This guest post is written by Mike Gasparro of AxialMarket. You can also view the post on AxialMarket’s blog.

According to the PriceWaterhouseCoopers study “Strategic deals and ‘mergers of productivity’ to drive M&A in 2010“, strategic buyers will remain a major factor in the M&A market in 2010. As such, if you’re a serious seller this year, understanding the goals of strategic buyers and how they differ from financial buyers is critical. In this post, we explore the key differences between strategic and financial buyers and how it impacts their acquisition decision-making process.

As a quick refresher, potential buyers / investors fall into two primary categories:

1. Strategic Buyers — These are operating companies that provide products or services and are often competitors, suppliers or customers of your firm. They can also be unrelated to your company but looking to grow in your market to diversify their revenue sources. Their goal is to identify companies whose products or services can synergistically integrate with their existing P/L to create incremental long-term shareholder value.
2. Financial Buyers — These include private equity firms (also know as “financial sponsors”), venture capital firms, hedge funds, family investment offices and ultra high net worth individuals (UHNWs). These firms and executives are in the business of making investments in companies and realizing a return on their investments. Their goal is to identify private companies with attractive future growth opportunities and durable competitive advantages, invest capital, and realize a return on their investment with a sale or an IPO.

Because these buyers have fundamentally different goals, the way they will approach your business in a M&A sale process can differ in many material ways. Below are five of the biggest differences we’ve witnessed:

Evaluation of Your Business

Strategic buyers evaluate acquisitions largely in the context of how the business will “tie in” with their existing company and business units. For example, as part of their analysis, they will ask questions like, “Are the products sold to their customers? Does your company serve a new customer segment for them? Are there manufacturing economies of scale we can realize? Is there intellectual property or trade secrets that you’ve developed that they want to own or prevent a competitor from owning?” Conversely, financial buyers won’t be integrating your business into a larger company, so they generally evaluate an opportunity as a stand-alone entity. In addition, they often buy businesses partially with debt. As such, they scrutinize the business’ capacity to generate cash flow to service a debt load and determine how to quickly increase the long-term value of the company to ensure an acceptable return on their investment.

In the end, both buyer groups will carefully evaluate your business; however, strategic buyers focus heavily on synergies and integration capabilities whereas financial buyers look at standalone cash-generating capability and the capacity for earnings growth.

Determining the Investment Merits of the Industry

While this might seem obvious, strategic buyers usually are more “up to speed” on your industry, its competitive landscape and current trends. As such, they will spend less time deciding on the attractiveness of the overall industry and more time on how your business fits in with their corporate strategy. Conversely, financial buyers are typically going to spend a lot time building a comprehensive macro view of the industry and a micro view of your company within the industry. It is not uncommon for financial buyers to hire outside consulting firms to assist in this analysis. With this analysis, financial buyers might ultimately determine they do not want invest in any company in a given industry. Presumably, this risk is not present with a strategic buyer if they are already operating in the industry

As the seller, the risk of having a sale process fail due to “industry attractiveness” factors is reduced by ensuring that you are soliciting strategic buyers.

Strength of Back-Office Infrastructure

Strategic buyers are going to focus less on the strength of the target company’s existing “back-office” infrastructure (IT, HR, Payables, Legal, etc) as these functions will often be eliminated during the post-transaction integration phase. Since financial buyers will need this back-end infrastructure to endure, they will scrutinize it during the due diligence process and often seek to strengthen the infrastructure post-acquisition.

As such, you’ll likely want to de-emphasize the importance and/or value of your back-office infrastructure in discussions with a strategic, whereas it’s important to be prepared for thorough evaluation of these functions when having discussions with a financial buyer.

The Impact of the Investment Horizon

Strategic buyers intend to own an acquired business indefinitely. Financial buyers typically have an investment time horizon of four to seven years. When they acquire and subsequently exit the business and how that pertains to the overall business cycle will have an important impact on the return on their invested capital (for example, if you buy a business at the peak of a business cycle for 8X EBITDA and can only sell it for 6X EBITDA 5 years later, it’s tough to make an attractive return).

