M&A Guide | The 4 Types of Buyers of Businesses

by Jacob Orosz (President of Morgan & Westfield)

One of the first lessons in Marketing 101 is this: know your audience. Who are they? Where are they? What buttons can be pushed? What incentives need to be dangled? If you’re not armed with this basic information (and more), it’s going to be a tough sell no matter what you’re offering, be it widgets or entire businesses.

This is especially true when it comes to marketing your company. By educating yourself about the different types of buyers in the marketplace, you can identify which type of buyer is most likely to purchase your business. This is essential to knowing what your business may be worth and developing a marketing strategy to sell your company.

There are four broad categories of buyers of businesses:

#1: Individual buyers tend to buy small businesses.

Individual buyers have two primary goals — income and freedom. Their primary concerns are how risky the business is and whether financing can be obtained to purchase it. For these buyers, the process of buying a business can be emotional. For this reason, they often stick to less risky investments and prefer to buy businesses with proven track records. When selling your business to an individual, we recommend minimizing the perception of risk and avoid overwhelming them with information.

#2: Financial buyers tend to buy small and mid-sized businesses.

Financial buyers primarily consist of private equity groups (PEG) and value a business based solely on its numbers without taking into account the impact of any synergies. Financial buyers have two primary goals — generating a high return and developing an exit plan. Their two primary considerations are generating a high return and retaining the existing management team. When selling to a financial buyer, you should focus on building a strong management team and increasing EBITDA.

#3: Strategic (Synergistic) buyers tend to buy small and medium-sized businesses.

Strategic buyers are the holy grail of buyers and may pay a higher multiple than others if they cannot easily replicate what the seller’s company has to offer. Strategic buyers have longer holding periods and have no defined exit plan. They usually intend to fully integrate your company with theirs and focus on long-term fit. When selling to a strategic buyer, focus on building value that is difficult to replicate and hire an M&A intermediary to conduct a private auction.

#4: Industry buyers tend to merge with or acquire direct competitors.

If your business is asset-intensive with less-than-favorable margins, selling to an industry buyer may be the only suitable option. In some industries, selling to a financial or strategic buyer may not be an option. Industry buyers are often seen as the buyers of last resort because they usually pay the lowest price. These buyers know the industry well and are not willing to pay for goodwill. Selling to industry buyers carries an additional risk — a potential leak in confidentiality. When selling to an industry buyer, hire a professional to negotiate on your behalf, build value that can’t be replicated, carefully track the release of confidential information, and never act desperate.

In the article that follows, we explore in detail the four different types of buyers and the goals, considerations, and risks associated with each. If you want to maximize the value of your business with your particular target audience, keep reading.

Individual Buyers

High-net-worth individuals purchase a minority of middle-market businesses compared with the other buyer types.

Here are some statistics regarding the number of high-net-worth individuals in the world:

  • There are 14 million high-net-worth individuals (HNWI) with financial assets valued at more than $1 million.
  • There are over 225,000 ultra-high-net-worth individuals (UHNWI) with financial assets valued at more than $30 million.

Goal #1: Income

Individuals are usually looking to purchase an income stream. They may have recently lost their job or be unhappy in their career and want to pursue the American Dream.

Goal #2: Freedom

Studies show that people start or buy small businesses primarily so they control their own destiny and achieve freedom.

Surprisingly, the goal of getting rich falls lower on the list of reasons these individuals want to buy a business. While an individual’s primary objective for purchasing a business is income substitution, they often value freedom and the ability to control their own destiny more than getting rich.

Consideration #1: Risk

For these buyers, the process of buying a business can be quite emotional. That’s because buying a business is a risky proposition that often requires parting with a substantial portion of their net worth. They may have never previously owned a business, which can make the decision even more difficult for them.

For this reason, they often stick to less risky investments and prefer to buy businesses with a proven track record. Most stick to industries they are familiar with; however, some buyers may consider purchasing a business in an unfamiliar industry if the business can be quickly learned or if the seller is willing to stay for an extended transition period.

Some individuals may be former small business owners. If so, these buyers are more likely to pull the trigger than a buyer who has never owned a business because they are familiar with the inherent risks involved — especially if they have owned a business in the same industry.

Consideration #2: Financing

Individual buyers finance the purchase of a business primarily through a combination of their own cash, seller financing, bank financing, SBA financing, or the use of their retirement funds. Most individuals acquire businesses valued at less than $10 million in transaction size.

