Selling Your Business to Private Equity: What You Need to Know

Speaker 1 – 00:00
We’re going to do a deep dive today on what you need to know if you plan on selling your business to a private
equity firm.
Speaker 2 – 00:06
People got this idea that private equity is going to come in and try to exploit some caveat or loophole in a
transaction to screw you over when this thing’s done. I can tell you confidently and that all the deals that we’ve
done with private equity groups, I have never seen that actually happen.
Speaker 3 – 00:20
Understanding what’s around the corner in a private equity deal is so important. If you have advisors that don’t
know it’s coming and they don’t understand that process, that will not turn out in your favor. One of the values that
investment bankers bring is the ability to cut through kind of their noise. Having someone that understands those
terms and those structures, both at closing, in terms of tax ramifications, employment contracts, earnouts, like all
those things, it’s really important to go through all that, spend the time to understand it and to explain it to our
clients because it affects them extraordinarily.
Speaker 1 – 00:58
Joined by Tom andy, industry experts in accounting, tax, M and A deals, we’re going to do a deep dive today on
what you need to know if you plan on selling your business to a private equity firm. Tom, you want to start what?
Give us the lay of land here.
Speaker 3 – 01:15
I think the first thing is that there’s a lot of people that we talk to just off out of the gate like, I’m never doing a
private equity deal. When you say why, they’ll say things like, well, they’re. They’re bad guys or hear horror stories
and everything. And there’s bad CPAs, there’s bad wealth advisors. So, like, you know, I think the first thing is to
understand why someone has a bias against private equity. Because all private equity is not created the same. You
could, you know, you can have a large private equity fund. You can also have a family office and say.
Speaker 1 – 01:52
And private equity is a loose term. So there’s different variations here.
Speaker 3 – 01:57
So it is a very loose term. So that’s, number one is just like, why are you against it? And secondly from that is, you
know, once you figure out the why or whatever the case may be, it just comes back to what we’ve talked about
other times. Goals and things like private equity has a goal. They’re taking other people’s money, generally
speaking,.
Speaker 1 – 02:24
And they don’t want to lose it.
Speaker 3 – 02:25
They definitely don’t want to lose it.
Speaker 2 – 02:26
They actually.
Speaker 3 – 02:28
Their typical model is that they’re going to triple it in five years. That’s their goal. And a lot of them do much more
than that. Some of them, their goals make 5 vacs. It all depends on. You’re not going to, you know, you’re, if that’s
your goal, you’re not going to come in and be patient and just let you grow at 3% in the cloud of dust. It’s like we
want to grow with rocket fuel. So I would say that’s the first thing is to know that like whoever your buyer is, like
what sort of capital partner are they patient or are they, you know, super growth focused? Because that’s going to
depend on how, what their expectations are.
Speaker 2 – 03:09
Right.
Speaker 3 – 03:09
And their pressure.
Speaker 2 – 03:10
And I mean, the only thing on that note is I do think it’s funny when people come to us and say, I just want to
entertain a private equity company. Right. Because by the end of it, I think a lot of things that people just think that
they’re the boogeyman of the universe. Right. They’re going to come in, they’re going to tear my company out,
they’re firing everybody, they’re going to change the model. The reality is that they have no desire to do that a lot of
times. Well, that’s it. Right.
Speaker 3 – 03:32
And if they do, if that is their intention, sometimes they’ll tell you up front there’s some equity groups that they don’t
want the founder owner to stick around and they’ll be upfront with you. They’ll say, we really want to change you
out in six months because we need someone in there that is going to align with us on like running it 100 hours a
week, you know, for five years.
Speaker 2 – 03:55
Yeah. See, I’d be more concerned about the expectations post sale.
Speaker 1 – 04:00
Right.
Speaker 2 – 04:00
As the people that we represent, this is what I say to them is I’d be worried more about what they’re going to expect
from you after the fact than the today implications of what private equity is going to do because you lay out your
terms and your transactions, you interview the right groups that have the right mentality. And a lot of times the
easiest thing to explain to a prospective seller when they’re going to go to private equity is that all the things that
you’re worried about private equity doing are on the table for a strategic acquirer. Right. It’s the same exact type of
mental math. It’s just that one’s a operating organization and one’s a larger scale private equity group. Right.