As such, financial buyers are going to be more sensitive to business cycle risk than strategic buyers, and they will be thinking about various exit strategies for your company before making the final decision to invest in / buy your company.

Transaction Efficiency

Financial buyers are in the business of making acquisitions. It it one of their core competencies to execute deals in a timely fashion. Strategic buyers may not have a dedicated M&A team, may be encumbered by slow-moving boards of directors, bureaucratic committees, territorial division managers, etc.

From our experience, combine these factors and the process with strategic buyers can often take longer than with financial buyers. No matter what, be prepared for a 6-12 month process BEFORE you decide to sell.

There is more to be said about the many important differences between strategic and financial buyers, but these are the basics. Any questions, as always please feel free to ask them in the comments or contact us directly if you want to take it offline.

Boring businesses are great for private equiteers because they attract less attention, ergo less competition during sale, ergo lower earnings multiples. I wrote about this in a post titled Borrrrrrrrrrring… but we love boring in private equity. However, there’s a problem with boring businesses… or a consideration, if you will.

A private equiteer’s boring business is also an employee’s boring business. And about the only time employees want to work for a boring business is when they need to be paid while doing other unpaid things (such as studying for school, writing a manuscript or using Facebook). But, this doesn’t nullify the boring business theory, it just poses considerations.

Anything to do with employees must be considered in a different light. Firstly, in a business where passion isn’t obvious (i.e. boring), you can’t expect people to work 80-hour weeks for 40-hour salaries. Secondly, you shouldn’t assume anywhere near as much loyalty. A glue packer will go elsewhere for a 20% pay increase, whereas an F1 engineer may stay even after a 50% pay cut. Lastly, you’ll be limited in terms of the talent pool; a regional GM of Apple won’t accept a CEO role at a glue factory for a 70% pay cut, but they may do so for an internet startup.

However, all is not lost. Focusing on productivity, efficiency and working with what’s available, has been a godsend to many a boring business. Oftentimes, you don’t need the big-name CEOs or loads of employee innovation. Sometimes, you just need a well-oiled machine that supports quick and easy bolt-on acquisitions (and as much as that may make us cringe, it really can create long-term value in boring industries).

P.S. I really don’t like using the word ‘boring’, but let’s not sugar-coat more than we have to.

In private equity, we make primary investments and bolt-on investments. A primary investment is a direct investment of cash into a new business (often in a new industry). A bolt-on investment is an investment via an existing portfolio company into a business that presents strategic value (usually in the same industry).

Primary investments get most of the press. But, many private equity funds spend just as much cash on bolt-on investments. And, bolt-ons have the potential to create much more value (I’ll explain why later). So, it pays for a private equiteer to give up some of the glitz and glamour of primary investments to become a quiet achiever through bolt-ons. Here are a few of my thoughts:

• Bolt-ons are usually smaller businesses, which attract lower multiples with better terms
• Bolt-ons provide the chance to create instant value (by acquiring lower multiple businesses using a higher multiple vehicle – see Public versus Private multiples)
• Bolt-ons often require less work because they are smaller and attract less competition
• Bolt-ons offer strategic value (revenue and cost synergies), meaning you can pay a little more and be more successful in an auction process
• Bolt-ons provide for easier due diligence since you have access to industry experts in your primary investment vehicle (access to this experience is invaluable)
• Bolt-on owners are more likely to do a deal with a larger industry player, since there is prestige in being part of a leading firm (compared to being gobbled up by financial vultures)
• Bolt-ons give you access to a whole new market of potential investees as certain mandated restrictions (regarding size) don’t apply

With that said, there are countless studies lamenting the destruction of value that occurs daily via mergers and acquisitions. So, it’s imperative to maintain focus on likely integration issues and ensure there’s a cultural fit. See my post in which I describe most bolt-ons as clip-ons (citing their failure to integrate and lack of strategic fit.)

