The 4 Types of Business Buyers: What Owners Need to Know
It’s tempting to gloss over the topic of understanding business buyers before selling your business. Aren’t all business buyers essentially the same? A check is a check, after all. Does it really make much difference when it’s all said and done?
The answer is a resounding yes!
Different buyers have different goals for purchasing your business. They also have different ways of financing the purchase and structuring a deal. Each buyer type may also view certain aspects of your business in a very different light.
When you sell your business, it helps to think of potential business buyers as customers. The more you know about potential customers — the more you understand their motivations and possible concerns — the better prepared you are to market your business for sale, find the right buyer, and get a deal done.
In this article, we’ll take a look at the four main types of business buyers. We’ll discuss their differences and similarities, as well as their reasons for wanting to acquire a business. We’ll also offer some tips on how to make your business attractive to any buyer type.
Who this article is for: This article is for owners of lower middle market businesses (annual sales from $2M to $25M) who are considering a sale – or choosing a small business exit strategy – in the next 6 to 36 months.
All Business Buyers Have 5 Things In Common
Before we get into how business buyers differ, it’s worth noting that most buyers have a number of basic things in common. These similarities can include:
- They are comparing your business to alternative investments.
- They want the owner to stay on for a post-sale transition period.
- They look for businesses with a solid track record and a bright future.
- They plan to pay out the full purchase price over time (not all at close).
- They will perform exhaustive financial, legal, and operational due diligence.
Knowing these things can help you prepare your business for sale and anticipate how buyers will approach the opportunity to acquire it.
To get further insight into the buyer’s mind, however, you need to have a basic understanding of the four main types of business buyers who are active in the lower middle market.
The first two buyer types are considered financial buyers. Strategic buyers are a category unto themselves, and both internal buyers and private equity buyers have a number of sub-categories. Let’s take a closer look at each type.
Individual Business Buyers
Many small businesses are purchased by an individual or small group of individuals. Some of these buyers are serial entrepreneurs who prefer to buy a successful business rather than start one. They tend to judge a business not only on the strength of its financials but also on its ability to improve and/or grow it after the sale.
Individual buyers may have plans to eventually sell the business when it’s achieved certain milestones, thereby receiving a handsome return on their investment. But these buyers don’t typically have a specific time horizon in mind.
These business buyers tend to be extremely confident in their ability to run a small business and often have deep expertise in an area of management like sales, marketing, finance, operations, or human resources.
One variety of individual buyer that you’ll encounter in the lower middle market is what might be called the opportunistic entrepreneur. This potential buyer is usually purchasing a business to replace a corporate job. In addition to wanting to own their own business, these buyers are looking for a reliable stream of seller’s discretionary earnings (SDE).
Individual buyers are financial buyers: They are looking for a business that generates a certain level of cash flow and has the potential to generate more. In particular, cash flow from operations must do the following:
- Replace or exceed a corporate salary
- Replace corporate health and retirement benefits
- Service any debt used to buy the business
- Produce excess cash flow to reinvest in the business
Many small business owners fall into the trap of thinking that the requirements above are the buyer’s problem, not theirs. In fact, the opposite is true: Your business will only be attractive to individual buyers if it has enough cash flow to support a purchase. This is why business brokers are forever advising owners to focus on cash flow and earnings metrics like SDE and normalized EBITDA (earnings before interest, taxes, depreciation, and amortization).
All financial buyers want a specific return on investment (ROI). Small business ownership as an investment class comes with a high amount of risk. Given the riskiness of business ownership compared to alternative investments, business buyers typically look for a business that will provide them with an ROI between 15% and 30%.
Private Equity Buyers
The term private equity often elicits a strong reaction from small business owners. Private equity groups (PEGs) have a reputation — deserved or not — for hornswoggling sellers into deals they don’t fully understand, only to saddle the business with debt, harvest assets, and extract egregious management fees.
Despite the mixed reviews, selling to private equity buyers can be an excellent way to exit your business, particularly if it’s positioned to scale quickly with additional resources (i.e., with access to more human and financial capital).