Speaker 2 – 04:38
So long story short is you’re going to entertain the same types of risks whether you Go corporate or whether you
go on the private.
Speaker 1 – 04:44
And it doesn’t matter if you’re, who’s buying, if someone’s going to infuse 50, 100, $200 million into something like
they want to get a nice return on it, right?
Speaker 2 – 04:55
So nobody’s working for free. And the long, you know, longevity of the group proves how successful private equity
groups in particular have been doing it. It’s typically our advice to seek out the right private equity group, not just
any private equity group, even if they’re offering more than the next, because that kind of chaotic situation that, you
know, people fear could come true. Right? So you want to know who you’re dealing with. And you know, the most
important thing is to recognize that selling your business, whether it’s private equity or strategic or to a strategic
acquirer, you know, it’s just as much as you interviewing who’s buying you as it is them interviewing you to acquire.
So if you’re uncomfortable with them or you get a bad feeling.
Speaker 2 – 05:37
We’ve dealt with owners who have had private equity groups that they’ve talked to that were like, you sure you’re
going to want to deal with these people after this is done?
Speaker 1 – 05:47
What’s a common, let’s start with what’s a common structure from a, like a founder, owner, operator. Doesn’t really
matter. I’ve seen, like you said, they want to get you out as soon as possible. I’ve seen, they want to keep you on for
two years. I’ve seen earnouts, I’ve seen roll ups into the new entity where you get, you know, 20, 30%. What’s like a,
what are some common structures you’ve seen as far as that Owner, operator, founder?
Speaker 2 – 06:14
Well, I’ll say on the private equity side, there’s a variety of options that are afforded the prospective acquisitions or
owners of prospective acquisitions. But there’s no consistent answer to what piece of this deal typically is
associated with a rollover. What piece is typically in or not, which piece is typically a note or which piece is cash.
What are my holdbacks? All those things. What’s important to know is that you’re going to evaluate comparatively
different types offers from different types of groups and you’re going to pick the group that qualitatively and
quantitatively meets your expectations, not just headline purchase price. Biggest recipe for disaster is to walk into
a room and say, I just sold my business for $100 million when your accounts were sitting back there saying, oh,
you really only got 15 million left of that after this was all Said and done.
Speaker 2 – 07:09
And you lost all your future income stream and you lost all your future potential, all the things, right. So there’s no
set formula for that. Private equity groups are actually a telltale sign as to whether or not they believe in the roll up
that they have going on or their investment theory that they have is that they limit the amount of rollover that they’ll
give you because they don’t want to give up the equity because of how valuable they expect it to be on the back
end. So that’s usually a confidence builder for us. If we hear that they say we’ll let you roll in 10% or 15%, but we’re
not going to go beyond that. That’s because it’ll cost them more to give you equity than it would be just to pay you
more cash today. That’s a good thing, right?
Speaker 2 – 07:51
Then I’m more excited about somebody reinvesting and taking a shot with a new group because we know that
their expectation is this is going to be worth a bundle at the end of the day.
Speaker 3 – 08:00
It also can point to how well capitalized or not they are. If they’re requiring you to do a 40% rollover, they might
need that to get the deal done. They don’t have the ability to finance it any other way. So most of the time, whatever
structure the equity group has, there’s a thesis behind it. They might use rollover equity as a way to keep
somebody engaged and as a hook. You know, that carrot is out there to grow it and to keep alignment going.
Sometimes they will use it as kind of a way to get somebody out the door. If it’s all cash or close, there’s no strings
attached. Either way, they’re not adding somebody to their cap table that they don’t know how to get rid of later if
they have to fire them or they retire or whatever.
