The 2 Types of Buyers

Now that we’ve covered what all buyers look for, let’s cover the extent to which the two main buyer groups value each of the factors already discussed.

There are two broad categories of buyers – financial and corporate buyers. Each group has different criteria and goals for buying a business and will place a different value on the factors previously outlined. It’s crucial that you understand the two general types of buyers in the business world and which type is most likely to acquire your company. Only then can you determine what changes to focus on to drive up the value of your business and receive the highest possible price from that specific buyer group. 

When preparing to sell your business, you should start by understanding the type of buyer most likely to acquire your company. By understanding these two buyer types and their criteria, you can best position your business to be as attractive as possible to the category of buyer most suited to it. This serves to maximize the price you receive and saves you from the wasted effort of making improvements to your business that a buyer may not desire.

Here are both types in more detail and what each buyer group looks for.

Buyer Type 1: Financial Buyers

Financial buyers primarily consist of private equity firms. These buyers are likely to consider businesses in a variety of industries, including the service, technology, retail, wholesale, and manufacturing sectors. They often have general criteria they’re seeking in a business, such as the level of cash flow or limitations on customer concentration, but they don’t usually limit their search to specific industries. While there are different subsegments of financial buyers and private equity that place a varying level of importance on various criteria, I’ve summarized the primary factors that nearly all financial buyers look for below.

Profitability

Financial buyers evaluate a business based on the income it can generate for them; hence their name – financial buyers. This kind of buyer is looking for an income stream and will often consider a business in any industry that meets their general investment criteria. Financial buyers are highly numbers-driven. That’s why they’re called financial buyers.

If your business is likely to be sold to a financial buyer, prioritize profitability over other factors until your EBITDA exceeds $5 million per year. If your business generates less than $2 million in EBITDA, it’s usually more beneficial to invest in sales and marketing to increase the revenue or profitability of your business than to invest in building a management team or infrastructure. To be sure, improving other value drivers helps, but most financial buyers prefer more cash flow over added infrastructure.

Since this sort of buyer is focused heavily on the numbers in the business, they’re often looking for the highest return on their investment, technically called the internal rate of return, or IRR for short. They scour the market for businesses selling at the lowest multiple, which is calculated by dividing the asking price by your EBITDA. They’re likely considering dozens of types of businesses in addition to yours.

Financial buyers are highly numbers-driven and evaluate a business based on the income it can generate for them.

Management Team

Financial buyers rarely become involved in the operations of a business. Remember, they are financial buyers, and they don’t become actively involved in the operations of the companies they acquire. Most private equity firms require that the management team and owner remain to continue operating the business after the closing, in addition to requiring significant infrastructure to ensure the business can scale. If this isn’t the case, they will bring in an external president to run the company, although this adds an additional element of risk for the investor. 

General partners in private equity firms focus their time on acquiring companies and don’t become actively involved in the management of their investments. So, either existing management must remain to operate the business, or the private equity firm must hire a management team to run the business after the closing. The only exception to this rule is when the private equity firm owns a portfolio company that competes directly with yours, and they plan to integrate your business with that company. 

In most cases, if you aren’t willing to stay to run the company and you lack a strong management team that can run your business without you, your business will be unsalable to most private equity firms.

Infrastructure

Some private equity firms specialize in lower middle-market businesses, which tend to have less infrastructure than larger companies. These businesses offer private equity firms more opportunity for value creation by implementing what is known as the “private equity toolkit.” This consists of a number of tools the private equity firm implements to build infrastructure into your company to improve its scalability and manageability. Other firms seek companies that already have significant infrastructure in place and shy away from any companies that lack this framework. 

In most cases, a strong management team is more important to private equity firms than strong infrastructure. While most private equity firms require significant infrastructure, the need will vary depending on the firm and its market focus. 

Private equity firms specializing in the lower middle market are skilled and experienced at installing systems and other infrastructure in businesses to enable them to quickly grow. After all, that’s one of the primary tools private equity firms use to scale a company. They often view installing infrastructure as less risky than building a new management team. Most partners at private equity firms have experience professionalizing dozens of middle-market companies. 

