Selling Your Business – Who Are The Purchasers?

Selling Your Business – Who Are The Purchasers?

By: Supertrac Business Divestments

It is important for business owners who intend selling in the future to understand the
motivations of prospective purchasers and the dynamics of the markets in which they operate.

Purchasers of businesses for more than $1M have been grouped into broad categories
according to their investment strategy and funding mechanism. Many investors are hybrids or
combinations of these. Some investment criteria are common to all groups. The categories are
shown discretely to simplify this discussion.

Public companies

The public company arena has industry consolidators in virtually every industry sector. These
are strategic investors who are expanding through acquisition, usually in their core industry.

Public companies operate with a different set of business dynamics to private companies.
Typically in private companies, profit is the driver of growth and investment and shareholder
value is a secondary consideration. In contrast, public companies focus on increasing
shareholder value.

As with private companies, acquisition is the fastest growth mechanism for a public
company. However, the benefit is multiplied several times. Not only does the acquired
business bring its profit into the public company as the primary benefit, but there is a much
greater secondary effect.

The returns required by the shareholders of public companies are usually much lower than for
equivalent private companies. The rigorous reporting requirements, greater share liquidity,
increased availability of investors and access to them usually drives the price of the shares
much higher than for a private company with an equivalent profit.

The capitalisation rate applicable to a business is also referred to as the Price/Earnings ratio
(PE ratio). PE ratios vary widely, but could be in the range of 10-20. This is on after-tax
earnings, which is important to shareholders. A PE ratio of 18 might be comparable to a pretax
earnings multiple of 12.

Now is the interesting part. If a public company with a PE ratio of 18 acquires a private
business earning $1.4Mpa in pre-tax profit (EBIT) at 4 times multiple, it would acquire the
business for $5.6M. However, as soon as it does, the investment has a theoretical value to the
public company of $18M ($1.4M less tax equals $1M after tax, multiplied by 18), which is
more than 3 times the investment price.

Assuming the public company can access substantial amounts of capital, it can dramatically
increase shareholder value simply by making acquisitions. The profit of the acquired business
does not need to increase for an acquisition to be successful. It could even decline to some
extent and the public company would still be able to ‘create’ significant shareholder value
from the transaction.

The more successful acquisitions the public company makes, the faster shareholder value
increases. Delighted shareholders continue to pour money into the company, providing a
ready source of funds for further acquisitions, driving the PE ratio even higher and fuelling
even faster growth and higher returns.

Public companies that adopt this business model may need to continue to make acquisitions
to meet shareholder expectations; i.e. to maintain the growth rates shareholders expect and
have already factored into the share price. This process can continue as long as the company
can continue making acquisitions. Readers may know of organisations in their industry that
have adopted this strategy.

It is important for prospective vendors to understand that public companies will not pay more
for acquisitions than they believe they need to, as there may be a virtually limitless supply of
acquisition targets. Although in some industries the voracious appetite of consolidators has
driven the market price of targets higher, this does not occur in most industries.

Private equity funds

A small but increasing proportion of the $billions invested in super funds is allocated to
private equity funds to pursue business opportunities.

Private equity funds understand the leverage mechanisms involved between private and
public companies and often position themselves in the sweet spot, right between the two.

Private equity funds can access funds and become industry consolidators in much the same
way as public companies can. Many are very good at making acquisitions of private
companies in a target industry, combining or consolidating them and installing competent
management and infrastructure, running them for a few years and then exiting though an IPO
or a trade sale. Many work to a timeframe of 3-5 years in such an industry play.

Private equity firms are run by very capable people as a rule. If the strategy is right and it is
executed skilfully, the returns to these firms and their investors are often astounding.

The typical private equity fund looks for investment opportunities with:

• Good team 
• Proven and scalable business model 
• Growth industry 
• Financials:
        - Revenues over $5M
        - EBIT over $1M 
• Ability to grow revenues to greater than $50M in 3-5 years 
• Exit strategy identified

Medium and large private corporations - same or related industry

The main volume of industry acquisitions and consolidations takes place among medium and
large private companies. Funds permitting, private companies are among those who will pay
the most, as they have the most to gain and the least to risk.

Industry players can also grow much faster through acquisition than organically. They may
want to expand into new geographic or strategic markets or bulk up for a future IPO, which
may require them to increase sales to more than $50M. Acquisitions can deliver fast track
expansion geographically, vertically and horizontally.

Other reasons include acquisition of intellectual property, technology or entry to
complementary markets, removal of a competitor or to gain access to key customers or
supply contracts.

Most benefits of industry acquisition are in the form of market leverage:

• Leverage off target’s customer base with existing products
• Leverage off existing customer base with target’s products

The strategic and cultural fit will be important, as this will determine the amount of work
required to merge the businesses and capitalise on the increased size and scale of operations.
If the strategic fit is good, it is usually quicker and cheaper to acquire a business already
established and doing what the purchaser wants to be doing, complete with infrastructure,
team and customers.

Private investors

These are high net worth individuals or consortiums of successful business people with
surplus cash to invest to earn higher returns than from other forms of investment.

Most private investors have a clear strategy for adding value and a mechanism for doing so.
They may seek businesses that are underperforming. The business may be undercapitalised,
under-resourced or not well managed. It may have good management and sound growth plans
but lack the funds to grow. They identify and provide the missing ingredients so the business
can grow quickly.

Purchasers from the same industry would expect to leverage the business with others. If not,
they may settle for a high, stable return. Accordingly, they can be very price-sensitive and
adopt hurdle rates of return as their initial qualifier for business assessment. Often, ahead of
strategic considerations, the first question is price vs profit.

Investors not from the same industry generally want the current owners/managers to continue
to run the business. This may suit vendors who want to cash out and are prepared to stay
involved.

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