So it’s really important to. One of the things we do every time we get an LOI is that we, you know, we’ll go through it
and we’ll ask, talk to the groups, hey, explain all this. How are you going to finance this? Does this have to get
approved by your investment committee? How locked into these terms are you? And like, to Andy’s point about,
you know, if they’re saying, well, we’re flexible on, you know, how much equity’s rolled, we’re flexible on all these
different things, we really want this deal. You know, you tell us what your client wants to do now, they might put
their foot down on certain things. Like if we say we want all cash, they might say no because they want to have
continued alignment, because they’re expecting that operator to continue. So it really depends.
Speaker 3 – 09:36
But you know, having someone that understands those terms and those structures, both at closing in terms of tax
ramifications, employment contracts, earnouts, like all those things, but then also the go forward, I mean, both in
terms of tax execution, what life will feel like, all those things, it’s really important to go through all that, spend the
time to understand it and to explain it to our clients because it affects them extraordinarily. One case, I have a
business that sold a number of years ago. The equity group was like, well, we’re probably going to sell this in the
next three years. We could tell based on their fun life and different things, they’re all lined up probably in the next
three years. Well, it’s been five. They haven’t sold. So there’s still value there to my client with the equity that was
rolled over.
Speaker 3 – 10:34
But he’s like, I kind of like my cash now. Well, there’s no guarantees, so you don’t know when and when. I mean, the
if is usually like, yeah, they’re going to trade the business at some point, but you don’t know when and you don’t
have any way to force them to do it. And if you go to them and say, hey, will you buy me out? You’re gonna have a
discount. So if you’re counting on getting that cash, you know, at some point, it’s like you can’t count on that
because you don’t have control over when that liquidity event happens. So that’s really important to consider and
think through, you know, all the ramifications of that.
Speaker 1 – 11:10
Let’s hit one thing. You said that I found very important numbers aside, like most situations, you probably get
enough money that you can live off for the rest of your life. Maybe not, but likely. So the bigger thing that I’ve seen
that’s more important than the finances is what you said. What are you. What is your day to day actually going to
look like after the sale? Because people can just, especially if you’ve run a business for a long time, you can just
like go mad with all this free time. So I’d say that’s probably one of the most important things. What’s the private
equity firm expect of you and what is your day to day actually going to look like after?
Speaker 3 – 11:46
Yeah, because, you know, you hear all the time of the sellers like, I won’t do private equity because they’re monsters
or whatever. Well, they’re just investors that have really high expectations. So there’s a lot of there’s a lot of reasons
for the, for the. Why private equity does some of the things they do. Because there’s horror stories in the other way
where they, after closing, the seller disappears, they can’t get a hold of them, they resign the day after and start a
competing business or they, you know, or there’s things that they didn’t tell them or they thought that they were
going to be around and on site managing it and they just sort of fade off and get lazy because they got their
money. So, you know, it goes in both directions. And so you’re absolutely right.
Speaker 3 – 12:33
Getting our clients to understand what it will be like and how you structure it and how you change things. If a client
says I want to be done as soon as possible, you have to know that in terms of how you have conversations and
how you structure things and all those. And it has consequences. And so that’s all really important to talk through.
Speaker 1 – 12:58
Let’s sit on some things that you should know before going into this. I’m thinking things like asset versus stock
sale f re Org could be important, right. Depending on the entity structure. Private equity usually won’t buy real
estate. So a lot of times you have to keep the real estate. If you own a building, what else? So hit sit on those and
then anything else that’s like useful that you should know going into this.
Speaker 3 – 13:23
Real estate’s a good one. That’s part of the evaluation upfront that sometimes you’re under market or over market.
You had to adjust for that. But yeah, most of the time they don’t want to keep the dirt. They don’t have flexibility.
Speaker 2 – 13:36
I think that’s a big one. Structure of the transaction always matters, right? So private equity is, I’d say they’re
agnostic when it comes to structure. What they want to do is they want to fit an enterprise in the best possible way
inside their existing structure. If it’s an add on or if you’re a platform, right. Then you’re going to, they’re going to
kind of inherit your structure. They may want to reorganize it after the fact. But in its simplest form, right, the tax
benefits to a buyer are not foregone by a private equity group in the event that you do an asset deal instead of a
stock deal. So I think anybody’s going to look favorably on the buy side to an asset deal or foreign asset deal.
