Understanding your buyers
This section explores the unique features and potential challenges of different types of buyers, including private equity, strategic, and US-based buyers.
Private equity
Jargon busting, documents, and drivers
For many founders, private equity (PE) jargon can be bewildering. The good news is that none of this is rocket science.
- ‘Private equity investor’, 'fund', 'sponsor', and ‘institutional investor’ – while these are all different types of investors, these terms are pretty much interchangeable.
- 'Leveraged buyout' – shorthand for any transaction where existing management and/or new management, together with a PE investor, acquire a company using third-party debt.
- 'Senior debt' vs 'junior debt' – senior debt is usually advanced by commercial banks and so-called because they normally take first-ranking security over the assets of the business. 'Junior debt' or 'mezzanine debt' ranks behind senior debt but ahead of equity. These can include high-street lenders or other boutique debt providers who specialise in this type of transaction.
The terms of the documents on a private equity (PE) deal may also seem somewhat 'over-the-top', perhaps even suffocating. It may be tempting to think that the buyer is looking to control the business. It is almost never the case that institutional investors want to take control, they would prefer to leave the management team to run the business day-to-day. However, they approach investments with heavy-duty documentation to ensure that a sufficient level of protection for their investment is maintained. The jargon and documents of the private equity world may be unfamiliar at first, but understanding what drives an institutional investor on a leveraged deal is simple. Essentially, it is getting the right mix of equity and debt to leverage the equity returns. This will be determined by confidence in the strength of the business plan and the amount of debt and interest it is believed the business can support through its free cash flow. The function of PE houses is to make acquisitions, help build and grow the business, and sell them. This means that PE buyers can often move faster than their trade counterparts due to their streamlined internal systems and external approach (including their familiarity with doing transactions).
In addition, perhaps unlike trade buyers, from the outset a PE investor will be considering their exit (which will typically occur within five years of their initial investment). This mindset is a defining feature of a PE buyout and will influence the structure of the deal and what protections you should expect.
How will you invest?
A PE buyer will most likely want you to re-invest or roll-over, grant sweet equity or some form of a stake in the newco structure (the percentage of your proceeds from the sale that they want you to invest will be a matter for negotiation). What does this involve?
Protecting your investment
As an investor after the sale, you will want to consider how best to protect yourself and your investment. Set out below is a list of the key equity terms and how you might want to position yourself against a PE investor. These are designed to be indicative of a typical situation and not to provide legal advice. You should always obtain legal advice and personal tax advice to understand exactly how the proposed structure will impact you.
Key Equity Terms
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Strategic buyers
Also commonly referred to as 'trade buyers', this is a type of buyer operating in the same or an adjacent space as your company, which is often making the acquisition for strategic rather than purely financial reasons. Strategic goals can vary, but typically include a desire to integrate assets and operations with a view to realising cost or other synergies, gain new customers, talent or intellectual property, expand product lines and offerings, and/or accelerate growth in new markets.
Sometimes, because they are buying for their own strategic reasons, trade buyers are prepared to make higher offers for businesses than PE houses who are looking for a purely financial return from the existing business. This is particularly the case now with many trade buyers able and willing to fund acquisitions exclusively from existing cash resources rather than having to rely on debt finance. Being part of a larger group may also offer new and enhanced opportunities to scale your business, with ready access to new markets, sectors, and/or sales and distribution channels, all of which will be particularly relevant if there is an earn-out or you are taking equity in the buyer group.
Against that backdrop, we consider some of the key features of an acquisition by a strategic buyer.
Deal structure
Strategic buyers tend to want to acquire 100% control when they undertake an acquisition and then integrate the business into their wider group. This may mean that ongoing management is given less autonomy than in a private equity deal, may find itself operating in a different business culture, or may no longer be required for the ongoing business. Management teams that do stay on are likely to need to make a transition from being "decision makers" to "decision takers", but the counterpoint to this structure and approach is that there is often a greater opportunity for a "clean break" than on a PE deal.
You may also find yourself dealing with a "hybrid" of PE and strategic buyers if a company already owned by a PE house (known as a "portfolio company") is making the acquisition (a "bolt-on" or “add-on” acquisition). The terms you receive as a seller may, in that case, be a combination of those provided by PE buyers on a typical buy-out (e.g. rollover or reinvestment on a higher level) and those of strategic buyers or more slanted to one type of buyer or the other, depending on the process of the negotiations.
Consideration structure
Unlike private equity buyers, strategic buyers do not tend to ask management to "rollover" or reinvest a portion of their sale proceeds into the company. They often instead offer more money up front, use "earn-out" consideration structures, and might, less commonly, offer shares in the ultimate, perhaps listed, controlling company of their group.
Earn-out
Earn-outs are used both to bridge valuation gaps between buyers and sellers and to incentivise the selling management team to stay on in the business, help with integration, and drive future performance. Unlike the equity issued to management on a PE deal, the upside of an earn-out is commonly capped, but it may be easier to achieve the target than performing above the third-party and shareholder debt hurdles set in a private equity structure (but, of course, this will depend on where the targets are set).
Share consideration
Selling your shares in return for shares in the buyer adds a new dimension to a deal, particularly where it is a pure share-for-share deal or where the share component of a mixed cash/share deal is significant. In those circumstances, sellers will need to grapple with many of the same issues as a buyer.
Valuation of consideration shares
If consideration shares are being offered, you will need to agree a value for them. This can be a thorny issue when it comes to unlisted companies, particularly if a buyer is seeking to rely on a previous valuation. It will also be important to understand what class of share you are being offered and where it sits in the return waterfall, noting that the consideration shares are being acquired for value and should be treated accordingly.
Reverse due diligence
Most sellers are not expecting to have to carry out due diligence when they launch a sale process, but where a significant portion of the overall consideration is in the form of shares, it would be worth carrying out some level of reverse/confirmatory due diligence on the buyer to ensure there are no material flags that impact your willingness to do the deal. If the buyer has completed a funding round recently or has itself been acquired (e.g., by a PE house), it might be possible to get access to the investors' due diligence reports on a non-reliance basis to short-circuit some or all of that exercise and bridge the gap between the date of those reports and your deal with appropriate warranty cover.
Contractual protections
As a future shareholder in the buyer, you should expect some level of contractual protection in relation to your "investment", both in terms of representation and warranties cover in the SPA (i.e., beyond the typical fundamental buy-side title/capacity warranties) and appropriate minority shareholder protections in the shareholders' agreement and/or articles of association. The extent of those protections will depend on relative bargaining positions and the size of your stake in the buyer – the stronger your hand and the larger your stake, the more you can expect here.
US buyers in CEE
It is increasingly common to find CEE growth companies the subject of interest from US acquirors, particularly given the relative strength of the US dollar and the perceived discount at which CEE targets trade relative to their US peers.
US buyers, especially those less familiar with the CEE markets, tend to have a different approach to deal terms and may look to implement these even where the target is based in CEE and local law is chosen as the law governing the transaction documents, so it is important to understand these differences in approach to help bridge the expectation gap on transatlantic deals.
We set out below some of the key differences between CEE/domestic and US buyers in their approach to the legal terms.