The 5 Types of Buyers for a Business

This was originally a post I wrote midstreet.com. It should be valuable for anyone interested in business to understand — whether you own a company or you aspire to.

Business owners are often approached about selling their company.

How are they supposed to know if a potential buyer is a good fit for their business?

In this post, I answer that question and go into:

1. The 5 types of buyers for a business
2. What to expect when selling to each buyer
3. Which buyer is right for a business owner

What are the 5 Types of Buyers for a Business?

1. Individual: An individual using his or her own money and likely an SBA Standard 7(a) loan.
2. Strategic: A business that sees value in combining its operations with the target business. Likely a competitor or supplier.
3. Private Equity: Investment vehicles that raise money to invest in companies and hold them for 5–7 years before selling them again.
4. Family Office: A company that invests on behalf of a wealthy family.
5. Employees: An Employee-Stock Ownership Plan (ESOP) can be used to gradually transfer a business’s equity to its employees.

In this article, we’ll focus on MidStreet businesses. These are organizations above Main Street and below the Middle Market, in the range of $1 million-$25 million in revenue.

Individual

At MidStreet, about 75% of buyers who purchase businesses are individuals.

Most of these buyers can be categorized as:

1. People from the corporate world looking to own their own business
2. High-net-worth individuals (HNWI), those with assets greater than $1 million
3. Individuals who’ve sold a business in the past and would like to purchase another company

Individual buyers are interested in buying a company they can feel comfortable with succeeding in, which means they place value on existing infrastructure, such as quality employees, written systems and processes, and training from the owner.

Most lenders won’t lend on businesses worth less than $5 million in purchase price because they have so much Goodwill.

So how do individuals purchase businesses?

The Small Business Administration (SBA) created the 7(a) loan program to encourage investment in small businesses and many individual buyers will use lenders backed by the SBA to purchase a company.

While the SBA 7(a) loan program is helpful, the total Project Cost of a business cannot exceed $5 million. What does this mean for a business owner?

If the company’s earnings are above $1.5 million, it likely won’t sell to an individual buyer.

But if the business is worth less than $5 million, and the owner values seeing their company to continue to exist with new ownership while achieving a premium sale price, an individual buyer is probably the best candidate.

The Project Cost of a business acquisition is the purchase price of the company plus closing costs, working capital, and any other costs required to maintain operations of the business.

Strategic

A strategic buyer is a business that desires to grow by acquiring other companies.

Often, these buyers are competitors within the company’s industry, but they could also be suppliers, vendors, or unrelated businesses.

Strategics buy businesses to recognize synergies between their existing company and the target business by reducing costs or increasing revenues.

Since they can see unique synergies in a potential investment of the target company that other buyers can’t, a Strategic might be able to afford to pay a higher premium for the business.

When going through the sale process with a Strategic, be prepared for an arduous due diligence process. Strategic buyers often have their CFO’s perform lengthy diligence or hire third-party accounting firms to perform a Quality of Earnings analysis.

A Strategic buyer may offer for the business owner to maintain an equity stake in their company (such as 30%), especially if the owner expresses interest in staying on to help with growth initiatives.

If the owner values receiving the highest price on the sale of their business and has a management team in place or are willing to stay on and grow the company, selling to a Strategic buyer can be an excellent choice.

When an owner sells to a Strategic, they should be prepared to lose employees or their company’s brand. There are many types of Strategic buyers and not all of them seek to increase profitability in the same way.

Private Equity Group

Private Equity Groups (PEGs) are investment vehicles run by acquisitions professionals. They raise private equity funds from other investors to get money to purchase businesses and typically plan to sell them in 5–7 years.

PEGs typically focus on a few key industries and identify investments in a specific earnings range (ex: $1 million-$15 million in earnings).

Earnings can be defined as either Seller’s Discretionary Earnings (SDE) or Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Private Equity Groups usually look for an EBITDA number, since they’ll want a management team in place.

When a Private Equity Group looks to acquire a business, they will look at it either as a “Platform” or “Add-On” acquisition.

A Platform investment is when the prospective buyer sees a company independent of their portfolio, while an Add-On (also known as a Bolt-On) looks at the company for the potential benefits it can bring to one of their existing Platform companies.

As with any buyer brought on as an equity partner, the owner should make sure their personality meshes with the operating group that will be overseeing the acquisition.

The downsides (or upsides, depending on the owner’s perspectives) of selling to a Private Equity Group are their short time horizon, lengthy due diligence, and their long-term oversight of the business.