Whereas A seller is inclined to look more favorably toward a AT stock deal. Right.
Speaker 2 – 14:26
In a lot of different ways. But there are ways to overcome that. And typically that includes valuation consideration.
Which what I’ll tell you is the private equity groups, while they have the capacity to be sophisticated, they’re
sophisticated enough generally to recognize that if you’re going to ask for some backend benefit that you’re going
to probably pay more up front for it. Or if you’re going to afford the seller a benefit, they’re going to suggest that
they should pay less. Those are conversations you just have to be prepared to have and you have to quantify it so
that you know that you’re not giving or taking too much in lieu of these, you know, this preferential tax treatment
one side or the other of a transaction. So that’s a structure. There are hybrid structures. You mentioned f
reorganization.
Speaker 2 – 15:10
So in the 338 section of the Internal Revenue Code there are a couple different mechanisms that let you actually
do a stock deal but treat it for tax purposes as an asset deal. I’d actually say that 70% of the transactions that we
see are structured in that manner. 338H10 or can you give like a.
Speaker 1 – 15:27
High level simple overview of how that works?
Speaker 2 – 15:29
Yeah. So it. What it is that it’s. So this typically occurs in businesses that have a need for contract continuation.
Right. So a. It’s heavy on the contract side. Like we had an engineering group that we just worked with at the very
end of last year. They had contracts across 15 different states with hundreds of customers. In order to do an asset
deal, what you would have had to do is you have to go in and retitle or assign all of those contracts to a new entity.
Speaker 2 – 15:59
And then they also had licensing considerations, which is a whole other element of this, where they had a relicense
to operate not only in each of these states, but then globally at the governmental level to be able to operate as an
engineering company itself in order to facilitate the work that they were doing out of a new enterprise. So their
suggestion, which was eloquent was let’s do this 338H10 type transaction, which is the equivalent in a lot of ways
of an F RE organization. But what it entails is it entails a sale of the shares of a company that are elected to be
treated as a sale of assets.
Speaker 2 – 16:38
So it takes an otherwise 20% long term capital gain treatment on the sale of shares and it converts it to, you know,
sale of assets underlying or that are located within the organization itself and the buyer gets a step up in basis so
that affords them that benefit. But legally the entity is preserved, right. And all its contract.
Speaker 1 – 16:59
Is this a new entity or it’s because.
Speaker 2 – 17:01
So there’s two different ways to do it there. In F reorganization there’s actually a drop. So you take all your assets
and you either drop them into a new company or you drop it down depending on how they’re situated pre sale. And
then that subsidiary entity is then sold. So that subsidiary entity, one way to accomplish this is to make that fall
under partnership roles. Fall under partnership roles. Then there is no such thing as a stock deal anymore. Right?
Because even if you sell a membership interest of a company instead of the assets inside that LLC or partnership,
for example, there’s treatment at 754 treatment which actually stipulates that you’re required to treat it as a asset
deal. Do purchase accounting and evaluate your gain on sale based on appreciation and underlying assets rather
than appreciation and a membership interest or shares.
Speaker 2 – 17:47
So typically yes, there’s a, you know, in an F reorganization scenario there is a dropdown and a subsequent sale of
an interest that then qualifies for 754treatment and goes into a new entity but survives. So all of the prevailing, you
know, tax attributes actually survive the transaction. The ein survives. All the legal, you know, implications of
transferring contracts or relicensing go away. And that’s how that works. 338 H10 is a little bit different. That’s a
merger based scenario. Right. And then that allows you to accomplish the same thing but through different
Internal Revenue Code provisions.
Speaker 1 – 18:21
Is there a time period when you would need to do one of these like prior to sale?
Speaker 2 – 18:27
No. So an F reorganization has actually stepped into the closing of a transaction or A338 for that matter. Now it
adds seven days to close, typically is what I would tell you. There are a series of entities that need to get formed,
transferred, contributed, all the things, right. And those have to happen in like daily tranches. So your stepped
checklist of items required to close gets a little bit expanded and a little bit more complex if you’re going to
undertake a transaction and utilize an F reorganization or a 338 type transaction structure.
