9/16/2014 | Axial

Whether you’re considering a sale of your business now or planning for a future transaction, understanding the mindset of different types of buyers is critical to your preparation and decision-making processes. By understanding the motivations and goals of each type of buyer, you can better prioritize which buyers fit your situation and focus on the right relationships.

For the uninitiated, potential buyers and investors generally fall into two categories:

Strategic Buyers

Strategic buyers are operating companies that are often competitors, suppliers, or customers of your firm. Their goal is to identify companies whose products or services can synergistically integrate with their existing P/L to create incremental, long-term shareholder value. In other words, their primary incentive for the acquisition is strategic, hence the moniker. These buyers can also be unrelated to your company and looking to grow in your market to diversify their revenue sources.

Financial Buyers

Financial buyers include private equity firms (also known as “financial sponsors”), venture capital firms, hedge funds, family offices, and high net worth individuals. These firms and executives are in the business of making investments in companies and realizing a return on their investments within 5-7 years with a sale or an IPO.

Because these buyers have fundamentally different goals, the way they will approach your business in a M&A sale process can differ in significant ways.

There are four primary ways they differ:

EVALUATION OF YOUR BUSINESS

One of the most significant differences between strategic and financial acquirers is how they evaluate your business. Strategic buyers focus heavily on synergies and integration capabilities, while financial buyers look at standalone cash-generating capability and the capacity for earnings growth.

Since strategic buyers are often incorporating the acquired business into a larger business, it is critical for them to consider acquisitions based on how the targets will “tie in” with their existing company and business units.

For example, strategic acquirers will typically ask questions like:

  • Are your products sold to their customers?
  • Does your company serve a new customer segment for them?
  • Are there manufacturing economies of scale we can realize?
  • Are there intellectual property or trade secrets that you’ve developed that they want to own or prevent a competitor from owning?

On the other hand, financial buyers generally evaluate an opportunity as a stand-alone entity since it won’t be integrated into a larger company. A financial buyer focuses primarily on the business’ ability to grow very quickly in a short amount of time. In addition, financial buyers often buy businesses partially with debt, which causes them to scrutinize the business’ capacity to generate cash flow to service a debt load.

One note of caution is that not all buyers can be neatly categorized. Sometimes ‘strategics’ are just looking to boost their earnings and end up acting like financials. Other times, ‘financials’ already own a company in your space and are looking to make strategic add-ons, so they’ll evaluate your business more like a strategic. By understanding the motivations of the buyer, you can understand how they’re determining your business’ value.

THE IMPACT OF THE INVESTMENT HORIZON

Another key difference between strategic and financial acquirers is how long they intend to own an acquired business. Strategic buyers plan to keep a newly purchased business indefinitely, often fully integrating the company into their existing business. Financial buyers, however, typically have an investment time horizon of only 5 to 7 years.

This infinite versus finite holding period will impact how much a buyer is willing and able to pay for a business. When a financial acquirer buys and subsequently exits the business, especially in the context of the overall business cycle, will have an important impact on the return on their invested capital.

For example, if your business is purchased at the peak of a business cycle for 8X EBITDA and the buyer can only sell it for 6X EBITDA five years later, it’s tough to make an attractive return. As such, financial buyers are going to be more sensitive to business cycle risk than strategic buyers, and they will be thinking about various exit strategies for your company before making the final decision to invest in / buy your company.

DETERMINING THE INVESTMENT MERITS OF THE INDUSTRY

The industry in which a business operates will also have differing importance based on the buyer type. Since strategic acquirers are usually wedded to a general industry, by nature of their core product/services, they will spend a great deal of time focusing on how your business can integrate with their overall corporate strategy. Very often, these strategic buyers are looking to make an acquisition that can quickly and clearly impact the bottom line.

On the other hand, financial buyers focus on the entire picture: both your business and the industry in which it operates. Since financial buyers are often not wedded to a single industry, they need to decide both on the attractiveness of a specific business and the attractiveness of the broader industry. It is not uncommon for financial buyers to hire outside consulting firms to assist in this evaluation.

For industries that are highly regulated, unpredictable, or discretionary, pursuing relationships with a strategic buyer can help mitigate the risks associated with an industry.

STRENGTH OF BACK-OFFICE INFRASTRUCTURE

Strategic buyers are going to focus less on the strength of the target company’s existing “back-office” infrastructure (IT, HR, Payables, Legal, etc.) since many of these functions will be eliminated during the post-transaction integration phase. Since the acquiring business will already have these systems in place, it would be redundant to keep both.

However, since financial buyers do not have these functions already in place, they will need this back-end infrastructure to endure. As a result, they will scrutinize it during the due diligence process and often seek to strengthen the infrastructure post-acquisition.

As such, it would be better to de-emphasize the importance and/or value of your back-office infrastructure in discussions with a strategic, whereas it’s important to be prepared for thorough evaluation of these functions when having discussions with a financial buyer.

Understanding these differences between strategic and financial buyers is one of the first steps in completing a successful transaction in the private capital markets. For more information, seek the counsel of a seasoned M&A advisor to help further the process.

Axial (www.axial.net) is the largest network for professionals who run, advise, finance, and acquire private companies. CEOs and transaction professionals join Axial to access advice and capital, build relationships and exchange opportunities that help them and their organizations succeed.