In this episode, Drew talks about the three highlights of how deals go down in the private equity process.
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- Three highlights on how deals go down in the private equity
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Hey, everybody. welcome to the Nerd Marketing Podcast. Drew Sanocki. I’m still here in San Diego, still stuck. East coast is being slammed by another nor’easter. My wife’s watching the kids. It’s always good when you negotiate with your wife like, “Hey, I need you to watch the kids because I got this business thing I gotta deal with on the west coast. It’s only gonna be 48 hours. I’ll be back in a couple days.” You negotiate that, she signs off, and then you’re there for the whole week, and every time they FaceTime you, they see palm trees in the background, and you FaceTime them, it’s like dark because it’s snowing. They’re losing power and stuff.
So shout out to my wife, Sarah. I love you. Thank you for watching the kids. But it allows me to talk a little bit more about buying and selling a company, private equity.
In this podcast, I’d like to delve into kind of how it goes down. I was working on the AutoAnything deal for maybe two months. It was accelerated because AutoZone wanted to close the deal by the end of their fiscal quarter. Typically, these process … I’ve been a part of deals that have gone for like six months, and those are only the bigger ones. On the other end of the spectrum, when I sold Design Public, my small first retailer, that probably took about a month.
It has to do with a lot of things: how sophisticated your buyer is or your investor, how buttoned up your own business is. But today I kind of want to talk about how the deals go down and really highlight three things.
Number one is the process. This is the process you will go through if you go to sell your business or raise money or, if you are on the other side of the table and you wanna buy a business. That’s the process.
Number two: quick sidebar on valuations, just where you get them. Do they come out of thin air or not? And I just wanna touch on the third thing: control. That obviously applies if you are not exiting a business, but if you take an investment, control becomes a big thing. How much control do you give up of your company?
Again, this all applies whether you are doing the buying or the selling, but let’s start with the process. The process for … I’ve probably been a part of 20 different deals, some as the buyer, some as the seller. It kind of all follows the same four or five steps.
The first step is that, if you are selling, you hire a banker to run your process or a broker or decide to do it yourself, but the general idea of the process is that the banker or you, whoever’s running the process, creates a deal book. The deal book is, I don’t know, 10 to 20 pages, nice and pretty, with a lot of charts and graphs showing just what a wonderful investment your company is. You spend some time working with the professional to kind of put that deal book together, and then you or whoever you’ve hired approaches potential buyers with that deal book. The idea is to drum up interest.
Typically, the banker will add some urgency into the process like, “Hey, here’s the deal book on Auto Anything, and if you are interested, we’d like some approximate bid or something by next Thursday.” There might be a couple calls with potential investors then or potential funds, but the first step is assembling that deal book and getting it in front of the right people.
That’s, I’d say, the more proactive way to sell your business. There’s always the reactive way, which is when you get an email someday that says a fund’s had their eye on you, and they wanna invest or buy you. But it’s one of those two ways.
At the end of drumming up some interest in the business via that deal book ideally is what’s called an LOI or a letter of intent. That’s where the fund or the buyer has done his or her homework, and they go off, and they say, “Okay, well, I really like this business here, and I think we are prepared to do a number of things. We are prepared to either, number one, buy it outright, or, number two, make an investment in it. We would like, if it’s the latter, we’d like this percentage of the business at this valuation.” That’s all put together in an LOI.
They deliver the LOI to you, the business owner, and you review it and say, “This works” or, “This doesn’t work.” If it doesn’t work, then it’s sort of onto the next potential buyer. If it’s in the ballpark, you sign that LOI, typically the buyer will want some sort of exclusive on the deal during which they perform diligence on your company. So the LOI kind of shows that the buyer is serious and ballparks a valuation.
If you sign off on both those … You’re kind of doing your diligence, too. You don’t wanna give an exclusive on your deal to just anybody. You wanna make sure this is a legit buyer. Maybe they’ve done deals in the past. You’ve done some research on them, and if you decide they’re legit, you sign off on that LOI. You give that one buyer an exclusive, not always, but usually that comes along with the territory, and then you set a period of time during which they can do diligence on your company.
You enter what’s called the due diligence period. Design Public, I think it was about 30 days, maybe 60 days. For bigger deals, it’s probably gonna be a matter of months, but, really, you wanna minimize that due diligence period as a seller because it’s invasive to your business, and it’ll take you down. You no longer can sit there and think about marketing ways to grow the business or what kind of products you’re gonna come up with.
Your primary job during diligence is to just interact with the banker, with the buyer through your broker or through your banker and provide things like financials. What did the business do over the last X years? They’re gonna want everything. They’re gonna want everything from exports from your accounting software, but they may wanna see contracts that you have with your vendors. They might wanna see supply chain documentation. They might wanna see customer data like how big is your list and how often do they buy? Really, it’s kind of up to you how much you are comfortable providing.
It kind of goes without saying, you’ve signed an NDA with the people at this point, but, really, like how invasive do you wanna let that buyer be? There’s probably two different categories. There’s the legit buyer who does not run any competing business, but there may also be the legit buyer who runs a competing business or is a bigger player in your category. It’s a tough decision in that case, how much do you wanna open the kimono for someone who may just use this LOI and this diligence period to build up competitive intelligence.
Decisions only you can make in consideration with your broker, but the diligence period will last a while. There’ll be a lot of phone calls, a lot of presentations, a lot of answering questions. You’ll go back to them with data. They’ll come back to you with more questions. It’s really painful, and it’s painful on both sides. AutoAnything, that was the period of time where I was flying back and forth from New York to San Diego to sit in a hotel conference room with whoever was sort of in the know at the company.