Speaker 3 – 19:02
So this is actually a benefit of dealing with private equity because they’re sophisticated, they’ve done all these
things. So if you’re trying to sell your business to your neighbor, the other hand knows, you know, or someone else
that isn’t as sophisticated, they probably don’t know any of this stuff and maybe don’t have an attorney that has
any clue. So now, I mean, we’ve had this before where we’re literally leading a buyer through some of these
concepts. And it’s like, this is really challenging to get this done when we’re explaining them, these concepts of
what it is. So, you know, selling to a sophisticated, well capitalized buyer, there’s actually some serious benefit to
that.
Speaker 2 – 19:41
Matter of fact, it’s the same thing that goes like private equity has. They build acquisition teams that are
knowledgeable and I mean, you can giggle or snicker at it, but, you know, a lot of them are, you know, Ivy League
graduates, right, that are fairly intelligent people and their whole job is to focus on the best way to buy this
company. So if you have a strategic acquirer, right, call it a competitor or ancillary business that, you know, it’s
called married years, they may not have those resources inside their organization, so they’re relying on their
counsel and their accountants to come up with these things. And I can tell you, even big companies sometimes
have bad attorneys and accountants or unsophisticated attorneys and accountants.
Speaker 2 – 20:22
So you could find yourself in a scenario where you’re leading the charge on something that they should be taking
the reins of. And you say, hold on, you know, am I really going to do this the right way? Are we sure we have all our
boxes checked? And again, that’s where if you’re working with an investment banker, you get some real value from
the guidance associated with that. But on the other end of that, like I said, this departure from private equity or this
fear of private equity, it’s not always necessarily a bad thing that they’re more sophisticated. And more importantly,
it’s what are you going to. My main question, I tell everybody is what would it be? Well, my main question would be,
what are you going to measure with respect to my performance after this deal closes, right?
Speaker 2 – 21:05
You got to look at how many hours I’m sitting in the office. Are you going to look at how many new clients I bring in
this year? Are you going to look at new systems that I develop? You know, any of those? I want to know what my
target objectives are so that 11 months from the date that we sell our business, they’re not looking at you saying
you didn’t do what we expected. And you say, well, I had no freaking idea what you expected in the first place. So
that’s the most important thing to me. And that’s whether you go to strategic acquirer or a private equity Group.
Speaker 1 – 21:37
What else needs to be known about selling to a private equity group?
Speaker 3 – 21:42
I mean, I would just say that I think one of the values that investment bankers bring is the ability to cut through kind
of their noise. Private equity groups, you know, and sometimes they hire search people and all these different
avenues to get close to business owners. And they’ll tell them a lot of things that. To get friendly with them and all
that, basically to try to get them to not go to market and talk to the whole market of potential buyers. So that’s
obviously what we want to do is show the buyer to all these different groups. Because if you only talk to one girl at
the dance, how do you know what the other girls are going to say or not say?
Speaker 1 – 22:26
So they’ll hire somebody to explain. Walk. Walk me through that.
Speaker 3 – 22:32
So they’ll hire a group, it’s usually called some research firm, and they’ll say, look, we’re working. We want to buy
financial advisory firms. And so they’ll hire a group and all they do is just make calls, an email and no, that.
Speaker 2 – 22:49
Legitimately connectors of people. That’s it. So they’re not sophisticated. They don’t negotiate the transaction.
They’re making a connection. But it adds an element of noise to a transaction because they’re very cagey about
what, who they’re dealing with, who they’re representing, who you’re talking to. It’s our job to go in and vet them and
say, are you dealing with a real person? Are you just fishing? Because there are actually guys out there that
independently, I should say people out there that independently will look through certain industries and they’ll say,
I’m representing a buyer. Would you be interested in selling? And then they’ll go to like five different groups, and
that’s their whole job, right? And then they’re going to try to get a contingent fee from the seller or the buyer on the
effective closure of a transaction.
