Ask @StartupCFO: What makes a good buyout target?

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In a prior post, I made the case for why founders (and their investors) should consider a buyout rather than a strategic exit. To recap, here are the main reasons:

  • About half of strategic sales fail to meet their objectives. In contrast, most PE deals succeed.
  • If you have VCs that need an exit but you don’t want to actually sell, replacing your VCs with a PE resets the clock. They get an exit. You keep your company.
  • With a strategic sale, you have a boss. With a PE deal, while you have a highly active board, you are still in charge. Your company remains independent.
  • PEs will work actively with you to build a company that you would likely not be able to build on your own. They do this by driving operational excellence and turning you into a buyer of companies.
  • Since you retain significant upside and since your PE investors help you achieve a bigger outcome than you could alone, a PE sale gives you ‘two bites at the apple’ — you get a partial exit today, but continue to hold a meaningful stake that should grow substantially before an ultimate exit.

Let’s say you buy my premise. Is your business right for a buyout? Let’s look at that.

Private equity firms come in many shapes and sizes and deploy various strategies for creating value. Some examples:

  • Distressed situations: Buying distressed or turnaround companies at a deep discount, then installing a new team and working hard to get the company moving in the right direction.
  • Financial engineering: Using leverage to enhance returns and force operating efficiencies. Servicing this debt requires that management find ways to generate excess cash.
  • Roll-ups/ consolidation: Buy a first company that will become the ‘platform.’ Then buy other companies to bolt on top. These companies may offer the same product or complementary products. If the same, then the strategy is basically to consolidate the market and migrate customers on to one platform. If complementary, then the strategy is to enable the company to cross-sell adjacent products in order to grow the value of each customer and provide that customer with a stickier, more complete solution.

These strategies are not mutually exclusive. A roll-up will likely make extensive use of debt as just one example.

For the sake of simplicity, let’s set aside distressed situations. Chances are good that this is not the kind of exit that you’re looking for.

Financial engineering scenarios apply to companies that are already profitable. Not just on paper, but actually generating cash from operations. If you are still burning cash, then adding debt to your balance sheet is not going to help matters. You can’t repay that debt without significant spending cuts.

Roll-ups apply in scenarios where you have either lots of similar competitors or where there are many adjacent product possibilities. Endurance International is a great example of rolling up an industry. It was built through 80+ acquisitions of hosting companies. J2 and Paysimple are examples of companies that have bought complementary products to cross-sell.

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Is my business right for a buyout?

With the above overview in mind, here are some criteria that I look for in possible buyout candidates:

The business is beyond early stage: This implies a minimum of $5 million ARR. More likely, $10 million ARR and up. Achieving this scale usually results in a few things that are important for PE investors:

  • You are well past product-market fit
  • You have clear, proven channels for customer acquisition
  • You have proven unit economics
  • You have likely assembled a strong senior leadership team
  • There is sufficient operating history that an investor can examine lots of data in order to arrive at an investment decision. There will be few to no leaps of faith required.

Growth is good, but not great: If you’re at $10 million plus ARR and still growing strongly (at least 75 percent, but more likely 100 percent), then you might be better served raising later stage venture versus private equity. These high-growth scale-ups tend to still be burning heavily, but because of their growth trade at high revenue multiples. The combination high burn and high valuation is not a fit for PE.

If your growth is more modest, then your business will trade at a lower multiple, moving it into PE territory.

You (likely) sell to business: While there are some PE firms that do consumer (B2C) companies, the vast majority that I know look for business-to-business (B2B) companies.

B2B is (generally) safer than B2C. The outcomes are less binary. The customers pay you directly. Enterprise value can be created in more predictable ways than B2C where you need huge scale (usually implying huge burn) and where the market leader takes all or most of the value in a category.

A great use case for PE is to invest in a fragmented market with many peers or many adjacent offerings.

Your business has been capital efficient: It is common for PE investors to come in to replace VCs. However, as a PE investor, I need management to have a lot of incentive to grow the business. If management owns a small amount then they may not have the motivation to go through the pain of swallowing debt or successfully bolting on acquisitions or making big improvements in operations.

Perhaps more importantly, since as a PE investor I don’t really like burn, if you burnt a lot of capital to get to this stage, will you be successful in a future where you can’t burn?

All of this has PE firms scouring the market looking for companies that have consumed little to no capital in order to achieve scale (and this means they’re typically looking for B2B companies since it is almost impossible to achieve scale in B2C without a lot of capital).

This quest is the reason why every growth stage CEO’s inbox is regularly flooded with inbounds from analysts. They are always on the lookout for companies that have achieved a lot with a little.

Your industry is highly fragmented: This may not apply in every case, but a great use case for PE is to invest in a fragmented market with many peers or many adjacent offerings that can be rolled up or consolidated to create a large market leader.

You have a strong management team: Again, this may not apply in every case as a PE investor may install leadership, but having a proven management team in place already is often key. These are the people that work with their new majority investor to create value. In a roll-up situation especially, it is important to have strong parent company management that can execute acquisitions and integrate them to build a large, well-run company.

When you put all of this together you create conditions that are ripe for PE: proven businesses, with reasonable valuations, strong management teams and a clear playbook for value creation. This is why PE investors expect to make money on every deal they do. Little is left to chance.

If you are checking most of the boxes above, then PE may be a great fit for you and your business.

Syndicated with permission from Mark MacLeod’s Real Exits blog

Mark MacLeod

Mark MacLeod

Since 1999, Mark MacLeod has been helping fund, grow and exit venture-backed startups. Mark has over 14 years experience as a CFO for leading companies such as FreshBooks, Shopify, Tungle and many others. Mark’s deep experience and passion for startups led him to found SurePath Capital Partners in order to guide and advise founders on how to fund, grow and ultimately exit their companies.