Key Considerations When Selling Your Business to a Private Equity Buyer

Few events are more stressful or exciting in the life of a successful founder or CEO than steering a company through an M&A exit. While the sale of a company can be filled with exhilaration and financial reward, the process that culminates in an M&A exit typically begins months, if not years, in advance, and can be especially time-consuming for a board or management team that is primarily focused on running a business.

M&A processes are inherently designed to maximize shareholder value, and therefore often involve both private equity and strategic buyers. Private equity buyers present a unique set of opportunities and risks that companies need to understand and evaluate when compared to an exit to a strategic buyer.

This article focuses on four key themes that companies need to be aware of when selling to a private equity buyer: execution speed, representations and warranties insurance (RWI), certainty of buyer financing, and rollover equity terms and conditions.

Execution Speed

Because private equity buyers are in the business of buying and selling companies, they often have more experience than strategic buyers navigating the acquisition process. This experience can allow private equity buyers to move through the stages of an M&A transaction, including executing a letter of intent, conducting due diligence, and finalizing definitive documentation, more quickly than strategic buyers. Many strategic acquirors are highly skilled at M&A but generally have larger teams involved in the deal process and require buy-in from more internal constituents, and may have more onerous internal approval requirements. By contrast, private equity buyers generally staff lean deal teams, have trusted relationships with financing sources and RWI providers, and have fewer decision makers, allowing for more efficient execution.

However, the efficiency of being acquired by a private equity buyer often comes at a price. Sponsors are typically not willing to pay as much of a premium as a strategic acquiror for the same target, due to the lack of the same cost or product synergies and other strategic benefits available to strategic buyers or the inability to obtain financing that can compete with a large strategic buyer’s balance sheet.

Taking full advantage of a private equity buyer’s ability to execute quickly requires a lot of preparation on the sell side, including collecting and organizing diligence documents and reviewing and strategizing around known issues in advance of engaging with a buyer. Sellers should engage their legal and financial advisors early in the process if they want to be in a position to take advantage of a sponsor’s ability to execute quickly.

Representation and Warranty Insurance

While a private equity buyer may not be inclined to pay as much for a target company as a strategic acquiror, private equity buyers often use RWI to get sellers more cash at closing and eliminate or minimize tail risk to the sellers. M&A transactions historically included indemnification escrows or holdbacks to provide the buyer with security in the event the seller breaches its representations or warranties. The advent of RWI allows buyers to insure against this risk. As a result, buyers who purchase RWI do not require an indemnity escrow for unknown claims. Eliminating that escrow gets sellers more cash at closing.

RWI also facilitates walkaway deals. Because buyers can look to the RWI policy in the event of a breach, buyers are much more willing to forego a post-closing contractual remedy against the sellers (absent fraud). Negotiating for a walkway deal should be a key consideration for any company with a broad shareholder base, and steering a buyer to purchase RWI is an effective means of providing buyers with a meaningful remedy while still achieving that objective.

Certainty of Financing

While strategic buyers often fund acquisitions from their balance sheets, private equity buyers typically use a newly formed entity that has few, if any, assets to serve as the “buyer” in platform acquisitions. Private equity–owned businesses may also acquire target companies using financing from the private equity sponsor, in addition to balance sheet cash and/or debt.

Sellers need to be sure that a buyer can fund the purchase price at closing. Therefore, in most transactions that do not have a simultaneous sign and close, sellers will require that the buyer’s private equity sponsor provide the buyer with an equity commitment letter to backstop the buyer’s obligation to pay the purchase price at the closing. If the closing conditions are satisfied and the buyer doesn’t pay, the seller can seek to specifically enforce the equity commitment letter, thereby requiring the sponsor to fund the buyer with cash sufficient to allow it to close the acquisition.

If a transaction agreement provides for the buyer to have liability in the event that the transaction does not close (for example, if the sellers seek damages rather than specific performance), then the seller may require that the buyer’s private equity sponsor provide a limited guarantee of the buyer’s obligations under the purchase agreement, including in respect to any reverse termination fee.

Rollover Equity Terms

Private equity buyers commonly require that key shareholders, particularly founders who remain involved with the business and members of senior management, retain a minority equity position in the target company post-closing. The retained or “rollover” equity is primarily intended to align the interests of the buyer and sellers in the post-closing success of the target company and is a tool that private equity sponsors employ more frequently than strategic buyers. Not all rollover equity is created equal, however; it is important for sellers to understand both the economic and governance terms of any security issued as deal consideration.

In terms of economics, rollover equity may be pari passu with the sponsor’s equity, or it may be subordinated. If it is subordinated, the subordination can put the rollover equity behind the sponsor’s liquidation preference, in amounts that may include a coupon or minimum return, in addition to a return of capital.

Except in limited situations where the rollover is substantial or in joint ventures, holders of rollover equity typically receive limited governance rights. Even when the rollover is small, however, sellers will want to negotiate for certain basic minority protections, similar to what a small venture investor might obtain. These rights typically include (1) preemptive rights on new equity sales, (2) tag-along rights on a change of control, (3) permitted transfers to affiliates and for estate planning purposes, and (4) appropriate carve-outs from any drag-along provision to ensure that the sellers are not required to enter into any off-market indemnification obligations or restrictive covenants in connection with a subsequent sale of the target company. Rollover sellers with more bargaining power may also seek to limit the sponsor’s ability to engage in interested party transactions, or at least limit such transactions to those entered into on an arm’s-length basis. In any event, negotiations over the economic and governance terms of the rollover equity often become a substantial part of the overall deal dynamic.

Conclusion

Selling to a private equity buyer can offer speed, deal certainty, and creative structures that appeal to many founders and boards, but these benefits come with unique considerations. Understanding how execution dynamics differ from sales to strategic buyers, leveraging tools like RWI to maximize cash at closing, securing robust financing commitments, and negotiating rollover equity terms are all critical to protecting value. By anticipating these issues early and engaging experienced advisors, sellers can navigate the complexities of a private equity transaction and better position themselves for a successful exit.

Alex S. Kaufman, Partner (San Francisco), Private Equity Practice

Jason Miller, Associate (San Diego), Corporate Practice
 

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