They’re casting such a wide net because that’s how they make their money, that there’s not a whole lot of value in
what they’re actually providing. So it adds an element of complexity and element of confusion. And our job as the
investment banker is to sift through the bull crap and then show them the light. You know, who are we really
dealing with? Do they even have the capacity to do this transaction? Are these people just blowing smoke?
Because the goal is to not waste your time on, you know, call it ineffective buying tactics or acquirers themselves.
Speaker 3 – 24:02
And there’s a lot of things that smell like private equity that aren’t. Yeah, like this concept of independent sponsors
is big today, where you have a group that has a fancy website and says, we buy companies and things like that.
And, and they’re, you know, typically have some sort of operating experience and they’re out there trying to get a
company under loi and then they try to go figure out how they’re going to finance it. Sometimes they have it
already. You know, it just depends. They’re typically not. This isn’t a broad, you know, this is a generalization. But
they’re probably not paying the highest, you know, valuation. So they’re not bad, but you just have to know who
you’re talking to. And so one of our jobs is to peel that onion, okay? Buyers, everyone who’s the equity group.
Speaker 3 – 24:51
I mean, typically we know this in advance, but you know, we’re asking them questions, how does it work? How are
they involved? And then we’re asking also for references. So allowing our clients selling to talk to other sellers who
have, you know, sold, you know, a lot of times into that platform entity so that they can go and talk to if they’re not
willing to provide references, that’s a red flag and things like that. So, you know, our experience helps get
comfortable and create the conversation, you know, the conversations that need to be had about what life’s going
to be like, the terms, expectations, you know, all those things. And that’s really important to get comfortable with
any buyer. But definitely in the private equity space.
Speaker 2 – 25:39
I also think what happened, what must have happened in the past, not in our lifetime, but maybe before, you know,
that, at least in our professional existence, is that people got this idea that private equity was going to come in and
try to exploit some caveat or loophole in a transaction to screw you over when this thing’s done. I can tell you
confidently and that all the deals that we’ve done with private equity groups, which are a lot of them, I have never
seen that actually happen. Right. I think that the private equity groups are on such a, they’re on such a crunch to
return value to their investors right now.
They don’t have time, nor would the dollars even be worth it for them to heavily focus on a loophole that would
save them a little bit extra on a working capital true up or something like that. You know, anything small that’s like
true up related, where it hurts their reputation.
Speaker 3 – 26:27
Yeah, they’re not going to get the next deal. They’re not going to. They’re going to lose out on the next deal because
the Next seller is going to hear about how they treated somebody else in their industry.
Speaker 2 – 26:35
It’s helpful because it helps us focus. Like if we know the little issues are just not worth our time to chase from a
dollar’s perspective, then we know where we’re focusing our efforts. When we’re negotiating on behalf of a
potential seller, we’re going to focus on the core elements of the transaction that are, you know, of real value. So
you look at what happened like in Rice Energy, they went public in a series of the, A, a series of the option holders
before it went public that, you know, theoretically that, you know, the world on the street was they were terminated
before they could realize the value of their options that they had available. And that money, theoretically went back
into a, you know, a more confined owner pool.
Speaker 2 – 27:15
That’s possibly happened, albeit, you know, I pretty sure that would legally have implications if that was actually the
whole story of that. But private equity groups are focusing on those kind of things, right? So like, what is your
equity that you rolled over attached to inside our organization? If you’re not doing what we feel like you should be
doing, that’s when they would come in and say, you know, you may be subject to some sort of clawback, but it’s our
job to mitigate the opportunity for them to do that. So we focus on things like that. Employment agreements, right.
So how do you define it verbally? And then does that match what’s actually in an employment agreement? Right.
What are your, you know, larger scale indemnity holdbacks? We have to focus on those, the parameters around
those. Right.