Many PEGs are actively looking for much larger target companies, which they often refer to as “portfolio” companies. They look to the lower middle market for smaller “add-on” or “bolt-on” acquisition targets that complement a portfolio company. Private equity firms also go on lower middle market buying sprees when they are pursuing a “roll-up” strategy by purchasing a number of small businesses within a certain industry.
There are different types of private equity, so it’s important to understand which type of PEG you’re talking to and which type may be the best fit for your business and personal goals.
Whether it’s a search fund, family office, or traditional boutique private equity group, look for the following characteristics:
- Operational expertise
- Open to a full exit by the founder
- Longer hold periods (3-5+ years)
- Clear ability to scale the business
- Industry expertise and connections
- Desire to keep the current management team
If your goal is to sell the business and move on to a new chapter in your life, avoid private equity groups that simply want the opportunity to recapitalize your business. Operationally focused PEGs have the best success with businesses in the lower middle market.
Private equity firms are professional business buyers. Like the individual category above, they are financial buyers, although they are accountable not only to themselves but also to limited partners and investors. As such, they are masters of financial discipline and will professionalize any business they acquire.
Strategic Business Buyers
Strategic buyers — sometimes called “synergistic” buyers — are often considered the holy grail of business buyers. Unlike financial buyers, a strategic buyer may be willing to pay a premium for the right business that helps them achieve their corporate growth strategy.
With that said, there needs to be a clear and compelling strategic reason for these buyers to acquire your business. They are typically larger companies — sometimes even public companies — and don’t simply buy a small business because they can. Their decision to buy a business is deliberate, analyzed rigorously, and weighed against alternative capital projects.
It’s not unusual for a strategic buyer to want just one piece of your business but still be willing to acquire the entire enterprise. Examples of this scenario are when a strategic buyer wants your customer list, employees, product line, or intellectual property. You’ll need to come to terms with the idea that this buyer will most likely take the piece they want, integrate it into their own operations and cost structure, then shut down and/or liquidate the rest of your business.
The big takeaway when it comes to strategic buyers is not to get swept up in the notion that they are the “best” possible buyer for your business. There are many suitable buyers for a lower middle market business. If you wait for a strategic buyer to come along and offer you twice the market value of your business, you may be waiting a very long time.
Internal Business Buyers
Another possible buyer for your business may be someone you already know well. Unlike the three buyer types listed above, this last buyer category is already “in” the business in some form or fashion.
Internal business buyers can include:
- Family members
- Employee Cooperative
- Employee Stock Ownership Program (ESOP)
There are pros and cons associated with selling your business to an internal buyer.
Advantages include a high level of trust in the buyer’s knowledge of the company, their proven ability to run it, and their commitment to continuing your legacy. Selling to an internal buyer can also be a more tax-efficient exit strategy for the owner and avoids having to pay a commission to a business brokerage firm. Internal buyers can also get favorable financing terms for an SBA guaranteed loan.
One downside of selling to an internal buyer is that it typically comes with a lower business valuation compared to selling to an outside buyer. In the case of installing an ESOP, for example, the value of the business cannot exceed the fair market value specified in a formal business valuation.
Additional downsides include family members and managers lacking the risk tolerance and grit that made the founder a successful entrepreneur. And selling to a partner can become a thorny affair unless you had the foresight to put a solid buy-sell agreement in place early on.
Selling your business to an internal buyer may seem like a simple exit strategy, but that isn’t always the case. Internal sales can be just as complex (or even more so!) than a sale to an outsider. Be sure to hire good advisors — an attorney, accountant, business broker, or merger and acquisition (M&A) advisor — and treat the process with as much rigor as you would with an outside buyer.
Understand Your “Customer” When Selling Your Business
Selling a business has a low probability of success. Most studies show that only about 20% of the businesses taken to market actually sell. The odds of success go up exponentially when you spend time on exit planning, understand who buys businesses in the lower middle market, as well as how they view business value and close deals.
Building a sale-ready business means understanding what buyers look for — what drives value in their minds — then making sure your business delivers. Far from being a speculative exercise, understanding what buyers want in a small business can translate into a higher asking price and a handsome payday when you’re ready to sell your business.
At Allan Taylor & Co. we believe in casting a wide net for buyers. We advise our business owner clients to keep an open mind: The best buyer for your business may be someone you’ve never even thought of.