Selling to Private Equity: Dream Buyer or Worst Nightmare?

Many business owners in the lower middle market (annual sales $2M–$25M) have a visceral reaction to the mere mention of the words “private equity.” In fact, some owners view selling to a private equity buyer as either the exit of last resort or simply unthinkable.

Do private equity groups (PEGs) deserve a bad rap, or are a few bad apples spoiling the barrel? Is selling your small business to private equity a good option when you’re ready to exit, or should it be avoided at all costs?

In this article, we’ll offer a quick overview of the private equity industry. We’ll discuss why PEGs have a spotty reputation, as well as the important role they play in the small-business ecosystem. We’ll also lay out what PEGs look for in a small business investment, and how to determine if a private equity buyer might be a good fit for you and your business.

Who this article is for: This article is for small business owners in the lower middle market who are planning a full exit from their business. While the future growth of the company may be important to you, this article does not address fundraising or recapitalizing your business using private equity investment.

Common Types of Private Equity

There are several types of private equity firms that invest in privately held companies. If you do a search on just how many types, you’ll get a variety of answers ranging from two main categories to as many as nine

You can sort private equity firms in a number of ways:

  • Size of PEG itself
  • Size of investment
  • Size of target company
  • Industry of target company
  • Stage at which the PEG invests

Here are three of the most well-known categories of private equity, and how they work:

Venture Capital 

Venture capital firms (VCs) are known for investing in startups and early-stage companies. While you can find VCs in all industries and locations, they are often associated with the high-tech industry and Silicon Valley. One example is Sequoia Capital, a venture capital firm that made early-stage investments in companies like LinkedIn, PayPal, Google, Instagram, YouTube, and Zoom. The preferred exit for most VCs is an IPO (initial public offering) or sale of the business to a strategic buyer.

Mezzanine Funds

Mezzanine financing is often used to help an established business take advantage of growth opportunities. The mezzanine fund offers a layer of financing that is a hybrid of debt (less risky) and equity (riskier). 

Mezzanine funds have several advantages for both borrowers and lenders. In addition to a higher interest rate, the mezzanine fund often earns an equity kicker as a reward for lending to a company that can’t get additional senior (bank) debt. From the borrower’s standpoint, mezzanine funding allows the entrepreneur to grow the business without having to sell more equity (diluting their ownership) or try to borrow more from a bank. 

Mega Funds (Bulge Bracket)

Another well-known category of private equity is the bulge bracket investment bank, or mega fund. Mega funds include familiar names like Blackstone Group, KKR, Carlyle Group, and Bain Capital. These large private equity firms engage in all types of investment opportunities, as well as merger and acquisition (M&A) consulting and financial services.

The mega deals done by mega funds usually make headlines, although some fly under the radar of the general public. Not all ubiquitous brands are public companies. In reality, many are part of a private equity portfolio, including Hilton Worldwide (Blackstone), PetSmart (BC Partners), and Dollar General (KKR).

Nightmare: Private Equity Behaving Badly

Let me start by saying that I’ve talked to a lot of private equity guys (yes, they are almost exclusively men) over the years. While it’s unfair to paint them all with the same brush — good, bad, or otherwise — they are some of the smartest business people you will ever meet. 

Private equity guys can indeed be the proverbial geniuses in the room. Not only do they rank high in terms of raw intelligence, but they also have the experience, network, and confidence to turn a ho-hum business into a household name (more on that later).

With that said, the business headlines are filled with stories of deals gone wrong thanks to shady private equity players. 

One classic PEG horror story goes something like this: A smooth-talking PEG convinces an owner to do a deal they don’t fully understand. Everything looks great on the surface. Soon it becomes clear that the plan is to sell off all the hard assets and saddle the business with debt. When the business is nothing more than a pile of smoldering ashes, the PEG has it declare bankruptcy, somehow walking away richer.

Other variations on the PEG nightmare feature obscene management fees, high-risk leveraged buyouts, and complex financial engineering gone awry.

There are bad actors in every industry, and private equity is no exception. But that shouldn’t dissuade you from considering them as a viable buyer for your business. The key is to find the right fit between your business and personal goals, and the experience and strategy of the private equity group.

Dream: The Ideal Private Equity Scenario

Private equity: executives happily talking

Private equity plays a vital role in the business ecosystem at every level. There are a number of business scenarios where private equity solves a multitude of problems. Private equity can provide much-needed financing and liquidity for accomplishing business goals — including the founder’s exit — while supporting management teams with sophisticated financial and operational expertise.

