If you are an entrepreneur or CEO looking to sell your company to private equity, there are a few things you need to know about basic deal terms. In this blog post, we will give you an overview of what basic deal terms to expect when negotiating with private equity firms; however, the topic could fill an entire book, so this will be precursory.
What is Private Equity?
Private equity is investment capital from wealthy individuals and institutional investors, such as pension funds and endowments. Private equity firms use this capital to invest in companies that they believe have the potential for high returns. In this way, their investors (LPs) aligned with the private equity firm (GP) in realizing returns.
Price is only one deal element when a private equity firm wants to buy your company. Great results come from negotiating the deal terms in their entirety. This can be a complex process, so it is essential to clearly understand what you want and what the other party is looking for.
Here are some of the key points you will need to negotiate:
Price is usually the most important point of negotiation for the seller. You will want to get the highest possible price for your company. However, the buyer will want to pay as little as possible or at least a “market” number. One man’s market is another home run or robbery, and there are many elements to getting to the best price. This is where seller education and an informed market valuation from your investment bank can align expectations.
Terms is a catch-all phrase that can include many deal items exclusive of price.
The “structure” of the deal will also be referred to in the deal. There are two common structures for private equity deals: all-cash deals and structured – (seller notes) or contingent payments such as earnouts. In an all-cash deal, the buyer pays the entire purchase price upfront. A seller note is exactly that, a debt instrument/promise to pay over a specific time and is typically not contingent on future outcomes. In an earnout, the seller receives a portion of the purchase price upfront and the rest over time based on certain conditions being met (such as financial targets).
Critical to assessing a deal’s risk is understanding the financing the PE firm will use, and the amount of leverage applied to the acquisition target. Two main types of funding for private equity deals are debt and equity. Equity financing means the buyer will own more of the company after the deal, but this is often more expensive. Roughly speaking, equity costs ~30% for most private middle market firms. And while there are various ways of calculating the cost of equity, this approximation generally holds true.
Debt financing is often cheaper for the buyer. However, it is riskier for the seller because it means that creditors will have priority over companies’ assets and potential liquidation if anything goes wrong. Private equity and other investors like to use debt to “juice” the returns on their equity by replacing equity with low-cost debt. They often use Senior debt (single-digit interest rate) and Junior or Mezzanine debt (double-digit subordinated debt). Why should a seller care? If you are staying in the business and running it, you will be responsible for that debt service as a CEO or senior leader, so it is essential to understand what you are signing up for. And if a portion of your proceeds will be dependent on the underlying company’s ability to meet debt service, your capital could be at greater risk the higher the debt level and the higher the cost of that debt.
Understanding all of these points is important before entering into negotiations with a private equity firm. If you need help figuring out where to start, we can help! Our team of experts has years of experience in M&A and various deal structures and can advise you on how to get the best deal possible.
In future articles, we will discuss some of the more complex intricacies of deal-making and structural and legal elements you will likely want to be familiar with, i.e., Earn Outs, Escrows, holdbacks, indemnifications, representations and warranties, disclosures, and other terms involved in an M&A transaction. While deep understanding of these terms and their interplay within a deal are crucial to achieving and outlier outcome, we find a seller (especially first-time sellers) understanding of the basic elements of a deal are critical to keeping deal momentum and increasing sellers overall satisfaction post-close.
Merit Investment Bank is here to help. Reach out to discuss the best path for your company to grow and for you to build generational wealth through the recapitalization or sale of your private company. 253-370-8893 | Craig.Dickens@meritinvestmentbank.com