Most private equity firms are meritocracies. And merit is largely founded on investment success. We can improve the chances of investment success by paying lower multiples, commanding preference coupons, investing in favourable structures and making smart strategic decisions. But by far, investment success depends on the price at exit.

So, here are a few tips to getting the best exit price for your business:

The Buyer Pool

Financial buyers (e.g. private equity buyers) look mostly at cash flows and likely investment returns. Strategic buyers (e.g. competitors, customers and suppliers) look at synergies, strategic value and brand power. But, don’t only focus on strategic buyers; keep financial buyers in the pool to increase competition and keep options open (financial buyers regularly forgo rationality and become competitive too).

Competition

Competition is good for bidding up prices. But, competition can also deter financial buyers who don’t want to compete with strategic buyers on price. You should maintain ambiguity in the early stages of a sale process and allow buyers to become emotionally attached to the business before stirring competitive tension. Don’t be the real estate agent who announces there are hundred of interested parties. Some buyers will flatly pullout if you announce competition. (Be especially careful with other private equity buyers; they don’t like competition.) Irrespective of the buyer though, focus on the value above maintainable cash flows to elicit the best price.

Expectations

High price expectations can drive potential buyers away. But, low price expectations can set a psychological cap on the price. Again, be ambiguous at first, but aim to set a floor on the price early without actually naming a price. Talk about similar transactions and other subjective measures that help plant the seed for a higher price. This is difficult, but if you’re too ambiguous, buyers will justify a lower price in their own mind and find it hard to move upwards later. Communicate methodically and try not let anyone hasten you.

Metrics

In the early stages, try to negotiate in multiples, as it leaves more room for flexibility. If you set a price at $xm, you give the buyer power to manipulate the deal (e.g. around cash, inventory and debt levels) while maintaining the price at $xm. Sure, you can increase a price, but you want to avoid setting unnecessary psychological caps. However, if you find the buyer is fixated on paying a certain multiple or price, adapt and put your efforts into negotiating on inclusions.

Inclusions

With both metrics, multiple and price, there is a lot of room for manipulation. So, be prepared for various discussions about inclusions, which include fixed assets, cash at bank, earnings normalisations, etc. Understand these subjective factors before talking to buyers and make sure your arguments are rational. Also, make sure you keep a few bargaining chips up your sleeve. (See this post for exactly what to do to prepare your business for sale.)

Integrity

Above all, maintain your integrity, be friendly, be honest, but remember, this is a once in a life time opportunity, so don’t be overly generous. However, if you’re too tough and manage to get an unfair price, you may benefit now, but you may also witness repercussions later. As a private equiteer, you already have more than most, so don’t take unsophisticated buyers (in a transactional sense) for a ride. Keep your spine, be decent, be one of the good guys. This is a controversial point, but I stand by it.

There’s much more to negotiations, but these are the points I thought especially salient for private equity.

Over at the Union Square Ventures blog, Fred Wilson discusses the failure rates expected in venture capital. He suggests a third of all deals are hit out of the park, a third are mediocre, and the last third fail (although his own firm’s empirical data suggests more of a 40/40/20 split). He also suggests that the overall cash return on such a portfolio may be 3-4x, which is pretty good if you can get it.

Private equity is quite different; we expect all deals to do well. Not out-of-the-park, but well enough to hit target returns (at least 20% IRR or 2x cash). Private equiteers generally believe this low-risk moderate-return approach is more successful than the high-risk high-return approach favoured by venture capitalists.

Image: Private equity, just sit back and relax [source: Shutterstock]

Now, although this difference in investment strategy may seem subtle, it actually means private equity and venture capital are miles apart in execution. Without decent growth, venture capital is toast. However, even with very low-growth, private equity can still bear fruit. How? Leverage, deal structure and multiple arbitrage.

This isn’t to suggest PE and VC are in any way substitutable. But, like all investments, we can analyse and consider the implications of each strategy.

