If you're an entrepreneur running an emerging company with a strategy of exploring an M&A exit, then this post was created for you.
There are basically two types of buyers: strategic buyers and financial buyers. Rather than constructing precise definitions of these two profiles, for the sake of this post, let's assume that (1) a strategic buyer is a large-cap, publicly-traded company with plenty of cash on its balance sheet and a growth strategy that includes a meaningful M&A program, and (2) a financial buyer is a private equity fund.
In his new book, "Never Make the First Offer (Except When You Should)", Donald Dell concisely points out one of the principal guidelines for negotiating a deal: Know Your Audience. While this tenet seems obvious, in my experience, sellers sometimes either aren't aware, or can under-estimate the importance, of the distinct profile and objectives of the financial buyer as compared to the strategic buyer.
The purpose of this post is to try to shed some light on some of these basic distinctions for entrepreneurs thinking about an M&A exit. While each deal has its own set of circumstances, and each party in any given deal may have unique objectives, there are some generalized distinctions between these two types of buyers. Two of the core distinctions are discussed in this post—namely, strategic and financial buyers' (1) objectives, and (2) approach to pricing. In turn, these comparative distinctions drive other aspects of deals with strategic and financial buyers that are not explicitly discussed in this post (e.g., financing contingencies).
OBJECTIVES
Unsurprisingly, most buyers—strategic and financial alike—engage in acquisitions to make money. That said, the key differentiator between strategic and financial buyers is that financial buyers are structured at their inception to put money to work for a defined period of time (typically exiting each investment within three to five years) with a certain expected return on their investment upon exit, and each fund making those investments has a limited life (e.g., 10 years). The strategic buyer, on the other hand, often has either no or a flexible targeted return, and often has no real time horizon for achieving that return; rather, the acquisition is expected to be . . . strategic. Compared to the financial buyer, the strategic buyer (1) can be relatively flexible and patient in procuring a return on its investment, (2) might engage in a riskier M&A strategy that assumes some smaller acquisitions might be worth pursuing even if some acquisitions ultimately fail, and (3) can execute an M&A transaction for strategic reasons that have little to do with producing absolute returns above benchmarks for competing investments (e.g., the buyer may decide to spend several million dollars precluding a competitor from entering a certain space, even if the target is not projected to directly add to the buyer's bottom line).
Knowing and proactively attending to the financial buyer's objectives upfront can make all the difference in building and maintaining momentum from an initial meeting through closing the deal and, as a result, maximizing value. For example, a financial buyer will typically be razor-focused throughout the due diligence process on any developments that might have an impact on its financial modeling. Each dollar shortfall of, say, EBITDA, is not just a dollar to the financial buyer. The reason relates to pricing.
PRICING
One way to appreciate the distinction between how financial and strategic buyers price acquisitions is to think about two classes of buyers with differing motivations for purchasing a house. The young family hoping to live in a house for many years to come and enjoy its intangible benefits, in some ways, is much like the strategic buyer. While the young family will reach its price limit based on perceived value and availability of funds, there may be no formula or identifiable metric that will be applied by this buyer to methodically determine value or its price threshold. On the other hand, the home developer, in some ways, resembles the financial buyer. The home developer will, in determining its top price, calculate the cost of purchasing the house, the cost of developing the house, the cost of financing the property in the interim period, the market risk of holding the house during that period, and the fair market value of the development team's time in building and re-selling the house—all compared to returns that could reasonably be expected from an alternative investment during that time period. The young family may run a similar analysis, but will have some freedom to make exceptions and out-spend the home developer if it makes sense on some intangible level. For example, some young families might pay a seemingly high premium to buy a house with "the perfect kitchen" (as an aggressive technology company might pay a sensible premium for some IP that is perceived to be of high value but is too early in its evolution to relate to an identifiable market); the home developer, however, would only pay a premium for the perfect kitchen if the developer could infer a positive (or at least not a negative) incremental return; absent that inference, the perfect kitchen is simply a drain on projected returns.
Financial buyers typically price acquisitions based on cash flow, which is usually calculated based on some variation of an EBITDA (earnings before taking into account deductions for interest, tax, depreciation and amortization expenses) metric. The price, from the financial buyer's perspective, is often phrased as an "EBITDA multiple".
For example, if the target's EBITDA (either for the last 12 months or as projected for the next 12 months) is $5 million and the purchase price that the financial buyer would need to pay to get the deal is $25 million, then the "EBITDA multiple" would be 5x.
Pricing based on an EBITDA multiple is of critical importance to the financial buyer, since the banks providing debt financing for the transaction will reach their funding limit based on an EBITDA multiple as well. The multiple as of any given time will depend on a variety of factors, including broader market conditions. For example, a senior lender may be willing to provide an amount of debt equal to 2x EBITDA, and a mezzanine or subordinated lender may be willing to provide an amount of debt equal to 1x EBITDA. That leaves an additional 2x EBITDA, which would be financed by cash, in the form of an equity infusion, by the financial buyer.
Essentially, the financially buyer has put 40% down on its investment, and has leveraged the remainder. In performing its financial due diligence, the financial buyer will run elaborate financial models designed to provide insight as to whether a later resale of the subject company is likely to command a price that achieves a certain baseline return on the financial buyer's equity investment (often in the 20%+ range). These ROI targets are designed to (1) attract and maintain the inflow of funds from the financial buyer's limited partner investors who, in turn, monitor their returns from private equity partnership interests as compared to alternative investment opportunities and (2) provide a sufficient "carry" to the financial buyer (i.e., the general partner of the fund) and its principals.
The strategic buyer doesn't have such rigid restraints, but, on the flip-side, the strategic buyer cannot necessarily be expected to be twice (or more, on the basis of leverage) as excited for a deal that might be projected to produce twice the EBITDA of a competing acquisition target. The deal has to make strategic sense—whatever that means in the context of the particular buyer and seller (typically technology and human resources)—with less regard to financial projections than that applied by the financial buyer.
PRACTICAL TAKE-AWAYS
Like Dell's advice to "Know Your Audience", the above overview is fairly basic and obvious on its face, but is hopefully a good reminder that not every M&A exit is the same, and a seller can have a meaningful opportunity to maximize value by customizing its approach to a deal depending on the profile and objectives of the likely buyer.
More specifically, consider the following:
· Company Information: A seller might consider preparing customized offering materials (e.g., a teaser / executive summary, information statement, etc.)—one set for strategic buyers and one set for financial buyers. While the overall information may be largely identical, the prioritization and emphasis could vary between the two sets of documents.
· Price Expectations: A seller should approach a sale process armed with up-to-date information as to (1) recent comparable sales from which its value assumptions are derived, with further comparisons of prices obtained from financial vs. strategic buyers, and (2) the current availability and terms of debt financing for the acquisition.
· Readiness to Transact: If the seller has a need, for whatever reason, to quickly initiate a sale process and must prioritize its preparation for engaging with potential buyers, the management team should consider whether to focus on financial statements and systems, confirming adequate protection of its core intellectual property, gauging its employees' interest in continuing employment with certain potential buyers, etc. commensurate with the profile and likely priorities of the likely buyer.
· Hiring Advisors: The seller should consider hiring a reputable investment banker with industry-specific expertise and experience engaging with strategic and financial buyers alike. The seller should also engage counsel and other advisors with particular expertise successfully completing deals with the type of buyer likely to engage with the selling company.
