Company Succession: The Private Equity Option

Selling a company to financial investors as a successor solution is difficult for many entrepreneurs to imagine.

According to the Conway Center for Family Business, “Even though nearly 70% of family businesses would like to pass their business on to the next generation, only 30% will be successful at transitioning to the next generation.” Of those businesses passed to the next generation, commonly cited research from the 1980s states that only 30 percent will thrive, and after that, a mere 13 percent will survive to the third generation.

Given those dismal statistics, what does an entrepreneur do if there is no suitable or willing successor? What do you do in the event of an insoluble dispute among shareholders before or after a succession? Who are the right partners for corporate succession, if not the entrepreneur’s family?

The right solution for succession can then be to sell the business to financial investors and private equity managers. The company not only survives but develops further under new management. The family receives its wealth but can now–because it is liquid–apportion it better.

In recent years, private equity companies have increasingly shifted their focus to small- and medium-sized companies. In our experience, this is a positive development and offers business owners more opportunities when selling their companies. Although many owners are familiar with private equity, their ideas and interpretations of this type of investor vary widely.

Related: Succession Planning as Risk Mitigation. 

Advantages of Private Equity

Financial investors are very attractive as successor partners for a company sale. These professional investors have a clear view of a company’s potential for development. They know one must make a company better and more successful to be successful themselves.

Private equity investors can serve as an incubator for the professionalization of corporate management with quick thinking and consistent action. If they have already invested in other companies in the same industry, they will also bring experience and know-how to help the newly acquired company prosper.

Financial investors find family businesses attractive, as such companies usually have a closed group of shareholders, are organized, and have short decision-making paths.

The conceptual counterpart to financial investors is strategic investors. They differ from financial investors, usually competitors, customers, or suppliers of the company for sale. Business succession with a strategist as a buyer is the subject of a separate article.

Private Equity as a Temporary Investment

Resale is part of the private equity business model. Financial investors only buy a company for a certain period, usually three to seven years. The financial investor intends to sell the company for a profit after increasing value through entrepreneurial development measures.

What is often misunderstood is that private equity investors do not seek short-term returns but work to increase the company’s value over the long term. This distinguishes them, for example, from hedge funds, which usually aim to achieve above-average returns with short-term, not necessarily sustainable, measures.

Typical Private Equity Scenario

In a typical company sale to a financial investor, the investor takes over the company completely. However, the existing management receives a stake back in the company.

After the acquisition, the financial investor does not use his staff to manage the company but builds on the industry and company knowledge of existing management. Continued participation in the company incentivizes management to run the company in a way that adds value. The private equity investor restricts himself to monitoring management through an advisory board or directly via shareholder meetings.

The purchase of the company by existing management is called a management buy-out. On the other hand, if an external management team invests together with a financial investor, one speaks of a management buy-in.

Minority Stake

Financial investors may enable the entrepreneur to withdraw gradually from the company if the entrepreneur wants to retain control of the company. At the same time, they prepare a sale with a partner in the long term. The financial investor then purchases a minority stake in the company, affording the entrepreneur extra time and cash to exit the company on favorable terms.

Especially in the case of a need for capital, unresolved successions, or disputes among shareholders, the minority stake of a financial investor serves as an intermediate step to professionalize the company and settle any disagreements in succession.

Necessary Contracts for Corporate Succession

Financial investors are professional players in a competitive market, the market for corporate transactions. Unlike most entrepreneurs, financial investors are experienced in buying and selling companies and keep a close eye on contractually hedging the value of their investments. Entrepreneurs best serve their interests to familiarize themselves with company acquisitions and devote their full attention to the related contracts.

The core of a company succession to an investor is the company purchase agreement. The parties determine the object of purchase (the company), the purchase price, and the seller’s liability for defects. The seller can either sell the company’s operating resources (asset deal) or the company’s shares that operate the business (share deal).

Share deals are often easier to implement than asset deals, which involve the individual transfer of each business asset (e.g., contracts, inventory, equipment, real estate). Asset deals often require approval by third parties, such as the customers and suppliers of the company, to be sold. Employees also have the right to object to the transfer of their employment relationship to the purchaser.

The company purchase agreement usually contains different models of complex purchase price clauses. Purchase prices can be provisional or fixed. The effects of such clauses are not necessarily easy to predict: a lot of money can be made or lost.

Buyers and sellers also delimit the risks associated with the company utilizing guarantees and exemptions in the sales contract. The seller bears the guarantee for a particular condition of the company. Such guarantees and exemptions may conceal traps for sellers that devalue the company and cost the seller money if they take responsibility for damage resulting from a breach of guarantee. Sellers should pay particular attention to so-called representations, warranties, and indemnities.

In addition to the company purchase agreement, financial investors negotiate a shareholder agreement with the managers in a management buyout. Even with a minority stake, the shareholder agreement is part of the standard program. In both cases, but with different nuances, the shareholders’ agreement defines the rights and obligations of those involved in the company’s management, development, and, ultimately, sale.

Succession: Carpe Diem

Business succession is a pressing issue for many entrepreneurs. The current financing environment enables many investors to finance a company acquisition at low-interest rates and offer higher purchase prices. One caveat: demand (investors) exceeds supply (suitable companies).

Today’s market for corporate transactions favors sellers. Anyone considering the sale of their company as a succession option should think whether a company sale–in whole or in part–should take place now.

Preparation Is Essential!

Corporate succession is a complex matter for entrepreneurs, not everyday business, especially if the successor solution is to sell the company. The best deal benefiting both parties (seller and buyer) depends on preparation. However, only a few entrepreneurs intend to withdraw from the company in a targeted manner and at a certain point in time.

Early preparation confers several advantages, including a positive effect on the company itself. The company’s dependency on a solid entrepreneur can be intentionally reduced, known risks eliminated or reduced, and the sales processes structured.

Preparation results in higher purchase prices, with the entrepreneur preparing himself and the company for separation, which improves the likelihood of a successful transfer to new management.

Finding the Right Private Equity Partner

The selection is huge: private equity companies of all sizes and markets are available for almost all needs. The plethora of options makes M&A advisors all the more important to steer the company safely through unfamiliar territory. The M&A advisor helps to find the right investor and set up the sales process in a structured manner. Where necessary, the M&A advisor calls in suitable specialists: such as auditors for company valuation or lawyers for drafting contracts. This expertise makes the process more efficient and gives the entrepreneur time for the daily operation of the business.

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Matt Lawver

Matt Lawver

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