An example of private equity at its best is the Udi’s Gluten Free story. Even if you’re not gluten intolerant, you’ve probably seen Udi’s baked goods on the shelves at your local grocery store. The company started in 1994 as a small sandwich shop in Boulder, CO, and is now a household name — thanks in large part to an investment from Indiana-based private equity firm E&A Industries.

In 2009, Udi’s gluten-free foods had sales of $4.3M, the year before E&A purchased a 60% stake in the company. Within three years the company was approaching $60M in sales and was acquired by Smart Balance, Inc. for $125M in 2012.

It’s not hard to see how this arrangement benefits all parties. PEGs get an excellent return on their investment, while entrepreneurs grow their companies and enjoy two liquidity events: The first when they sell a controlling interest to the PEG, and the second when the PEG has their exit (called the “second bite of the apple”).

Private Equity Options for Small Business Owners

The types of private equity available for the lower middle market have some of the same features of the well-known categories listed above. Regardless of size, all PEGs have the following in common: 

  • They invest in private companies (although some focus on real estate and other asset classes)
  • Their goal is value creation by making the companies they buy more profitable
  • They hold the growing company for a period of time (their investment horizon)
  • They eventually exit through a full or partial sale of the company

Hold periods can be as short as two to seven years or have no designated endpoint. PEGs may make a full or partial exit in the form of an IPO, sale to a strategic buyer, or sale to another (larger) private equity group.

What PEGs Look For in a Small Business

The best PEGs are crystal clear about their investment strategies, and what they look for in the small businesses they acquire. They will refer to this collectively as their approach, investment criteria, or investment thesis. PEGs value the following characteristics in a lower middle market business:

  • Strong business model
  • Desirable customer base
  • Opportunity to scale quickly
  • Businesses in growing industries
  • Will benefit from professionalization
  • Strong management teams in place
  • Businesses that can be part of a roll-up or add-on
  • EBITDA of $1M to $2M+ (sometimes as low as $500K)

Regarding the role of the business owner, some PEGs want the current owner to stay during a transition period, while others are willing to install a new CEO to replace an exiting owner. In either case, they value strong leadership teams who can run the business and possibly take on greater responsibility post-sale.

Unlike VCs, PEGs in the lower middle market are looking for established small businesses that have strong cash flow from operations, along with a proven history of consistent financial performance. Some focus on specific industries — like healthcare or pharmaceuticals — while others are industry agnostic.

9 Questions to Ask a Private Equity Buyer

Finding the right private equity buyer for your business hinges on three things: Fit, fit, and fit. You’ll want to do your own due diligence on any private equity group that is interested in buying your business. Important questions to ask may include:

  1. What is their hold period?
  2. What are examples of similar deals?
  3. What industries do they specialize in?
  4. How much do they have in committed capital?
  5. Do they want you to continue holding equity?
  6. What operational expertise do they bring to the table?
  7. What role do they want you (the seller) to play post-sale?
  8. Will your business be one of their portfolio companies?
  9. Will your business be an add-on to a portfolio company?

You’ll find private equity funds doing deals in both the private markets and public markets. Make sure you’re working with a PEG that understands privately-held, lower middle market businesses. Unfortunately, many of the active PEGs in large financial centers like Chicago, New York, and Los Angeles have trouble working with small business owners. If the PEG seems too pushy, condescending, or opaque, it’s probably best to move on. 

Remember that the PEG is going to grow the business in a way that you never did. Unlike you, they will have access to capital — both human and financial — to scale your business. Their expertise and strategy for the future of the business need to align with your goals, or at least be palatable to you. 

Don’t Rule Out Selling to a Private Equity Buyer

It’s easy to vilify private equity investors and ignore the role they play in maintaining a thriving small-business ecosystem. Are they all sharks? Maybe. But the good ones are like whale sharks, taking smaller fish to new waters on their giant backs. 

You’ll want to cast a wide net for buyers when it comes time to sell your business. Don’t be too quick to rule out private equity as an excellent way to exit your business while ensuring its future success.

At Allan Taylor & Co. we’ve worked with buyers of all kinds, including private equity groups. If you’re ready to sell your business and would like to learn more about business valuation, likely buyers for your business, or the sale process reach out to us today.


Barbara Taylor is the co-founder of Allan Taylor & Co. You can follow her on LinkedIn and Twitter.

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