The Hunt: How Private Equity Firms Find You

Whether or not you are interested, a number of private equity firms would likely want to get to know you better. Some private equity firms employ business development professionals whose sole role is to find potential companies that fit a particular investment strategy, so you will probably hear from them on cold calls or see them at trade shows or other industry events.

Most are more targeted than that, however. They may already have investments and expertise in your industry. They may own one or two of your competitors. They may maintain relations with investment bankers who would also like to work with you.

Even if you are not considering a sale now, you can hear their pitch and learn something about the other companies in their portfolios. Most investment bankers and private equity principals are happy to speak with business owners, even if they are not for sale. If private equity is a growing presence in your industry, a little knowledge can go a long way.

What if you want to hunt for the right partner, either to sell to or invest in your company? As discussed above, the team you assemble will lead the hunt. An experienced investment banker will know your industry and the financial and strategic buyers that would be interested in speaking with you. Taking this proactive approach gives you greater and earlier visibility into possible options, along with better control over the process. The time when you have the most leverage is when you are picking your partner … and it is always better to be the hunter rather than the hunted.

Prepare Yourself

Before you approach any potential investor, it is a good idea to assess what you expect from a deal and whether or not your potential partner shares your goals. This is another area in which consulting with your advisors can smooth potentially rough waters. Many astute owners also save themselves considerable grief by hiring an accounting firm early in the process to do a readiness assessment, which should include a quality-of-earnings review. Meeting with your team provides an opportunity to cover everything from whether or not co-owners have realistic expectations for what a deal will accomplish straight through to what a buyer or investor is likely to uncover while conducting due diligence. Sorting out any potential issues ahead of time can expedite the process later on, as well as help prevent nasty surprises after a letter of intent has been executed.

As we discussed above, one number that matters greatly to private equity firms is EBITDA, which is earnings before interest, tax, depreciation and amortization. Many entrepreneurs may not focus on their company's EBITDA, but for a private equity firm, EBITDA is the principal method for determining valuation and whether your company is a good fit for their portfolio. For instance, a private equity fund with an average investment size of $100 million is unlikely to be interested in a company with an EBITDA of $2 million, unless it is for an add-on investment to bulk up one of their primary platform portfolio companies. EBITDA is also one of the numbers used to assess risk, determine how much leverage can be applied to a deal and establish a valuation for your company.

When determining EBITDA in the sale context, this number will be "normalized" or "adjusted" to add or subtract those income or expense items that are not "ordinary course" items. For instance, items such as one-time litigation expenses and owner's perks will be added back to increase EBITDA. This adjusted number will be the subject of the quality-of-earnings review that the buyer's accounting and financial consultants will perform as part of their due diligence. Any private equity firm interested in making an investment in your company will also undertake an extensive market study of your company and the industry or industries in which you operate, and its lawyers will perform an intensive legal review.

Buyers, in general, will scrutinize your income statement and balance sheet, assessing the quality of your earnings and focusing on working capital issues in particular. They will analyze many issues throughout this process. With regard to intellectual property, they will analyze whether you own the intellectual property used by your company, what intellectual property is leased and the importance of that intellectual property to your overall operations. They will assess your management team—the team you have versus the team you should have. Advance warning: Many private equity firms have noted that the manager most often missing in action is the CFO. Even if you love your part-time bookkeeper or you think it is not worth the expense, your company will look more attractive to an investor if financial controls are set up by a professional. The lesson: A good financial executive should pay for himself or herself. Also, audited financial statements, instead of compilations or reviewed financial statements, make a significant difference in a private equity firm's analysis of your financial position. Other housekeeping issues, such as taking the time to put your contracts, leases and other agreements in proper order, will enable you to project a positive image to prospective investors.

Strategies

To attract a range of buyers, you should consider what really matters to your potential bidders. Whether you are thinking about positioning your business to be more attractive to a strategic buyer or a financial buyer, you may want to start thinking about what your company can do that no one else can—whether it's a product, a process or personnel. For a strategic buyer, one question to ask yourself is: What is it that would make a company that already does exactly what you're doing want to pay a premium to buy your company? Whatever that is for your business, focus on that, continue to grow that competency and stay laser-focused on those areas where you can deliver better than anyone else.

Buyers are also attuned to the risks associated with your business. Identify what keeps you up at night. Whatever the risks are in your business, think about how you can mitigate them. Among other issues, supplier interruptions, key personnel issues, unexpected customer defections and competitive technology innovations can all play havoc with an established business. Remember, no battle plan ever survived contact with the enemy. Think about how your business could survive and flourish should one of those risks come to pass. This is another area in which your team may be able to help you evaluate your business in advance of a sale or investment.

When private equity firms look at your company, they will find those same risks and worry about them even more than you. They are not as up to speed with your business as you are, so they will never be as comfortable as you are with those risks. The risks that exist with your company will come into play when a potential investor is ascribing a value to your company.

Choosing Your Team: It Starts with the Right Lawyer

Before you approach the process, you should have an experienced lawyer who will represent your interests in all aspects of the process, from planning to structuring, and from negotiating to closing. However, your best bet will be a lawyer (and law firm) that has been to this rodeo before; if your legal counsel is your family attorney, you may not be getting the best advice for this kind of a transaction. If you have good counsel, they will do more than draft legal documents for you; they can provide introductions to investment bankers and business brokers. Also, they know what is standard for the process and "market" for transactions, and can thus allay fears of the unknown, which may unnecessarily undermine the achievement of your goals. Therefore, start early, take your time, get recommendations and interview prospective legal teams. Do all the things you would do if you were picking a new supplier or hiring a manager.

A good law firm can also help with wealth planning. The law firm will be able to advise you on whether you can minimize capital gains and gift and inheritance taxes, possibly by changing the equity structure of your company before you sell. Give yourself as much time as possible to consider and execute your wealth planning strategies. Remember, a planning process that starts at least one year in advance, and perhaps longer, is recommended in most instances.

Chemistry Check

If you decide to use an investment bank to shop your business, you should go through an interview process that is equally rigorous. Choosing an investment banker based on which one hints at the highest valuation could prove a mistake—after all, the banker does not set the price; the market does. It is vital that the chemistry feels right and that you are confident in his or her abilities, and that he or she can and will devote their time to your company. Since it can take one year from start to finish, on average, to close a sale, you are going to get to know your investment banker really well … so make sure it is someone with whom you want to spend time.

If you are going to partner with a private equity firm—especially if you will have a continuing equity and management stake in your company—you will want to know even more about that firm. Ask for the names of the last five entrepreneurs with whom a private equity firm has worked, and get in touch with them. What was their experience in working with this firm? What happened when things were tough? What would they have done differently? Ask to speak with owners and management of bad or failed deals.

These steps to educate yourself and prepare your company for a major investment or a sale will take time away from the day-to-day operation of your company. Is it worth the effort? Many serial entrepreneurs have learned, through trial-and-error experience, that it makes good sense to run a business as if it is always for sale, even if it is not. If you are always prepared for a sale, you can take advantage of any opportunities that may present themselves and shouldn't find yourself without options. This, among many other good reasons, is why a key piece of learning here is: Prepare now and don't let your exit be an accident.