One of the major implications, especially in mid-market private equity, is that we don’t mind skipping over high-growth businesses. We know there’s less competition for lower-growth businesses and that less competition means lower purchase multiples.  And, with an eye firmly on moderate target returns with very low-risk, we know paying a lower multiple is a great risk mitigator.

We also know that stable revenues are more conducive to leverage, and leverage amplifies our returns. While leverage also amplifies our risk, we know particular deal structures can transfer some of that risk to other investors in exchange for a taper on our returns above a specified target. This is okay for us, because remember, we are more concerned about mitigating risks than overshooting our target by orders of magnitude.

So, as you can see, lower-growth (aka boring) businesses can actually serve our cause more effectively. You may see larger private equity funds going crazy with mid-20s purchase multiples in public markets, but down here at the mid-market level, we have choice. We can invest in the most boring businesses you’ve ever seen, conservatively apply debt, structure the deal well, simplify and organise management, exit when the time is right at a higher multiple, and achieve our objectives, even without significant increases in revenue. In private equity, we love boring.

Hiring new staff has always puzzled me. You spend an hour, maybe two, maybe even three to get to know each other. Then you say “I do”, lift the veil, consummate the relationship with a handshake and that’s that. Signed, sealed and delivered.

But, imagine… just imagine you told your mother (or your best friend) that you were about to marry someone after knowing them for only a couple of hours. And, imagine telling them that you didn’t just meet this person randomly. You prepped them on exactly what you were looking for and were truly surprised when they said things that made you happy.

I hear you. Yes, there’s a big difference between employment and marriage. Sure, you see your husband/wife at least three hours a day, while you see your employees only between 10 and 12 hours a day. Agreed; big difference.

So, I’m thinking, all of the wisdom you hear about getting to know someone before marriage should also apply to employment. Moving in with them, enduring their habits, arguing with them, making up with them (hey, hey)… all of the stuff that is prattled on about by older learned folk. Of course by this I mean you should trial them.

Now, I don’t mean put them on probation, so if they kill someone or defraud you for a billion franc you’ll fire them. I mean put them on a fixed contract for a month with the intent that they’ll only be hired temporarily. Naturally, you’ll mention the potential to land a full-time gig, but you’ll also explain the uncertainty. Don’t even give them a title; call them a consultant or executive or something equally vague.

During this period, you can work them into the ground, enjoy a warm ale with them, put them in front of intimidating clients, have at least one heated argument with them and if you’re lucky, you’ll be able to tell if they really have what it takes to work in your esteemed organisation. Sure they can put on an act for a month, but that’s much harder than for just 60 minutes.

Before you ask (and you shouldn’t need to ask), a private equiteer’s first best friend is carry. Coming in a distant second, a very distant second, a private equiteer’s next best friend is tax.

Here are the reasons:

1. The typical private equity investment is highly geared, ipso facto, it has high interest expenses. Those high interest expenses provide a tax shield, which means private equity investees often don’t pay a cent of tax. And not paying tax while receiving the benefit of others paying tax is a private equiteer-friendly concept.
2. Tax gives private equiteers a bargainning chip. All of a sudden, they can justify paying a lower price because of the tax implications. They can refuse to grant management options because of the tax implications. They can make a case for their preferred legal structure because of the tax implications. They can gear the business up to its eyeballs because of the tax implications. They can justify just about anything because no sane person understands the Internal Revenue Code (or whatever applicable tax code) in enough detail to debate it.
3. Lastly, a private equiteer’s heartfelt campaign to have the vendor pay less tax creates an alignment of interest. “I want you to pay less tax because it increases the value of the transaction for you, it helps us both create a better business for your employees, and… no one likes the tax man (chuckle, chuckle).” How could you turn down a line like that? You’d love it if you were a vendor, wouldn’t you?. Now that we’re best buddies with a common enemy, I proceed to show why I should pay you less for the business, why the strike price on your options should be higher (so they don’t incur tax) and why the business should be geared at 6 x EBITDA.