If an owner wants to take a significant amount of money off the table today, this option lets them grow the business to the next level with a professional team and offers a lucrative payout when the business sells again in the future.

Variations of Private Equity

Micro Private Equity

A Micro Private Equity Group is set up similarly to a traditional private equity group but focuses on acquiring and operating businesses with values less than $5 million.

Often, Micro Private Equity buyers are less sophisticated than their larger counterparts and are set up as partnerships between two or three people, with each partner having expertise in a certain area to help operate or grow the business, such as operations, accounting, distribution, etc.

These buyers can be a great option if the owner is interested in selling to a sophisticated buyer but prefer less oversight than a traditional Private Equity Group requires.

Search Fund

The Search Fund model is a relatively new type of buyer and allows someone to own a business with little to no money down.

This buyer is a version of private equity headed by an individual looking to purchase a business as a full-time owner-operator. Search Funds are backed by investors who have to approve the investment.

If the owner is worried about a new buyer struggling to learn the business with a lack of experience in the company’s industry, selling to a Search Fund might not be the best option.

Selling to a Search Fund can be a great choice if the seller is interested in dealing with an individual who will take an owner-operator role in the business once it’s sold, like a traditional individual investor.

Search Funds are also known as “Fundless Sponsors,” or “Unfunded Buyers,” since the investors and lenders they work with are not firmly committed. Although the individual running the Search Fund might be interested in the business (and even submit an offer), their investors might not be on the same page, which could lead to the seller spending time with an unqualified buyer.

Independent Sponsor

Also known as a Fundless Sponsor, the Independent Sponsor model is when a private equity individual or group finds businesses to purchase, then checks with investors and lenders to see who will fund the deal.

An Independent Sponsor could be a better option if the seller wants more assurance that they can get to the closing table (not always the case with a Search Fund, for example — what if their investors don’t like the deal?), especially if the sponsor has done deals before and knows what businesses his investors and lenders will or won’t say “yes” to.

Interested in learning more about the differences between private equity, micro private equity, search funds, and fundless sponsors? Check out this article on the topic.

Family Office

Although they perform many functions outside of investing (shown above), for the purposes of this article, a Family Office is a company that invests on behalf of one or more wealthy families (usually with net worths greater than $100 million.

While Family Offices are constrained less by having to achieve an impressive return in a short time period as with Private Equity Groups, they are primarily focused on preserving wealth and are thus highly risk-averse.

If the seller’s business has a long history of consistent profitability and wants to stay in the business, or there is a management team in place to run the day-to-day operations, a Family Office could be the right buyer for a business owner.

Employees

An Employee-Stock Ownership Plan (ESOP) can be used to gradually transfer a business’s equity to its employees.

In theory, this can be a way to gradually transition the seller’s ownership out of the business. However, it can be expensive, introduces significant risk, and is highly dependent on the owner’s situation. Here are some questions for an owner to ask themselves if they’re considering an ESOP:

• Are you comfortable with relying on your employees to gradually pay for your exit?
• How will you decide who will become the leader of the organization?
• What happens if an employee doesn’t want to participate in the ESOP?

A leveraged ESOP gives the employees financing to buy out a portion of the owner’s equity in the business up-front. This gives the owner more money upfront but will involve a third-party lender conducting their own due diligence on the operations and providing ongoing oversight.

Image Source: americanbar.org

Selling to employees could be the owner’s best option if are comfortable with the risks of an ESOP and own a larger organization with a sophisticated management team in place.

We rarely see ESOPs work successfully on MidStreet businesses.

Conclusion

Now that you understand each type of buyer, how do you find the right one for a business?

Although owners spend years building profitable businesses and have acquired many skills along the way, most have never sold a company before.

Some owners consider calling private equity firms or strategic buyers and asking if they’d be interested in purchasing their business.

Of course, in doing so they run the risk of breaching confidentiality, which could lead to employees, suppliers, or vendors finding out about the owner’s desire to sell and thus quitting, changing the terms of the company’s contracts, or worse.

When qualifying a business broker to represent a business, the owner should check their listing inventory on their website and businesses-for-sale websites such as BizBuySell.com.

Qualifying buyers and managing the buyer-seller relationship is one of the many reasons business owners who choose quality business brokers keep more money in their pocket and achieve better terms when selling their businesses (even after paying a fee).

When selecting a business broker to sell a business, the firm should have experience with the types of buyers the owner is most interested in selling to, so they’re prepared to present the company in the best light for each buyer.

Thank you for your time in reading this article. Please email me at jonah@midstreet.com if you have any questions or comments.