keep your brand and team. They will want to grow revenue and moderate (or cut) expenses as quickly as possible and then sell your business to someone else in 3-5 years. 

What does that mean for you as a Founder? 

  • If you are going to continue to run the business: 

    • The PE firm will want you to “roll equity” (keep a chunk of minority equity…say 20%). So the big number they float isn’t all cash. You still own a piece of your company and you are counting on them and yourself to deliver another big payday in several years. 

    • They are likely to help you hire a more robust and professional management team.

    • Add-on acquisitions - sounds fun that you get to be the one going around and being the Strategic Acquirer (whether competitive or collaborative)...but guess what - you are now responsible for integrating the companies (and remember that most fail - so that’s on you if it fails).

    • You no longer have control over your company but you are inside running it. That can be very uncomfortable for an entrepreneur who is used to controlling their own destiny.

  • If you are not going to keep running the business:

    • You need to be comfortable with someone else in your chair as CEO (which is true of any business)

    • They still are going to want you to roll equity - one PE person I spoke to said that a Founder who is unwilling to roll equity knows something bad is going to happen in their business and it’s a huge red flag about the Founder or the business. I countered with - “Maybe they just don’t trust you to run it and it’s a huge red flag about you and your team.”

    • You may get a board seat, but don’t be confused. You have no control in the situation - over strategic direction, management of your team, or how and when they sell the business to the next buyer. No control over anything. That can be fine, just don’t be confused.

Add-on or Tuck-in Buy: Once a PE group has a “platform” company, remember that they want to grow it and sell it pretty quickly (within +/- 5 years). One of the fastest ways to grow revenue is by buying revenue. They call this “inorganic growth” because PE people find silly reasons to use silly terms. Regardless, your business might be of interest to them as an add-on to one of their platforms.

What does that mean for you as a Founder?

They still want you to roll equity but now you own not just a smaller piece of your own business but an even smaller percentage of the platform company and any other businesses that they buy. Same lack of control but with even less visibility into how that business has historically performed or its future prospects.

They are less likely to want you to keep running it. If they have a robust management team for the platform, they are likely to expect that team to run your business as a division or an additional product.

They are still going to inspect every aspect of your business but because this is a much smaller check for their fund, the transaction is way less strategic for them and they may be working multiple add-on deals simultaneously for the same platform so they’ll cut your deal loose if it becomes too hard or if they find anything unexpected. This is, unfortunately, true of most PE deals (even platform deals). But what it means is that the biggest thing to ever happen to you in your professional life is just another Tuesday to the PE group. Go in eyes wide open!

Let’s talk about PE Funds, timing and why it matters.  PE groups raise funds from institutional investors. Essentially the pitch goes “We would like to have your money please. We would like to hold your money for 10 years. We will buy things with it. Hold those things for a few years. Make them better. Sell those things and return to you 3x your money after 10 years.” If institutional investors like the firm they will say “Yes please.” and away we go. Why does that matter to a Founder selling to PE? The game and the timing. 

The game is that they buy your business to sell it. Before they even close on your deal, they are thinking about who they could sell it to. You really have to be ready for your ‘baby’ to be in someone else’s control and you need to be ready to move on.

Timing matters because of their fund life cycle. You especially need to ask the right questions if you are rolling equity (and remember, they always want you to roll equity). If you are one of the first acquisitions in their fund they have another 8-9 years to grow the business before they have to sell it. Good news - that’s plenty of time to make strategic decisions and grow in a healthy way. Tough news - your rolled equity is locked up for a VERY long time and that might not be what you want. If your deal is later in their fund, they may only have 3-4 years to grow it before they have to sell it. Good news - your rolled equity *may* turn to cash sooner. Tough news - they are going to have to scramble to get some growth out of the business to make it more valuable to the next buyer. That means short-term decision making, which is rarely the most healthy thing for any business.

Going into diligence with a PE group can make a root canal seem fun. Like any buyer, they want to see your P&L, balance sheet, churn metrics, customer concentration, etc.. Unlike strategic buyers, they may be looking for a reason to not do the deal. PE groups will have dozens of deals in their pipeline at any one time. Strategics might have 1-2. This matters to you, as a Founder, because you are walking into the most important professional event of your life. There is asymmetry between “who wants it more” and “who has the most information and experience.” Unfortunately, a lot of groups will prey on that asymmetry. 

The worst way that PE groups prey on those advantages is by “re-trading” deals during diligence (usually at the last minute). Let me explain. After the business root canal and after you have gone through months of a process to pick a buyer and then months more diligence to convince the buyer that they have made a good decision and you have negotiated all of the terms of whether you will stay on or not…whether you roll equity or not…what happens to you team, etc., etc. it is all too common for a PE buyer to “re-trade” the deal…always at the last minute. It goes like this, “I know we said we would buy your business for $20M but we found X, Y, and Z in diligence that give us some concerns, so we’re now offering you $16M.” This (lousy) trick works because by this time, you as the seller are so committed to the deal. You are exhausted from the process. You and your loved ones have been thinking for months what life would be like with the money from the sale and without the stress of running the business. THAT is what they are preying on and why many sellers accept a re-trade at the last minute. They don’t want to start over.

I hate to give such a bleak picture of selling to private equity but there’s a reason that Founders don’t like that option. I don’t hate the players, I just kind of hate the game.