So, to recap, private equiteers love tax because they don’t have to pay it and still get the benefit, it creates a bargaining chip, and it helps to show alignment with vendors. I’d be a billionaire if I was paid a million dollars every time I heard a private equiteer raise the strike price on management options citing tax implications. My advice, just give it to people straight; they tend to value that.

Contrary to common belief, merchant bankers have feelings too. In fact, bankers think of us (private equiteers) the same way we think of them; as cold, callous, calculating financiers. Sure, we act like close comrades in tête-à-tête, but deep down we boil each others’ blood. You see, bankers hamper our dealmaking efforts. They may think we wouldn’t have access to deals without them, but we actually think we’d have a more direct path to deals if they disappeared. We’d understand vendor needs to a greater extent, be able to negotiate more effectively and not have the usual problems dealing with middlemen. So, it’s a little love/hate as you can see.

But, this is a dangerous view. Bankers undoubtedly have influence over markets and their clients (who just happen to be our potential investees). And even leaving the banker value-add debate to one side, it’s impossible to make a case that states bankers have no influence over our deals. They are hired as stewards, have pride in this implied stewardship and don’t exactly have a lack of access to private equity firms (or other potential buyers).

So what’s my point? Well, we only hurt ourselves by disrespecting merchant bankers. I’m not talking about the kind of disrespect that gets in a banker’s face; I’m talking about the disrespect we try to obfuscate but secretly hope isn’t too obfuscated. The disrespect that says you’re middleman pond scum and we’re the kings that control the money. The disrespect that they feel when we beguile their efforts to manage the transaction with them at its epicentre. However, apart from being pretentious and pugnacious, this disrespect just doesn’t help our cause (and I’m sure Dale Carnegie would agree).

I’ve (secretly) found it pays high dividends to empathise with a banker’s soulless benevolent endeavours and to treat them as equals. They provide additional deal flow, intel on the market, hints to handling vendors, notes on competing offers, honesty around expectations and suggestions on deal structuring. But remember that they’re generally quite perceptive, so any egregious attempt to appear best pals will just make the situation worse. You need to find some genuine empathy, which may just be the difference between a great deal and no deal at all. Plus, you never know, your new-found banker friends may even provide good company over a cold ale on a hot summer’s day.

The worst principal-agent scenario is one where the agent (management team) has no equity interest in the investee. The second worst principal-agent scenario is one where management have an equity interest in the investee, but haven’t had to part with any cash for that interest (e.g. stock option plans). The only principal-agent scenario that a private equiteer should ever entertain is one in which the management team invests cold hard cash into the business for an equity share.

Now, you may say the founders have invested enough cash and effort over the years to excuse them. And, you may find that the founders even want to withdraw cash from the business in concert with your investment. But, if the founders are at that stage (i.e. taking money out and winding down), you need another champion to work alongside the founders. That is, a champion willing to invest cash with enthusiasm and with the energy to facilitate exponential growth.

The fact is, private equiteers have their interests spread across a portfolio of investees. So, they really do need someone working within the business on a full-time basis whom feels the same urgency. Stock options without an initial investment are better than no equity interest, but the human psyche is skewed toward a potential loss rather than a potential gain (see this post for more information). That means, a loss of $1m of equity value affects most people much more than the expiry of options with a potential value of $1m. So, get as many people writing checks as possible and you’ll be able to sleep just that little bit easier.

There’s a simple yet particularly salient post over at Carried Interest about exiting founders and the lack of implied alignment. The age-old question is,

why are you selling your entire business if you’re young, healthy and ambitious, and if the business and industry have huge potential?

It doesn’t make sense when you hear it, read it or think it. Yet, we have to ask this question at least once a week. Sometimes I almost convince myself to ignore it, but it’s safest to go with common sense and avoid these situations because chances are that the business/industry isn’t so great and the founder is being opportunistic.

