Private equity firms often prefer to buy companies in a process known as "two bites of the apple." Here's how it works.
There’s an old saying that a rising tide lifts all boats. When it comes to selling your business, being in the right industry can help.
Take Dan Pahos, the owner of Home Instead Senior Care, in Birmingham, Alabama. Pahos and his team provide care to people who would like to live in their home instead of a retirement center or hospital.
Although not looking to sell, Pahos let my colleague Jim Erben, President of Austin-based exit planning firm Erben Associates, LLC take a look under the hood of Pahos’ business for this article.
“With 11,000 Americans turning 65 each year, the wind is at Dan’s back,” says Erben. “No one client represents more than 3 per cent of Dan’s revenue, so he has a diversified revenue source from a growing market that will be attractive to an acquirer should Dan ever want to get out.”
If, like Pahos, you find yourself in a growing industry that is consolidating fast, expect to get a call from a partner at a private equity firm. “Traditionally, private equity firms have focused on companies with at least $3 million dollars in EBITDA,” says Erben, “but more recently they have been coming down-market and regularly seek out companies with a million or more in pre-tax profit, provided they are in growing industries where the demographics are right.”
Each private equity company has its own formula for making acquisitions, but most will use some variation of the “two bites of the apple” strategy. As an owner, your “first bite” is when the private equity firm buys a portion of your shares, usually at or slightly below standard industry multiples. That allows you to take some money off the table. The private equity firm will typically insist that you keep a good chunk of your shares -- maybe 30 to 50 per cent, so you are motivated to help the private equity firm achieve its goals.
The second bite of the apple
The private equity company will usually inject more money into your business -- this time, at a higher multiple -- for expansion and will often try to roll up companies similar to yours into one larger company. Most private equity firms then try to sell the spaghetti ball they’ve built to a strategic buyer within about five years.
Strategic buyers pay a premium because
a) you and your stepbrother and sister companies are duct-taped together into one larger company; and
b) they have a strategic reason to buy the business.
Strategic reasons vary. Your company could help the acquirer make better use of resources it already owns or could eliminate a risk the acquirer is worried about.
In theory, instead of selling all of your shares for an average multiple, you sell the first half of your equity for an average multiple and the second half for a larger multiple. The theory is that you would not have qualified for this higher multiple without the involvement of the private equity firm.
In practice, hopping into bed with a private equity company is not for the faint of heart. They tend to be demanding managers who care first and foremost about delivering a return for their shareholders. That said, if you’re in a growing industry, like Pahos, with 11,000 potential new customers created every day, expect to get a call or three from private equity firms wondering if you would like to take the two-bites-of-the-apple approach to selling your company.