Let’s say you’re an owner of a small business. It’s valued around $10 million. Someone wants to buy it.
Here are warnings and watch-outs when assessing offers.
GREEN FLAGS
- Cash-only offers
- The buyer wants to be owner-investor and personally run it themselves as their main gig
RED FLAGS
- It’s a private equity (PE) firm
- The buyer has a portfolio of other businesses they are not personally running
- They aren’t paying you out in cash, but rather a mix of cash, equity, and then buying out over time
The last bullet point above is the big red flag, and the point of this post. I’m stealing all of this content from this guy’s video.
In this cautionary tale, the former owner describes a situation where:
- You get paid $1 million in cash
- You get $3 million in equity (whatever that means, because then how are you getting it out?)
- The PE firm is paying out the rest through income from the business over time
The danger in this formula is the firm is not as interested in the business as you were. Not only are you the subject-matter expert, but you have the personal, emotional incentive to actually grow the business.
To them, your entire business is another line on a spreadsheet.
(Trust me, I used to work for a firm bought out by PE. Would not recommend as a long-term plan.)
On top of this, the PE firm wants cashflow from the business. They probably want something close to 10% of a return, AKA $1mm per year.
Ignoring interest for a second, that means they’re getting a cash-on-cash return of 100% a year for their buyout.
Meanwhile, you are still chained to the business because of your equity stake. So you’re incentivized to make sure your 30% stake is still worth at least that much. You’re still stuck.
So that leaves you running the same business, bleeding out cash of a million/year to someone else (which could’ve simply been yours), except now any growth you create isn’t yours, and your stake may not grow anyway. You don’t have final say.
What to do instead?
- Take all-cash buyouts. Who cares if they have to borrow to get it, as long as you get the cash up front?
- Sell to an operator-investor. Not a group. An individual. The operator wants your business to grow, not just sit, or else they wouldn’t buy it. In this situation, even seller-side financing may not be a bad idea (but the new operator must be extremely carefully vetted).
If you do seller-side financing, make sure you have a clause to be a certain amount of cash returned out by X date, with equity penalties or even reverting ownership under certain failure conditions.
Both of these options means incentives for both buyer and seller are lined up 1:1. The second one is more complicated, and obviously more risky than just getting bought out, but if you’re in a niche enough market that you can’t find an all-cash buyer, it may be your best option.