Tips for Dealing with Individuals

When dealing with an individual buyer, we recommend the following:

  • Minimize any risk associated with your business. For individuals, the perception of risk kills more deals than the absence of opportunity. Retain an independent third party to objectively analyze your business and identify ways in which you can make your business more attractive to these types of buyers. In our Assessment, we analyze your business as a potential investor would and prepare a report that contains a determination of your business’s marketability, an analysis of the risks and opportunities, potential deal killers, methods of reducing risk, and a list of steps you can take to reduce risk in your business and maximize its value.
  • Don’t overwhelm them with information. Many individuals are nervous about making the leap into buying their own business; sending them more information or arranging too many meetings will only overwhelm them if they are not ready. Most serious buyers should be prepared to make an offer after the second or third meeting. If they don’t, move on.

Financial Buyers

Private equity is technically “equity that is private.” This is distinct from public equity, which is equity that is publicly held or traded. Private equity groups are the largest and most common buyers of mid-sized companies.

Financial buyers primarily consist of private equity groups (PEG) and value a business based solely on its numbers without taking into account the impact of any synergies.

There are approximately 2,000 to 3,000 private equity firms in the USA. In addition, there are also family investment offices and other types of investors that function very similarly to private equity firms.

Private equity groups raise money from institutional investors and then invest these funds into private companies on behalf of the investors. The fund usually has a lifespan of 10 years, and the PEG normally has a holding period of three to seven years for each business in which they invest. The PEG makes a profit either from distributions it pays itself out of the company’s earnings or from selling the company at a higher price than it paid.

Goal #1: ROI

Financial buyers are the most common buyers of middle-market companies and are focused on the return of investment (technically internal rate of return, or IRR), as opposed to any strategic benefits of the acquisition.

PEGs are experts at scaling companies through building strategic relationships, building strong management teams, and developing efficient sales and marketing programs. A seller may be able to scale a company more quickly with the strategic assistance and direction of a PEG. The end goal for many PEGs is to sell to a strategic buyer.

PEGs purchase a company as a stand-alone entity, and the changes they make to the business post-closing are designed to increase the value of the business. Any changes they make are focused on increasing profitability and making the company more attractive to future investors.

As a result, financial buyers analyze a company’s cash flow on a stand-alone basis, without taking into account any benefits of integration, with a focus on the capacity for increasing earnings and the value of their investment over the next three to seven years.

Price is an important consideration for these buyers because the business is typically run as a stand-alone company post-closing unless they own a similar company in their portfolio.

PEGs do not usually plan to integrate a newly purchased company with another company post-closing, as strategic buyers do. As a result, PEGs are restricted as to the multiples they can pay, and these multiples are fairly easy to predict. The only exception to these rules is when a PEG owns a company in their portfolio that may have some synergistic benefit with your company.

Goal #2: Integration

The only exception to this is when a financial buyer owns a company in their portfolio that is a direct competitor of the target company. In these situations, the buyer can be thought of more as an industry buyer than a financial buyer.

Developing an exit plan is paramount if you wish to sell to a PEG. If there is no defined exit, it’s unlikely the PEG will be interested in your business. The PEG must be able to significantly increase the value of your business before they consider acquiring it.

Most PEGs target an internal rate of return (IRR) of 20%-30% per year, which means they must generate a return on invested capital of two to four times if they exit the investment (re-sell your business) in three to five years.

Consideration # 1: ROI

PEGs use significant leverage when purchasing a company because the leverage increases their Internal Rate of Return (IRR).

IRR is also heavily dependent on the holding period, or the amount of time the investment is held, which is why a PEG’s holding period is shorter than the holding period for other buyers. If leverage (i.e., bank debt) is used to acquire your business, your business must generate enough cash flow to cover the debt service. As a result, a PEG cannot pay more for your business than the numbers dictate.

Consideration #2: Retaining the Management Team

Private equity firms almost always prefer to retain the existing management team and owner. After all, private equity firms are often not industry experts and will need someone to run the company post-closing. If the existing owner and management team do not stay to operate the business, the PE firm must bring in a team to operate it.

Should you sell to a financial buyer?

Selling to a PEG allows an owner to sell a portion of the company now, thereby diversifying their risk and potentially achieving a second, larger exit in three to seven years when the PEG re-sells the business. The PEG incentivizes the owner to stay involved in the company through the retention of equity, normally encouraging the owner to retain at least a 20% interest in the business.

For example, the owner sells 80% of his shares now, which is usually enough to secure retirement, and retains 20% of the company post-closing. The remaining 20% equity may lead to a larger exit for the entrepreneur than the initial 80% sale.

Tips for Dealing with Financial Buyers

When dealing with financial buyers, we recommend the following:

  • Build a strong management team. Financial buyers typically require the existing management team to remain to operate the business after the closing.
  • Increase EBITDA, the primary metric financial buyers use to value a business.

Strategic Buyers

Strategic acquisitions occur in nascent industries, especially those dominated by venture-capital-backed companies or “winner take all” industries, such as technology platforms or industries in which research and development (R&D) is critical to the ongoing success of a company.