Companies generating nine-figures (greater than $100 million) tend to already have significant infrastructure in place, are run professionally, and don’t benefit as much from the private equity toolkit as do companies in the lower middle market. On the other hand, private equity firms that operate in the middle and upper-middle markets tend to use different tools, such as financial engineering, to create value more than PE firms operating in the lower-middle market.

Financial buyers target an internal rate of return of 20% to 30% per year, which means they aim to double or triple their investment in 3 to 5 years before selling the business again to another buyer. You might hear this referred to as a 2x or 3x MOIC, or multiple of invested capital. Generating these kinds of returns is often possible only with systems and infrastructure in place, and installing these systems and infrastructure costs time, money, and risk for the financial buyer. If your business doesn’t have this infrastructure in place, it will still be salable to a PE firm, but you won’t receive top dollar for it. 

While infrastructure is essential to financial buyers because they won’t be involved in the day-to-day operations, it’s less important than a strong management team. If you want to sell your business for the maximum amount possible, focus on building a business that’s scalable from day one. 

Ability to Replicate

The more attributes your business has that are difficult to replicate, the more value PE firms will see in it. Most PE firms will attempt to rapidly grow your business for three to five years after they acquire it before selling it to a strategic buyer, or another private equity firm. Often, the only way the private equity firm can maximize the selling price when they exit your business is if your business has attributes that are difficult to replicate in the marketplace. 

If your business is no different from other businesses out there, it’s replaceable, and the buyer will have no reason to buy your particular operation. To maximize the price when selling to financial buyers, spell out why your business is unique compared with other businesses to avoid having your business reduced to a set of numbers.

Growth Plan

Financial buyers primarily value a business based solely on its numbers without taking into account the impact of any synergies. They are experts at scaling companies through creating strategic relationships, building strong management teams, and developing efficient sales and marketing programs. 

Your growth plan should lay out how the PE firm can grow your business in the coming years. Showing a plan to increase EBITDA will specifically appeal to them since it’s the primary metric they use to value businesses. Remember that most private equity firms target an IRR of 20% to 30% per year, which means they must generate an ROIC of two to three times if they exit the investment in three to five years. Laying out a plan for how they can do just that with your business will appeal to all private equity firms. Making plans that quickly plateau will greatly diminish your credibility. 

Learn More

I have interviewed many partners at private equity firms and strategic buyers for my podcast, M&A Talk. If you’d like to learn more about how private equity firms think and the types of businesses they like to acquire, you can listen to the following M&A Talk episodes at morganandwestfield.com/resources/podcast:

• The Basics of Private Equity with Jeff Hooke
• M&A Perspective as a Corporate Acquirer and PE Firm with Joan De la Paz Hellmer
• The Private Equity Toolkit with Michael Roher
• The Basics of Independent Sponsors with John Koeppel
• Behind the Scenes of Private Equity with Jim Evanger & Brent Paris

Buyer Type 2: Corporate Buyers

Corporate buyers primarily consist of direct and indirect competitors and strategic buyers, and each group varies in what they specifically look for in a business. Strategic buyers look to capitalize on synergies that can be obtained by acquiring your business that they might not be able to replicate on their own, such as valuable intellectual property or long-term customer contracts. Corporate buyers that are direct or indirect competitors often look to acquire not for synergies but as an alternative to organic growth. Despite those differences, much of what corporate buyers look for is similar. I’ll explain each factor here. 

Every corporate buyer prefers to build if they can – because it’s much cheaper.

Profitability

While EBITDA is important to corporate buyers, it’s less important to them than to private equity firms. Financial buyers are fully numbers-driven, while corporate buyers will consider many other attributes of your business. To be sure, corporate buyers place a lot of weight on the EBITDA the business generates, but there are many other factors they also consider.

Management Team

The same can be said of your management team when it comes to corporate buyers. While corporate buyers value a strong management team, most are in the same or a similar industry and are willing to tolerate a less-than-ideal management team, especially if they plan on integrating your business with theirs. If the buyer will be fully integrating your company with theirs, they will require less bench strength than if they were to keep your business operating on a stand-alone basis after the closing.

