Capital Flows to Middle Market Companies – Is it Time to Sell?
With the recovery of the U.S. economy and with record-setting amounts of capital in the hands of large corporations (“strategic buyers”), Private Equity firms (“PE”) and hybrid buyers (neither strategic nor PE; for example, wealthy individuals and family offices), private business owners contemplating a sale are fortunately faced with a myriad of options. Small and mid-size CEOs are reporting that they are getting unsolicited calls nearly every day from potential buyers. The question is threefold: Is this the right time to sell your business? To whom should you sell it? Should you sell at all? If someone wants to buy your business, maybe there is value that you don’t see.
A recent study, recently fielded by Inc. and Harris Williams & Co., surveyed nearly 700 CEOs and top executives of privately held, high growth companies that have been recognized on the Inc. 5000 lists. The research provided insight into middle market companies across a wide range of industries about near-term plans for M&A. The results show that about 81% of survey respondents are interested in M&A over the next three years. The majority of respondents, 52%, indicated that they anticipate selling their business, but only 25% currently have a detailed exit strategy in place.
Middle-market company sale transactions expanded to 71.4% of total buyout activity — its highest share in the last decade, largely driven by Private Equity buyers who generally want to purchase at least 80% of the company but will provide capital for growth. Typically, the PE buyer will target a 5-7 year exit for the business and will quite often resell the company to another PE firm. They will most often want to or at least be open to keeping a founder involved for a period of years to “earn out” part of the purchase price, but you will be working for someone else.
Before selling, consider some of the alternatives to completely letting go of the business you have grown and nurtured over many years.
Larger corporations (so-called strategic buyers) are actively acquiring smaller companies in order to gain technology, market share, products, or people. Often, a strategic buyer will pay the highest value in that the product or service of the target, when added to the buyer’s business, will be “accretive” (i.e., it will create more value for the whole). Some strategic buyers purchase a company for its assets: its intellectual property such as software or patents and a few of its personnel, such as its top engineers. Others want to keep the company intact, operating as a distinct unit as part of their organization.
And lastly, there are several large family groups looking for good investments in small companies, many from Europe, the Mideast, and Asia.
No Shortage of Strategies
Companies have a range of different types of capital available to create liquidity without an actual sale in small and middle-market companies:
1. Senior Debt – generally term debt with a low rate of interest available from banks and often secured by company assets or company cash flow. This form of debt is generally tied to LIBOR or the prime rate or can be fixed as a corporate bond (Range of cost: 5-10%).
2. Mezzanine – available as subordinated debt (behind in priority to senior debt but above equity) from lenders or PE firms, often with a warrant or other equity kicker (Range of cost: 10-16%). Often used to finance short-term needs for expansion.
3. Equity – often issued in the form of stock together with options. With respect to a PE firm or strategic buyer, control of the company is important and the owner will have a new boss and board of directors. For owners wanting to sell a business but stay on for a period of time as CEO, this may be an attractive strategy alternative. (Range of value often begins at 10 times EBITDA and up, depending on the success and potential of the business).
An Alternative: Recapitalize the Company
There are other options available that would allow a company to generate capital for growth and provide cash to existing owners without giving up control of the business. There are PE firms that will purchase a minority interest in a company (at a lower multiple given that the PE firm will not gain control). Generally, most of the capital will have requirements that it be utilized by the company to fund growth but some cash may be available to the owners. Alternatively, subordinated debt can be used to generate cash for the owner without giving up any part of the ownership of the company (unless the lender is requiring warrants or options).
A recapitalization is a good tool to take advantage of current cash flow and to position the owners of the company for a final exit in the future. The steps are:
1 Raise subordinated debt or minority equity based on current cash flow and use the proceeds to pay dividends to owners.
2 Reinvest profits in the company and grow the top and bottom line of the financial statements.
3 Position the company for a final sale down the road and sell 100% to a strategic buyer, paying off the debt or retiring the converted equity and distribute the remaining proceeds to the owners.
The wise company owner should consider all options and if they decide to sell, make sure that no value is left on the table. Prices are high so there is a lot at stake. And lastly, it is not all about the money — companies can be recapitalized in today’s low interest, cash-rich lending environment where the founders can retire and the next generation can continue to build the company.
Michael Evans is the National Managing Partner for Newport LLC, a firm of operating executives providing advisory service to middle market companies.