How Important is Your Management Team when Selling to a Private Equity Group
By John Herubin,
The M&A market has once again reached activity levels nearing the pre-recession peaks. There are numerous reasons for this level of activity, but one of the more visible influences is the growth and availability of funds to purchase companies from financial buyers, more specifically private equity groups (PEGs). You have likely heard the saying “business is people”, and this axiom is being demonstrated by many PEG buyers in today’s market, where management teams have become a particular focus. We have increasingly seen PEGs place an emphasis on existing/in-place management teams as essential for determining, maintaining and increasing an entity’s value (their investment). Strategic buyers are generally less concerned with management strength as they will likely consolidate/eliminate redundant positions and functions to realize efficiency and operational synergies, although even some strategics will need key managers for an acquisition. Many of these PEG buyers do not have the “bench strength” to place key management people at the acquired company, and it may take time and significant expense to find qualified management, or augment and supplement existing key management employees. Depending on the particular business, key management employees may include sales managers or key sales people, CIO, CFO, COO, CTO, product or design engineers, or anyone viewed as being integral or essential to the continuing growth of the sales, operations, or customer/vendor relationships of a business. This current emphasis on “people” should not be ignored or minimized by a selling owner.
We have seen attractive offers erode in value after operational due diligence reveals that the management team is not very strong in a capacity desired by the PEG buyer to maintain or increase the profitability of the business. Many times the buyer is not directly exposed to the key management employees until the latter stages of due diligence, so making sure the employees are capable of articulating or demonstrating their competency and value is crucial to the seller.
Selling owners should continually assess the strength and weaknesses of their management team. The sooner before a sale (1-5 years) an owner begins looking at management team strength, the more options available to ensure the management team will ultimately be desirable and valuable post-sale. We have seen companies enhance their management teams through any or all of the following:
- Hire from competitors
- Executive search firms
- Through acquisition
- Recommendations from advisory boards
- Consultation with potential buyer pre-sale
Most deals we see in the lower middle market require the selling owner to remain with the company post-sale to assist with transition, generally for a 6-12 month period, and longer if private equity purchased. If the owner is not going to be active beyond this period, they should consult with their investment banking advisor to determine what types of buyers may ultimately be approached. Some PEG buyers may expect the succeeding management team to be ready to “plug and play” and seamlessly operate the business. This expectation may assume that key management can perform beyond their current capabilities (i.e. increase sales (2-3X) in a short period of time, grow in foreign markets, expand product lines, industries served, or current operating locations, pursue and complete acquisitions). Management may not be capable or experienced in any of the above.
If the owner has some level of contingent compensation or value tied to the deal (which is often the case), they need to understand these expectations, and more importantly the management team’s limitations prior to moving forward with a particular buyer to make sure the management team is capable of meeting those future growth and profitability hurdles. Sometimes this assessment by the owner is based more on qualitative and not quantitative considerations. We recently conducted an engagement to sell a client’s business that received numerous offers to purchase. As we assessed the offers, one stood out with a quality PEG firm that was higher in dollar value over the others, although there was a meaningful contingent value component to the selling owner. Upon further discussion with the prospective PEG buyer, it became apparent that their expectations of the successor management team were to aggressively grow the business into multiple new markets at a rate that they had never previously attempted or achieved. They were not comfortable or capable of performing at the projected levels. This can be a recipe for disaster for an owner, the PEG buyer, and the viability of the business.
Our client valued his management team which was talented and capable, but was not quite the skill level fit for the level of expectations that the PEG buyer desired. The owner did not want to jeopardize his future contingent value, the livelihood of his employees, or the future success and existence of the business in a small community. We ultimately negotiated a deal with a family office buyer that had a slower and more deliberate growth plan that meshed better with the talents and capabilities of the existing management team. Having a longer growth strategy enabled the management team owners and buyer to assess key employee needs going forward to meet the growth and profitability strategy they desired.
Since many PEG buyers expect a willing and capable management team post-sale, and often offer post-transaction equity-based incentive compensation structures, the current owner needs to assess whether the management team possesses the requisite ownership mindset. The PEG buyer will want to insure that the management team is properly incented to continue growing the business and executing on the buyer’s strategic plan which will increase the value of the PEG’s investment as well as the personal net worth of the management shareholders. Several types of stock ownership or incentive compensation plans may be available pre-sale to incentivize and retain key employees and management. This strategy will enable management to experience the feeling of actual ownership and adopt a more proprietary role in operating the business. Some management team members are not interested, nor capable of taking on an ownership role. The current owner needs to discern this so that appropriate measures can be taken to minimize or eliminate the impact on sale value this may have.
These same employees may also possess key customer relationships, industry expertise, or technical skills that need to be preserved post-transaction. This is often accomplished through such measures as non-compete and non-solicitation agreements, and retention bonuses to ensure certain key employees stay through the completion of the transaction and for a period following.
In the event an owner identifies a management team need pre-sale, they should cautiously consider and assess the impact of hiring to meet that need may have on the ultimate sale price. We advised a client several years prior to selling that a subsequent buyer would likely decide he needed both a more experienced CFO, and an outside sales representative. Since every dollar used to hire management team talent reduces EBITDA (profitability), spending $250,000 on these positions could possibly result in a reduction of sales price of $1,500,000 (in this case the company ultimately sold for 6X EBITDA, so 6 x $250,000 = $1,500,000). The client realized that by hiring an outside sales rep with established relationships; he was more likely to generate greater profitability sooner than by hiring a CFO over the currently competent Controller. The PEG buyer was able to find a more desirable CFO to meet their long term strategy. The seller did not spend the money to hire the CFO which resulted in a greater profitability and ultimately a greater sales price for the seller.
The following questions about the management team are some of the more important things for both sellers and buyers to know in determining management’s value to the business:
- How active is the owner on a day-to-day basis?
- Who do key customers call when there is a problem?
- Do key managers receive performance reviews and are they performing to expectations?
- Do key management employees think and act like owners?
- If the owner is hit by the proverbial “bus”, how will the company operate?
- Does the management team meet as a group to discuss short and long-term strategic goals with the owner?
It is the rare instance where a PE buyer is not critically assessing the value a management team contributes to a selling business. Owners who are going to eventually sell should be vigilant about continually assessing the strengths and weaknesses of their management team also. This internal diligence should include consulting with their trusted advisors to grow and maintain these essential assets (management team) that will attract a premium value from a buyer as time moves closer to a sale date.