Private equity is very much about growth through acquisition. Acquisitions give the private equiteer the ability to create instant value through multiple arbitrage (see here), synergistic cost savings and synergistic revenue increases. While synergies can take time to realise (some may be instant), it’s the multiple arbitrage that can really boost value quickly.

Because of this phenomenon, private equiteers are highly motivated to make high-value acquisitions for their primary investments. However, it is important that these acquisitions are highly strategic in nature, otherwise long-term value may be negatively affected. Acquisitions should create real synergistic value, they should align with the core objectives of the group, and generally, they shouldn’t just be based on multiple arbitrage.

The reason for this is manifold. Prospective buyers of the overall group will only apply market multiples to businesses that make sense. If I’m trying to sell a furniture retailer at a market multiple of 10x, most strategic buyers won’t also pay 10x for a small green grocer that I’ve bolted on.

Additionally, even if I bought the green grocer for only 3x, there is an administrative overhead with running another business. With another furniture retailer as a bolt-on acquisition, this overhead may be relatively minor since the skills already exist to run the business and most of the back office integrates anyway. However, with a green grocer, we don’t have the skills, there’s virtually no integration and we now essentially have an investment in a completely new market.

Out of all this, I don’t think the term bolt-on acquisition is pejorative enough to describe many of the acquisitions that are occurring. Maybe more fitting is the term clip-on acquisition, stick-on acquisition or (more originally) completely-unrelated acquisition.

Private equiteers often boast that irrespective of their percentage ownership in a business, their shareholder terms are so tight that they act as a proxy to majority control anyway. This may be true for certain terms, but it’s important to note that the type of control a private equity firm wants is the control that limits their losses when disaster strikes (or that may lead to disaster). It’s not so much control over the daily operations of the business or the growth initiatives that management drive.

Many private equity firms join syndicates to invest in larger businesses, but that has its own issues. I find that syndicates are difficult to manage, especially when all firms are looking to add real strategic value to the business. Some argue that two heads (firms) are better than one, but others argue that syndicates create often-unavoidable conflicts.

Either way, firms like to own enough shares to make their investment influential, even if their shareholder terms are restrictive. I can only speak for the firms I’ve worked with and dealt with, but this is typically at least 15-20% of the firm. Having majority control (i.e. 50%+) is more a myth than anything, except for firms dealing with special situations (e.g. turnarounds).

So, a typical deal may sound like… I’ll pay you $x for your business, of which $y is paid now and $z is paid if you meet next year’s EBITDA budget. The $z, which is predicated on future earnings, represents an earn-out. That is, the vendor has to earn that additional capital payment by hitting budget. I’ve written about earn-outs many times before, which you may like to visit before continuing:

• Are earn-outs fair… or just a product of private equity avarice?
• The value-based components of a private equity deal
• Unpaid earn-outs and discontented vendors

But, when the time comes and the business has exceeded its EBITDA target, where does the money come from to pay the vendor for the earn-out? If you’re buying 100% of the business, the vendor doesn’t really care where you get the cash from (as long as it is paid) because they no longer have an interest in the business. However, if the vendor is retaining a share of the business or if there are other shareholders remaining in the business then they will certainly care about the source of funding for the earn-out.

Let’s use an example. If I pay you $100m for 50% of your business, but $20m of that is an earn-out (so $80m up front), you may assume it’s all coming from my own pocket (or the bank’s). But, what if I suggest the company’s cash flow covers the earn-out? Well, since you will still own 50% of the business, you will essentially be paying $10m of your own earn-out.

Now, this isn’t necessarily a deceptive term suggested by the buyer; it’s simply a valuation play. Of course this structure would be disclosed upfront for you to analyse, so all I’m saying here is that it’s an interesting way to adjust value in a deal to meet conflicting expectations. In the above example, you would receive $100m if the business met budget, but theoretically $90m is from my pocket and $10m is from your own. As long as you think of it this way, there’s no issue.