Speaker 2 – 27:58
How easy is it for them to go in and grab that money under speculation of, you know, some infraction? The answer
should be it shouldn’t be very easy for them to do it. Right. If it’s harder for them to do it, then they’re going to be
less inclined to nickel and dime you for little things that may or may not be relevant. And then lastly, it’s going to be
just, you know, does it fit culturally? Because private equity groups need to fit culturally just as much as strategic
acquirers do. I mean, private equity groups all have a different flavor. There are some that are, you know, wholly
profit oriented and growth oriented. And if you’re, if you fit that mold as an individual, like you’re always chasing the
next deal, then that may work for you.
Speaker 2 – 28:37
But if you’re more of a lifestyle business operator and you’re going to go into that environment, that’s going to be a
hard thing culturally to change about Yourself, Right. It’s going to lend itself to critique, criticism and future turmoil
with respect to the buyer itself.
Speaker 1 – 28:54
What about employees, key employees? Do they normally get retained? Do they boot them out? What’s common?
Speaker 3 – 29:02
I’ve never seen a private equity group come in where they just start firing people. Sometimes people get fired, but
it’s because they deserve it. It’s not because they’re coming in and cleaning house and that’s how they’re going to
make all this money. That’s one of the stigmas about it, that if you vet, you know, the buyer and you understand
what they’re doing and you have conversations with them, like Andy said, it’s just as much of an interview of them
as they are of you. And we help facilitate that. Both like interviewing them independently, but then also bringing the
management team, the owner and the buyer together through a, you know, typically a full day meeting, dinner,
ancillary conversations and things like that. So that should be happening. If there’s no conversation before closing
that, like, how does everybody know this is going to work?
Speaker 3 – 29:59
So that’s really important. I think one of the other things we haven’t talked about is just the deal terms and like the
mechanisms like Annie was talking about indemnities and escrows and working capital. Most business owners
don’t know those terms. There’s also one of the things that happens is, you know, you get into due diligence and
you have a quality of earnings analysis where the buyer’s gonna be looking to support the ebitda. You know, that
you’ve put forward and looking at your historical earnings. And sometimes what can happen is if you haven’t done
a good job of that upfront internally with an investment banker or some other consultant to understand what that
is, you might think that you’re selling off of 10 million of EBITDA, but when they bring their group in and they recast
that, it’s really like 7 million.
Speaker 3 – 30:57
Now all of a sudden, your valuation is way different. In that private equity group or any other buyer is probably
going to retrade valuation. They’re going to change the deal and diligence. Now you’re in a tough spot, you’ve lost
leverage and all these different things. So you know how the understanding what’s around the corner in a private
equity deal is so important. If you, if you have advisors that don’t know it’s coming and they don’t understand that
process, then that will not turn out in your favor. Like, I can’t see how it possibly could.
Speaker 1 – 31:33
So how do you, in your EBITDA example, how could an owner mitigate that? Just have a do it in advance smart
team that is properly accounting for everything.
Speaker 3 – 31:45
Yeah. It’s not necessarily that the accounting’s wrong. It’s that sometimes they’re just taking out. Like a real easy
example is during COVID people got PPP loans and that ended up as being income in their P and L. Well, you don’t
get to count that. And the buyer’s not going to pay you multiples of EBITDA on your PPP loan forgiveness income.
You got to take that out. But there’s some buyers that don’t understand that concept or if you had some gain from
litigation or you sold a bunch of trucks or something, those are one time events that you take out. It can have the
reverse effect too is there could be expenses that you need to take out so to increase your ebitda. But a buyer’s not
going to tell you that they come across those. Right.
Speaker 3 – 32:28
So like what we do up front is that, you know, we’re underwriting that. We’re, we’re doing that analysis up front, you
know, so that we know what’s coming when they do it. And getting their accountants and everybody prepared, hey,
this is coming, this is what’s going to happen. And so that’s really important to understand that because
everybody’s going to do that and some buyers candidly will use that as an opportunity to retrade, change the
valuation before closing. And you have to set the ground rules in advance with buyers, say we’re not going to
retrade before you even get in there so that they’re only coming forward with real serious problems.
