In our first article, we provided an introduction to our framework for identifying the most logical buyer along with a high-level overview of the general categories of buyers of small and middle market companies. Today, we’ll take a deeper dive into the profiles of individual buyers, small business owners, middle market private equity investors (both traditional funds and search funds), and strategic buyers.
When individuals buy businesses, they are effectively buying themselves a job. The majority seek a business with a retiring owner whose role in daily operations they can quickly replace.
The primary motivating factors for individuals are autonomy and financial gain. They are driven by the ideal of being their own boss, increasing their earning potential, and investing in an asset over which they have direct control.
Financing drives their valuation decisions, as very few individuals have enough cash in the bank to pay for a business on their own (and any that do tend to prefer to finance it, anyway). Lenders will value companies based on their cash flow. The most common type of financing comes from a bank and is backed by the SBA (Small Business Administration of the federal government).
The most common scenario when selling to an individual is that the seller exits the business relatively quickly after closing, as the new owner plans to take over daily operations. They may require transitional support, including introductions to key customers and suppliers, transfer of any contracts that weren’t assigned prior to closing, and positive reinforcement to employees. Exceptions include internal successions, especially when both buyer and seller play key roles and the absence of either one creates a void; in such a case, a longer transition period may be required.
Other Small Business Owners
Existing small business owners acquire other companies as a means to accelerate growth. Acquisitions have a much higher success rate than de novo expansion (e.g. startups), and provide an instant boost to the top line that greatly exceeds reasonable organic growth expectations.
Most small business owners typically seek companies in their local market, usually adjacent cities just outside of their reach. This gives them access to new customers and new markets without cannibalizing existing business or expanding too far afield. Service companies may also make acquisitions within their local markets in order to acquire a competitor’s customer contracts.
Small business owners typically utilize third party financing, and their valuation considerations are very similar to those of individual buyers. It is typically easier for an existing business owner to obtain financing than it is for an individual, as he or she can combine a track record of success with an existing business that can be pledged as collateral. This in turn can enable them to obtain a larger loan or better loan terms, if not both.
Small business owners are typically active in their existing businesses, and therefore may not be able to personally replace the seller. Depending on the size and staffing levels of each company involved in the transaction, the seller may still be able to exit quickly upon selling, although longer transition periods are more common than they are with individual buyers. Sellers who want to keep working after the deal closes have a better opportunity to do so when selling to a competitor than to an individual.
Middle Market Private Equity Investors
In recent years, private equity investors have shifted down-market, demonstrating a willingness to acquire smaller companies than they had in the past. Whereas lower middle market funds used to only invest in companies with a minimum of $5M of EBITDA, today numerous funds will invest in companies with EBITDA of $1M. Further, we’re witnessing a surge in search funds, investment vehicles through which investors financially support an entrepreneur's efforts to locate, acquire, manage, and grow a privately held company. Several search funds will acquire even smaller businesses, seeking minimum EBITDA of $500k.
The traditional model involves hub-and-spoke acquisitions, acquiring a larger business in a major metropolitan area and growing it through a series of smaller regional acquisitions. Once they secure a platform acquisition, private equity investors typically seek to complete several acquisitions per year for the following five years.
Private equity investors utilize a combination of debt and equity to purchase companies, a model classically referred to as a leveraged buyout. They bring strong lending relationships to the table in any deal, so their ability to secure financing is rarely a concern; however, given the sizable amount of debt, their valuations are strongly correlated to the amount of financing available.
Private equity investors rarely get involved in daily operations, and instead hire a management team to actively run the business. This could involve a partnership with an existing owner or management team, or the hiring of an outside CEO. Sellers who are very active in operations, especially those with customer-facing responsibilities or without a strong middle management layer, are typically required to continue working in the business. Alternatively, the entrepreneurs leading search funds are seeking a company with a retiring owner or CEO who they can replace, meaning the seller can usually retire more quickly or transition into an advisory role.
Strategic buyers are large public or private companies in the same or similar industries, making acquisitions as much for strategic benefits (e.g. access to new customers, entrance into new markets) as for financial impact. They can make acquisitions as part of a roll-up strategy, utilizing M&A as the primary means to generate growth; or, more selectively to access new customers, markets, or technologies.
Investment criteria varies by company, industry, and market. In certain industries, strategic buyers will make very small acquisitions. For example, we work with strategic buyers in industries as diverse as healthcare practices and facilities services contractors that are willing to acquire companies with less than $1M in annual revenue.
Strategic buyers’ size enables them to use their own capital for acquisitions, so they don’t have to source financing each time they pursue a new opportunity. They typically have large credit facilities, and therefore are not immune to the credit markets, but they don’t usually have to solve for financing each time they buy.
An owner’s ability to exit upon selling to a strategic buyer varies based on the buyer’s approach, the industry, and the owner’s role in their own company. It’s standard practice in certain industries for an owner to continue working for the buyer for 3-5 years after selling, while in other fields owners retire almost immediately.