Infrastructure

The degree to which corporate buyers require scalability and infrastructure in your business depends on if they plan to merge your business with theirs or if they want to run your business as a separate entity after the closing. Here’s a breakdown of each: 

• Integrated: Corporate buyers who will be integrating your company with theirs require less infrastructure in your business than if it will be run as an independent business after the closing. In these cases, the buyer already has existing infrastructure and doesn’t require your business to have as much infrastructure than if it were to continue to run as a stand-alone entity. For example, the acquirer may provide legal, accounting, and human resources services to its business units or divisions and may therefore not require that these functions be highly streamlined in your business.
• Stand-Alone: Corporate buyers who will keep your business as a stand-alone entity will require more infrastructure than if they were integrating your business with theirs. They may not be interested in acquiring your business unless your company has adequate infrastructure in place and can continue to operate on a stand-alone basis without your involvement. In some cases, this type of buyer may promote a manager at their corporate office to run your company as president. Still, your business should have a management team and systems in place to ensure that operations continue to run smoothly during the transition process.

Ability to Replicate

All corporate buyers carefully weigh the “buy vs. build” decision. To buy is to make acquisitions, or to grow inorganically. To build is to pursue growth organically, such as through sales and marketing programs or by introducing new products. Every corporate buyer prefers to build if they can – because it’s much cheaper. So if they can replicate, or build your business from scratch, they will. If they can’t replicate your business, only then will they consider acquiring you.

All competitors will examine the extent to which they can replicate attributes of your business, or generate a similar level of organic growth. It may be possible to replicate your business by starting a comparable business from scratch, acquiring another similar company, or launching a new product line that is close to what your company offers.

The more difficult it is for a competitor to replicate your business, the higher the multiple you’ll receive. The degree to which a buyer can reproduce your business depends on your industry and your competitive advantage, and how difficult that advantage is to copy. While other factors may influence the price, the degree to which your business can be easily replicated is one of the most important factors these buyers consider when evaluating your company.

Certain industries have low barriers to entry, while others have high barriers to entry. Industries with high barriers to entry receive higher multiples because businesses in these industries are often difficult to replicate. Competitors also compare the cost of investing in your business with the cost of other corporate development options such as joint ventures, partnerships, or strategic alliances. 

Corporate buyers are usually in the market for a business with a competitive advantage that’s sustainable and not easily replicated. Your business must have a competitive differentiation or other attributes that a buyer can’t easily reproduce. 

If your business is easy to replicate, the buyer will do just that. They will build instead of buy. If your business is likely to be sold to a corporate buyer, then focus on building a business that possesses attributes that are difficult for the buyer to replicate.

Growth Plan

Corporate buyers have longer holding periods than financial buyers and often have no defined exit plan. They typically expect to fully integrate your company into theirs and hold it indefinitely. Make sure your growth plan highlights the difficult-to-replicate value in your business. Show how you could leverage that value in your growth plan. Focus on aspects such as intellectual property or long-term customer contracts in order to make buying your business more appealing than organic growth. 

Conclusion

When preparing to sell your business, it’s important to understand the different buyer types, their criteria, and how you can position your business to be as attractive as possible. Know the different types of buyers and the degree to which they require systems, a management team, and other attributes before you invest time in building them. Each type of buyer has a different set of preferences regarding the type of infrastructure, systems, and other elements they desire in a business. 

Many buyers will consider a profitable business that lacks infrastructure. But few buyers will consider an unprofitable business that has significant infrastructure in place. Always prioritize profitability over infrastructure until your EBITDA exceeds several million dollars per year.

For most businesses, developing a management team is the most critical factor other than profitability in building a salable business. For other businesses, creating systems or increasing cash flow may create more value. There’s no cookie-cutter formula. Knowing the potential types of buyers for your business can help you maximize your sale price and properly market your business for sale to the right audience when the time comes, setting it apart from other companies like it.