Speaker 2 – 33:17
You got to understand what you’re asking for recognizing. So if you want this alone, you may not be privy to the
concept of a Q of E. Right. Which is a requirement of almost every single PE firm that’s out there. Right. Even if you
have audited records, the reason it’s required is that the quality of the earnings that they’re buying is, you know, is
opportunistic for them. Right.
Speaker 2 – 33:39
It’s either going to show a really good picture and they’re going to be really, you know, let’s say, extremely excited
and ecstatic about doing the deal, everything turns out exactly the way that it is, or there are going to be gray items
that exist within the realm of the computation of what we call adjusted earnings or normalized earnings as
opposed to your just reported EBITDA number that they have an opportunity to challenge and ultimately reduce
purchase price. They’re never going to come back to you and say, this should be more. Your ad back for whatever
entertainment should be more. So we’re going to pay you more. What they’re going to do is they’re going to look at
that entertainment category and say, was this necessary to continue the operations of the business? If it was, why
are you adding it back? Right.
Speaker 2 – 34:22
They’re going to challenge those concepts. Where we step in is that we organize our responses to those questions
in a way that has effectively satisfied other groups through other sale processes in the past. So we’re not geniuses
by any stretch of the imagination, but we’ve been through these conversations. So when we walk in, we say, here’s
why we’re adding this back. You know, it’s not necessarily a bulletproof, but it’s a more defensible. It’s a more
defensible response. And the funnier things are, is these groups are hiring these. The quality of earnings that get
done typically happen at a big four firm. At least. A lot of the deals that we do are dealing with big four firms. And
you could have their New York group, you could have their California group doing it. Right.
Speaker 2 – 35:09
It just depends on the size of the deal and who the private equity group is comfortable working with. But then the
caveats that come with that are that, you know, you have things like salary add backs or replacement cost of
certain salaries. We have one deal where went in, were looking at it, we said, we need a CFO to replace the owner
who’s got, who’s a dual role in person. He’s CEO and cfo. Right now they had somebody lined up to take over the
CEO portion of his job. They did not have somebody to take over the CFO portion. And they said, well, what’s that
cost like? We put in, I think $150,000 for a controller CFO person as a replacement cost, which reduced their
earnings and ultimately the purchase price.
Speaker 2 – 35:48
And they came back and said, oh, you’re going to get somebody for less than 400 grand. I remember talking to
them asking if they have any open positions, because I’ll take $400,000 for a low level controller CFO position any
day. It just doesn’t happen in Pittsburgh. But they’re jaded by being out of state and they’re trying to apply global
economics to a very specific area. You know, Pittsburgh is just a different market. So you have to call them on it.
They have to try to call you on it. You have to See if you can hold your ground. But if you do your job up front, you
know, the quality of earnings can be an easy exercise. It just is an ominous information gathering exercise at the
end of the day.
Speaker 1 – 36:24
Cool. Well, I think that’s a good 2.01level. You know, we obviously could get more detailed.
Speaker 3 – 36:31
We could definitely go down some rabbit traps.
Speaker 2 – 36:33
That one we could tell a lot of stories about. But yeah, I tell you about my one guy, if I didn’t have to hop on this call.
But yeah, this one guy we talked to and he was a very arrogant guy and was fine, but we sat with him like four
times. We put a whole pitch together, showed him what his company was worth, everything. He sat down, he’s like,
I am knocking on a private equity. And he basically walked us out of the room. By the time were done, were like,
you’re crazy if you don’t entertain it. What’s it hurt to talk to him, right? Let’s see the disparity in the offers before
you turn it down. And he’s four up and down. He’d never do it. They’re evil. I hate them. You know, they’re just
assholes. I’m more successful than they are.
Speaker 2 – 37:10
I ain’t having any kids. Tell me what to do. We got to the end of it. We said, look, we wish you the best. If you need
any help, call us. We’ll do some consulting, but we’ll just leave it at this. Six months later, he sold the private equity.
I was ready to call him and be like, you’re something else, man. You just locked us out of the room.
Speaker 1 – 37:32
A lot of pros and cons to selling to a private equity firm. We hopefully went through that. And if you have any
questions or find yourself in this situation, feel free to reach out.