Typically, you’re selling a company, you’re not letting everybody at the company know. It may just be you and your accountant or maybe you and your executive team. Whatever it is, you don’t conduct these meetings on site. You go to another location and typically meet the potential buyer, and the broker or the banker is right there to make sure everybody is, everything’s above board and proper questions are being asked. But that’s the diligence period.
What the buyer is doing with the diligence is assessing things like potential risk in the business. Are the stated numbers legit? Are they sort of being fudged? Are there any accounting irregularities or legal problems we gotta worry about with this business? That all informs the ultimate bid. I think it’s not in poor form to change that bid that was in the LOI, but you gotta remember, the LOI was just a ballpark bid based on publicly available information. After the due diligence period, comes the more informed bid on the company.
Typically it’s lower. I don’t know, out of the deals I’ve been a part of, how many times it’s gone up, but you gotta expect the deal to trade down a little bit by that ultimate bid. That ultimate bid is where a lot of conditions might come out. You know, “We will value you at 10 million if you personally stay involved in the business for X months or years” or “We’ll give you 20 million for the business if you’re open to taking 10 million up front and another 10 million as like a seller financed or something.”
That’s where the deal happens. You, of course, say yes or no to the bid or maybe pushback, renegotiate. That happens at the end of the diligence period. If all parties agree, hopefully there’s an investment, and the investment could be to buy you outright or it could be to take a share of your company in exchange for some growth capital.
That’s roughly the process you follow for any of these deals. The investment is sort of marked by what’s called an APA or an asset purchase agreement if it’s an asset deal. If it’s not an asset deal, if it’s a stock deal, there’s a similar document, but it just has to do with whether the buyer is assuming the legal structure of your current company. You sign off on that APA, send it in, and you get the cash transferred to you.
That’s the very end of the process. You probably have a couple new board members if you’re gonna keep the business, but roughly, that’s the process you follow. There are a couple levers that, obviously, even if you’re selling, there are really two things that get negotiated. Number one’s the valuation of the company.
Number two is the control that you give up.
Let’s talk about valuations for a sec. Valuations determine how much of your business you give away in exchange for some capital. That might be 100%. As I said in the last podcast, this is typically based off a multiple. What the buyer is gonna do is put a multiple on your company based off of what they are seeing out in the marketplace.
If you are listening to this podcast and running a SAS company, most SAS companies now are bought and sold on a multiple of revenue, and most e-commerece companies are bought and sold off a multiple of owner’s discretionary cashflow or EBITDA, which is earnings before interest tax deduction amortization. This is total rule of thumb. It depends. It depends on a million things.
“What impacts the multiple? Well, I already talked about size. The bigger the company, the bigger the multiple. Growth impacts your multiple, so if you are growing like a rocket ship and plowing all your available profits back into the business, now that’s, obviously … You might argue for a multiple of revenue. Then, you’re not gonna have any cashflow to slap a multiple on.
On the other end of the spectrum, if you’re in decline and this business is just going down year after year even though you are profitable, the multiple may be lower because the buyer’s like, “Eh. This is a falling dagger here, so it’s a much lower multiple.” It depends as far as the multiples are concerned. For most e-commerce companies doing under five million in revenue, three times owner’s discretionary cash flow is what I see.
If you’re curious for a more detailed estimate or a more accurate estimate given your unique position, maybe pop up in the comments of this episode or reach out to any of the brokers that kind of deal in your space FE International, Quiet Light are some of the bigger ones. Those guys will run a valuation for you.
But valuation determines how much of the business the acquirer will get, so if you’re look to raise five million dollars and the valuation of your business is ten million, you’re gonna expect to give away 50% of your company for that five million. Right? Makes sense.
That immediately leads to the next question: control? When I think about control, I read Tech Crunch like everybody else, and you see … Or Fast Company. The headline is always like, “Congratulations! This company just closed a 35 million dollar round.” I find that ironic because it just means that that company gave away … It’s like, “Congratulations! This company just gave away 30 to 60% of its equity to somebody else.” “Congratulations, founder, you own like 30 to 60% less of your company.”
That’s sort of lost in the hype around the headline of how much money you raised is that, yeah, you raised it because you gave away a lot of your company. Equity investments are expensive. They’re expensive because you’re giving away your company. Debt is a lot cheaper. Debt being, “I’m gonna go get a loan.”
I’m gonna get a loan, and if the loan’s from the bank or the small business association and there’s an interest rate on that, I just gotta service that loan, but I haven’t given away any of my company to get it. Right? So equity is expensive, something we should keep in mind. Again, it gets debated in lockstep with valuations when you are raising money.
If you want some growth capital, be prepared to discuss the valuation of your company and think in the back of your mind about how much of your company you’re gonna give away in exchange for an investment.
The internet is rife with tales of founders who lose control of their companies. You gotta ask yourself if you give away the majority of your company, are you gonna like your new boss because you’ve just, essentially, hired a new boss? For some people that’s a good decision, it’s a very strategically well thought out decision. For others, it’s not as well thought out. Just make sure you think about it.
That’s kind of a short episode on how a deal goes down. In the next episode, I’m gonna talk a little bit more about maximizing your valuation. If you are in the position to raise some money or sell your company, there are a couple things you wanna do to maximize that valuation, to make sure it’s higher, obviously, because it means more money in your pocket at the end of the day.
That’ll be next episode. From sunny San Diego, I wish everybody a great week, and I’ll talk to you next time. Thanks.