Search Funds:

Another type of financial buyer is called a Search Fund (or Searcher, or Independent Sponsor, or Entrepreneur Through Acquisition). I hesitated to put this in for fear of adding confusion. But this is a small but growing segment of the business buyer market, and I think there are some things that entrepreneurs should know about this category. Most importantly that they exist and that they are different from PE groups or holding companies.

A searcher is usually a newly minted MBA, likely from a fairly fancy business school (this trend started at Stanford and is still mostly contained to the top tier of business schools and the corresponding networks). A searcher has essentially decided “I want to own a business but I don’t have any money. So I’m going to find some wealthy people (or a government loan) to help me buy a business.” Nothing wrong with that on its surface. I’m a huge fan of entrepreneurship whether someone builds or buys a business. 

Here’s where it gets tricky for Founders. Remember that cold email example that I shared above? The dozens of cold emails we all get could be from a respectable PE group that, for all of the pros and cons, can and will close on the right transaction. But often, those emails are from searchers who are trying to look like private equity groups. They are usually named after bodies of water or trees or roads in obscure small towns. The website looks fancy with photos of people that ‘look like’ they have impressive business track records. But the searcher has likely (like 99.9% likelihood) never done this before. Even more importantly, they probably don’t even have the money to buy your business yet. 

Let’s go back to how a searcher gets started and what happens from there. They want to own a business but they don’t have any money. Often they will convince some investors to “fund their search”. That just means they raise a little bit of money to fund their lifestyle while they spend 1-2 years looking for a company to buy. (Pay attention, this is where it gets scary for owners). They then try to get the seller to commit to an “exclusive Letter of Intent (or LOI)”. This means that you and they have agreed on a price and high level terms. And if you sign this as a seller, you cannot entertain any other offers until the LOI expires. Then the searcher goes about trying to convince the little investors to become bigger investors in the specific deal they have found. If that group isn’t into your business, they need to find other investors to fund it. So they lock up your business via an LOI before they have the money. They are now trying to do diligence on your company while convincing investors that it’s a great investment. This adds a LOT of uncertainty to the deal closing. As a seller, you need to ask a lot of questions from a buyer before you sign an LOI and “Do you actually have the money?” should be question #1.

Let’s say the searcher can raise the money from investors or via an SBA loan. Another red flag to look out for is  whether or not they can operate the business after you hand it over. Whether you are rolling equity after the sale or not, you want your business to continue to thrive and succeed under the new ownership (this applies to any buyer that you sell to). A concern for a lot of Founders when selling to a searcher is “they have a decent education and some work experience…but they’ve never operated a business.” Whenever a searcher asks me for advice, my first question to them is “how many people have you fired?” Every owner/operator has had to do that. It is a part of life when running a business…but it isn’t fun and most people have deep and painful memories about firing people. Either you, personally, made a mistake in hiring, or someone else did,but either way it feels like a failure. If someone has never fired anybody (or even better, fired lots of people), I worry whether they have the operational chops to take over someone else’s business and run it.

Enough about search because I don’t want to sound like a hater. I just want business owners to know what this category is, how to look out for it, and what risks there are with selling to a searcher.

Holding Company

Our last type of financial buyer is a Holding Company. This is what Big Band Software is. We buy great businesses with no intention or requirement to sell them. Some examples of this are Constellation Software, Roper Technologies, Berkshire Hathaway, and SRC Holdings. These groups (and Big Band) have a different approach to PE or Search. 

We have all of the experience and capital of good PE groups (our partnership group has acquired 50+ businesses in our collective careers). But we don’t have the sharp elbows and cutthroat attitude. We’re much more interested in building long term relationships with sellers and playing long games with other long-term thinking people.

Because we have no fund timing, we can purchase a business without ever intending to sell. That means we can make the best decision for each portfolio company at the right time and take a long-term approach to building a healthy business (just like most entrepreneurs do). 

Unlike searchers we have money and don’t need to raise to close a specific deal. We are just proud to be the next stewards of great businesses. (Haters: surely there are some cons here, Kevin!) OK, one ‘con’ is that if a seller wants  to roll equity with their business…we can do that…but we don’t intend to sell. So when are they going to get the rest of that equity? For that reason, we prefer to do 100% buyout of companies. In some cases, we can offer a seller equity in Big Band itself but it has to be the right circumstances

Family Offices:

A corollary to Holding Companies are “Family Offices”. This is a fancy term for ‘people with a lot of money.’ Some people or families with a lot of money decide that they want to buy businesses and operate them rather than just give money to a PE group who charges fees and carry. There is a saying that goes ”if you’ve seen one family office…you’ve seen one family office.” So what do Founders need to know about this category? Ask a LOT of questions. Who makes the decisions? How many acquisitions have you done? What sectors are important to you? How long do you intend to hold onto my business? The challenge is that if there is just one rich person calling the shots, you don’t know what happens if that person changes their mind on what to do with their money or, heaven forbid, they die.

In conclusion, I’ve tried to shed some light on what can otherwise seem like a murky process. The above is based on my experiences, those in my network, and hundreds of Founders that I’ve met along the way (ChatGPT was not invited to participate). 

I’m sure I have some things wrong, and I’d love to hear about it online (seriously). This is meant to be a resource for Founders to try to go into selling a business with a little more knowledge than you had before. If you’ve made it to the end…god bless you. If I can clear anything up, please email me at [email protected]. And be sure to sign up for our newsletter where we’ll continue to drop content to help Founders build, grow, and exit their companies as successfully as possible.

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