In the 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, specialize in these two-stage deals. Generally, the motivation for a 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 entrepreneur’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, even assuming they were all for sale (which is far from the case), are the aforementioned 5,000 funds. Even if each did one transaction a year, we would run out of candidate companies in pretty short order.
The reality of the private equity marketplace is a little more muddled. According to Doug Tatum of Newport Board Group, 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? I’ll go into that next week. Readers are welcome to post their ideas and opinions.
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