Google, Salesforce, Microsoft, Apple, PayPal, and many other technology companies are perennial acquirers. Once nascent industries mature, companies make acquisitions to eliminate competition (such as Facebook’s acquisition of Instagram and WhatsApp, PayPal’s acquisition of Braintree, Google’s acquisition of Motorola, and HP’s acquisition of Compaq). In these industries, the pace of growth is so fast that companies furiously compete to become the dominant industry leader in a winner-take-all pot.

Strategic buyers are the holy grail of buyers and may pay a higher multiple than other buyers if they cannot easily replicate what the seller’s company has to offer. This is the key distinction — if they cannot quickly replicate.

Goals

Strategic or synergistic buyers are often direct or indirect competitors that purchase a company as an alternative to organic growth.

They can include competitors, customers, or suppliers and may be looking to enter new markets or acquire proprietary products, technology, or access to customers.

These buyers have longer holding periods than financial buyers and have no defined exit plan. They typically plan on fully integrating your company into theirs and holding it indefinitely. They may sometimes only seek to acquire your technology, intellectual property, or customer base and make plans to close your operations and lay off your staff after the closing.

In an acqui-hire, a competitor purchases your company with the sole objective of acquiring your staff and ceases operations at closing. Acqui-hires are common in the technology sector and other sectors in which talent is scarce.

It may make more financial sense for a strategic buyer to grow through acquisitions than to grow by creating new products and services or by acquiring new customers.

This happens most often in mature industries, such as the cellular industry (T-Mobile’s acquisition of Sprint and MetroPCS), media (AT&T’s acquisition of Time Warner or Walt Disney’s acquisition of Twenty-First Century Fox), or consumer products (Heinz’s acquisition of Kraft) in which organic growth has slowed and the most suitable option for increasing revenues is to “buy growth.”

Considerations

These buyers focus on long-term fit with their company, synergies, and the ability to integrate your company with theirs.

All strategic buyers will recreate whatever value you have to offer if they can do so at a lower price than what it would cost to acquire your company. These companies also take into consideration the amount of time it may take to recreate your value proposition. If the company must move quickly, it may make more sense for them to acquire your company due to the lost opportunity cost of building it from scratch.

Tips for Dealing with Strategic Buyers

When dealing with strategic buyers, we recommend the following:

  • Focus on building a company whose value is difficult to replicate. If the buyer can easily replicate what your company has to offer, then they won’t buy your company.
  • Be realistic in determining if your company is a suitable investment for a strategic buyer. Consider retaining a middle-market M&A advisor, such as ourselves, to perform an unbiased assessment of your business to determine if a synergistic buyer may be a likely candidate for your business. In our estimate, less than 5% of middle-market companies can be sold to a strategic buyer.
  • Hire an M&A intermediary to conduct a private auction. Strategic buyers do not offer to pay for strategic value unless they are aware that other buyers are also competing to acquire your company.

Industry Buyers (Direct Competitors)

If your business is asset-intensive with less-than-favorable margins, selling to an industry buyer may be the only suitable option. In some industries, selling to a financial or strategic buyer may not be an option. Or your business may be so specialized that only a competitor may purchase your business.

Goals

Industry buyers are often seen as the buyer of last resort because they often pay the lowest price. These buyers know the industry well and are not willing to pay for goodwill. The value of your company lies in what the buyer cannot easily recreate.

For example, if you want $10 million for your business and the buyer could achieve the same level of revenue by investing $3 million into marketing, then they will not buy your company if it costs more than $3 million.

Risks in Selling to a Strategic Buyer

Selling to industry buyers carries an additional risk — a potential leak in confidentiality. Approaching direct competitors is risky, and it’s inevitable the word will get out. Once it does, competitors are likely to use this against you and may attempt to poach your customers or employees. This can further undermine the value of your company and may also kill a deal you are currently negotiating.

Tips for Dealing with Industry Buyers

When dealing with industry buyers, we recommend the following:

  • Hire a professional to negotiate on your behalf, as these buyers will often initially offer a very low price. They will only increase their bid if they believe there may be competition to purchase your company.
  • Build value in your company that cannot be easily replicated by a competitor, such as intellectual property (patents, trademarks, trade secrets, recognized brand name) or long-term customer contracts.
  • Carefully track the release of confidential materials. Serialize your confidential information memorandum (CIM) and other documents so a leak in confidentiality can be traced to its source.
  • Never show any signs of desperation. If you do, this will be used against you throughout the negotiations.

Summary

When selling your business, keep in mind who the most likely buyer will be. Consider if it’s most likely you will be approached by an individual buyer, strategic buyer, financial buyer, or industry buyer, then market your business accordingly, based on its size and individual advantages.

Knowing this will help you determine the steps you need to take to prepare your business for sale as well as determine the best marketing strategy and overall sales approach to maximize the value of your company.