InSight

Exit and Growth Strategies for Middle Market Businesses

Should You Consider a Recap? Part 4

By Robert St. Germain | Mar 29, 2012

Money GraphThis series of posts has examined the different types of buyers of middle market companies, focusing on selling to a third party.  Learning more about how the financial buyer makes investment decisions is important to anyone considering a business sale.

Although, as previously discussed, each Private Equity Group (PEG) has its own specific investment criteria, most of them are attracted to acquisition targets with certain general characteristics that independently and, in aggregate, help reduce the risk of their investment. Therefore, sellers interested in exploring recap opportunities should be aware of these and put as many as possible into place before marketing themselves to the PEG community.

The first prerequisite is a strong management team willing to stay on post-close because PEGs, as also earlier discussed, are not constituted to run the day-to-day operations of the companies in which they invest. If necessary, they will recruit managers to selectively fill holes in and strengthen a team; but inheriting a strong intact team is better from their perspective. “Lone Ranger” type business owners who wear many hats and have no depth to their management bench transfer to any buyer the risk of hiring, training, and integrating new players to form a complete and effective team. To a PEG, in particular, that would at least diminish the valuation of a target company and might eliminate any interest altogether.

The second prerequisite is a diversified customer base where a general rule-of-thumb is that no single customer should account for more than 10% of a company’s sales. As customer concentration increases, the target company is deemed riskier and will elicit a lower valuation from a PEG, assuming their interest is maintained at all. Business owners may be making a good living off just a couple or a few customers; but, before considering an exit, they should broaden their customer base to reduce that risky posture.

The third prerequisite is a large percentage of revenue being of the recurring type (e.g. rents, maintenance agreements, service agreements, licensing fees, per use fees, royalties, long term supply contracts, etc.). The more recurring revenue contributes to the P&L as a percentage of total revenues, the less risk there is from the PEG’s perspective. Contrast that with the risks associated with a business model where all revenue is completely dependent upon discrete short term projects and the continual need to replace them with the next set of projects.

The fourth prerequisite is a history of strong margins and revenue growth allowing the PEG to buy into and build upon positive momentum. Though some PEGs focus exclusively on or will otherwise consider distress situations, more are interested in healthy companies with previously demonstrated success and a convincing business plan that addresses future growth.

The fifth prerequisite is some sustainable competitive differentiation/advantage arising from having a niche specialty, proprietary products/processes, market leadership, strong intellectual property, an enduring brand, etc. Being a “me too” provider of a commodity product or service dependent upon pricing as the main differentiator is typically of little or no interest to a PEG.

The last prerequisite that will be covered here is that the seller should have complete and clean fiscal records. That is best demonstrated by having the last several years of financials available in audited form. Yes, that is an additional expense; but it lends credibility and transparency to financial claims and reduces the investment risk for the PEG. To the benefit of the seller, there is also empirical evidence that, all other things being equal, audited financials increase the purchase multiple by a fraction.

 

Posted by Robert St. Germain.


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