Finding the right buyer for your small business (less than $1 million in EBITDA).

One of the biggest challenges facing a business owner thinking about an exit is selecting the right buyer.

It's relatively easy to find a buyer in today's market, especially if your business generates more than $3 million in EBITDA (earnings before interest, tax, depreciation and amortization. What about if your business is much smaller and generates less than $1 million in EBITDA? What kind of buyers are out there for your business and how do you choose which buyer to work with?

Businesses with less than $500,000 in EBITDA are almost always sold to individuals. Companies that generate $500k to $1 million in EBITDA are typically sold to individuals or to strategic buyers as "bolt-on" deals. Less frequently, these companies can be sold to financial investors on a standalone basis. These buyers have different objectives and you should think of the implications of selling to each one.

Individual Buyers

An individual buyer's objectives are 1) service the debt incurred in the purchase, 2) earn an income, and 3) build long-term wealth by increasing sales and profits. Individual buyers typically invest a material percentage of their net worth into equity in the deal and sign a personal guarantee for the senior debt. The senior debt is often more than their personal net worth. The need to service the debt is very high on their list of priorities, so they are very focused on operating the business at least as well as you have. Individual buyers typically don't have deep experience in your industry. They rely on you and your employees to help them learn the business for the first 6 to 24 months. A prudent individual buyer won't make major changes to a profitable business until they have had time to learn how it works and how it makes money. The individual buyer will focus on profitable growth while gradually paying down debt rather than radical transformation. They will normally keep almost all employees. Layoffs are uncommon unless the company is in distress. Typical changes might include adopting new IT systems, new digital marketing strategies, hiring new sales people, and making incremental operational improvements. The typical buyer would essentially do the things that you would do if you were planning to keep running the business for the next 10 years. In fact, many buyers will ask you what you would do with the business if you kept it, and then do exactly that once you sell to them.

An individual buyer will almost always ask you to carry a seller note. Seller notes are almost universal if they are funding the deal with an SBA loan. In general, you want 80 percent or more of the purchase price in cash, because your seller note will be subordinated to the senior bank debt. A seller note can be attractive, though, because it pays you the headline interest rate on the note amount before capital gains tax is paid. In other words, you are effectively reinvesting in a bond without taking a 20 percent haircut from capital gains taxes. This means that your pre-tax return on the seller note is 20% higher than if you took the proceeds in cash, paid capital gains tax, and then bought a commercial bond. The interest on the note is taxed as ordinary investment income and the principal repayments are taxed at capital gains rates spread over the life of the note. This can be a nice way to reduce your immediate tax liability and provide significant amount of cash flow over the life of the note. The terms of the seller note will be dictated by the senior lender - the buyer doesn't typically have a lot of power in that relationship.

An individual with financial backing from a family office like ours or a private equity fund, will behave just like any other individual buyer, except they have more resources to contribute if the company requires it. This can reduce the credit risk on the seller note, even without an explicit loan guarantee (which you won't get), because the investor doesn't want to lose their equity investment to a loan default.

Strategic Buyers

A strategic buyer is someone who wants the business because of the position it occupies in the marketplace. They already have a business - most likely a competitor, but possibly a supplier, customer, or a similar business in an adjacent market. Some strategic buyers are family owned, some are owned by private equity (typically called "platform companies"), and some are large companies owned by financial investors. When dealing with a strategic buyer, it is very important to understand exactly why they are interested in your business. They want more than just the cash flow you generate. Typically, strategic buyers purchase to capture share in your market and/or because they see significant cost savings (i.e., "synergies", also known as headcount reduction) from the acquisition. The business will see the least change if the buyer isn't active in your geographic market and doesn't sell a competing product or service. Back office functions, such as accounting, HR, and IT will almost certainly be centralized. Most of your employees who work in these areas will probably lose their jobs. The number of front-line employees involved in sales, production, or direct service to customers will probably increase because the buyer will invest in increasing sales and growing the business. Top management will probably stay in place for a while, giving the buyer a chance to evaluate them and decide whether they fit with the new company culture.

Selling to a strategic buyer that is a direct competitor will lead to significant change in the company. In many cases, the buyer wants your customers, but doesn't necessarily want any of your people. After all, they already have a factory, a warehouse, or a service center, as well as all of the back office functions at their headquarters. It is not uncommon for the majority of your employees to lose their jobs in this case, often shortly after the sale closes. Because a strategic buyer often considers post-closing cost reduction (i.e., layoffs), they can offer a higher price for the business than an individual or financial buyer. A strategic buyer will also probably offer a higher percentage of the deal price in cash at closing than an individual or financial buyer.

Financial Buyers

Financial buyers rarely purchase companies in this size range to operate on a standalone basis unless the owner agrees to stay with the company in an executive role. Companies with less than $1 million in EBITDA typically don't have a large enough management team with the skills and experience to operate the business profitably without the direct day-to-day involvement of the owner. You know you are selling to a financial buyer because they will require you to reinvest a significant part of the sale proceeds in equity in the business and they will want to tie you up with a three to five year employment agreement. This makes sense for some people, but not all. For example, if you are nearing retirement and are ready to move on with your life away from the business, a financial buyer may not work for you. On the other hand, if you want to stay in the business and are selling so you can diversify your net worth away from the business, this might be an attractive option. Some business owners make as much money selling their minority interest five years down the road in a second transaction as they did from the first sale.

The typical financial buyer will tell you all about their operational experience and how they are going to add value to the business above and beyond the capital they bring. This is generally false in my experience. Rarely do financial buyers have any real understanding of how to run your business. Rather, they expect you to know how to run it. They will hold you accountable to new financial metrics that you may not have used in the past. Some will be useful, some less so, but you will effectively have a new boss, even though you still own part of the company. Your new boss will be quite demanding, asking why you are not meeting your sales and profit goals. If you meet your goals, they will raise them for next year. If you don't meet their goals, they may fire you, which can trigger a forced sale of your stock at a discount to market value. Selling to a financial buyer can lead to financial independence at the expense of operational independence. Many business owners say that being their own boss is one reason why they started a business in the first place. Only you can say how you would feel about this. Of the people I know personally, very few enjoy this relationship over the long term.

Which of these buyers is right for you?

It depends on what's most important to you. If you are ready to walk away, don't sell to a financial buyer who expects you to stay. If you want the highest possible price and don't really care what happens to your brand or your employees, a strategic buyer who can capture cost synergies (i.e., lay off lots of people) is often the best option. If you want your business to continue, but with a fresh injection of vision, leadership, energy, and commitment, consider an individual buyer.