What to Know & Discuss When Negotiating with a PE Firm (Part 3/4)
Congrats! You have decided to seek support from a private equity firm and have inquired internally on all the important questions to consider in a PE deal. Now let’s discuss what to know about PE firms when negotiating, topics PE firms will focus on while negotiating, and more.
Before negotiating with a PE firm, it is wise to be informed on what they will discuss, specifically the objective and timeline for each investment. Traditionally, PE firms set a goal for each investment to deliver a substantial return in three to five years. Often, the goal is to either double an investment in three years or see it triple within five years.
A time-constrained, returns-based approach to M&A means that PE firms are interested in identifying whether your company, for example, has high growth potential or if efficiencies or bolt-on acquisitions can markedly increase your short- to medium-term profitability.
Technology companies need to be aware of the focus on growth and create detailed plans and strategies for how such short- to medium-term goals can be realized without jeopardizing long-term growth and the future vision for the company. Reaching a constructive agreement with the PE firm on such plans is crucial.
What PE Firms Focus on While Negotiating
When negotiating with a PE firm, PE firms will focus on the following, among other areas:
- Technology: The firm will assess your products, services, technology, intellectual property, and R&D. IP rights and future potential in a rapidly changing market are two key areas that PE firms pay extra attention to during negotiations.
- Management/employees: The PE firm will focus on the ability of management and employees to deliver on business strategy, overcome challenges, create new solutions and grow the business. Documenting your track record of reaching set targets will also be crucial.
- Succession planning: Your company should have a pipeline of talent and a complementary strategy in place for replacing key employees if they retire or leave the company.
- Contingency plans: Every industry and individual business goes through ups and downs. Specific clauses that address what happens in case of market changes and govern the decision process in such cases will be mapped out by the PE firm.
- Market trends: The firm will evaluate where the market and sub-industry you are part of is headed — both on a macro and micro level. Changing customer demands, new technological developments, and similar trends all have the potential to benefit or threaten your market position and service portfolio.
- Cash flow: Documenting recurring cash flow and the ability to expand sales to both new and existing customers can go a long way towards securing a PE deal.
- Investments: The firm will want to know what you are going to use the money from the deal for and how it helps you achieve growth.
- Exit strategy: Every PE deal needs an exit strategy. What happens with the company, and funds raised, through a future sale or IPO?
- Areas of exposure: The firm will assess risks, such as tax liabilities, quality of earnings, revenue recognition policies, sales and international tax exposure, and other areas that could potentially expose the business to legal threats. Often, PE funds will engage established accounting firms to perform this due diligence.
Prior to negotiations, PE firms will have mapped out their take on various aspects of your company, including its and used it to form an outline of deal terms. Carrying out a similar process and preparing your own arguments — based on detailed data and documents to support them — will give you a much stronger starting position for negotiations and help speed up the negotiation process. Knowing how to value your company is also an integral aspect of being prepared for negotiations
Know PE’s Situation When Negotiating with a PE Firm
Another important factor when negotiating with a PE firm is knowing what the situation is like on the other side of the table. It helps make it easier to discern your position and whether different tactics will be effective. BDO’s bi-annual Private Capital Pulse Survey provides good insight into the current situation for PE firms, which can stand you in good stead during negotiations.
Among the survey’s findings are:
- Healthy competition: The market for PE firms is very competitive — and becoming more so.
- Dry powder: PE firms currently have access to a lot of capital to spend on new deals. A robust fundraising environment and easy access to leveraged loans with relatively loose covenants is a driving force for increased competition.
- High valuations: Available capital and competition are driving up valuations for technology companies, which are considered attractive deal targets.
- Strong investment appetite: Although rising valuations and deal multiples would often make PE firms more reticent towards new investment, the favorable investment environment and access to capital seem to outweigh those concerns.
- Longer investment periods: PE firms’ rule of thumb of keeping an acquired company on the books for between three and five years seems to be eroding. PE firms are generally favoring extending investment periods.
In summary, PE firms see increased competition for attractive acquisition targets, which has driven up valuations. While this would often lead them to wait on making further investments, the readily available capital and beneficial market conditions have counterbalanced those concerns for now. Simultaneously, PE firms are generally looking to grow their acquisitions for longer periods before potentially selling them on, leading to longer periods of collaboration.
While difficult to generalize, the current investment environment means that technology companies currently have a strong negotiation position — if they know how to employ the right strategies to leverage it.
Private Equity Deal Structure
Once the PE and the target firms negotiate, the investor will write the final clauses in a term sheet. The PE deal will cover the method of funding and will often contain provisions preventing stock dilution and requiring the original owners of the company to maintain a form of employment at the company after the deal is executed.
There are many ways for the PE firm to fund the target company, including the following:
- Common stock: The buyer and seller simply exchange common stock in the target company for funding.
- Preferred stock: This is similar to a purchase of common stock, but PE firms often favor preferred stock because it provides priority access to dividends and can be converted to common stock.
- Participating preferred stock: This is a combination of preferred and common stock. Participation is usually either based on seniority of rounds or distributed equally. During an IPO, it can be converted to equity without the participating features.
- Options and warrants: These derivatives provide the option to buy or sell a company’s stock at a fixed price.
How to Establish a Post-Closing Relationship with a PE Firm
Private equity deals often include anti-dilution provisions that prevent the target firm from diluting the shares of the PE company by issuing stock at a lower price than that originally paid by the PE firm. PE firms also commonly propose employment or independent contractor agreements after the closing date with the seller or key management personnel. In these cases, the buyer and seller must reach an agreement on what their post-closing relationship will be. An agreement should answer the following questions:
- Will the relationship be that of an employer and employee or will the seller be engaged as an independent contractor?
- Will the seller (or management personnel) be involved in normal management duties or only transition consulting services?
- What are the short- and long-term goals of each side and how does the employment agreement contribute to those goals?
- What form and level of compensation will the seller receive?
- How long will the employment last?
The goal of signing employment contracts with the seller or key management personnel is to provide a smooth transition and the appearance of continuity. Ideally, the buyer and seller will reach a mutually beneficial agreement that reasonably compensates the seller while ensuring the transfer of ownership does not disrupt the company’s operations.
Have All Your Documentation in Order Before Negotiating with a PE Firm
Documenting your strengths in the areas that PE investors — and other types of investors — will likely focus on during a deal negotiation process should be a continuous effort, one that starts very early in your company’s lifetime.
One of the things that often comes as a surprise to technology companies when entering negotiations with a PE firm is the level of granularity of their questions. These questions can cover areas such as financial, legal, and tax issues, as well as existing business processes, future earning perspectives, risks, and much more. The maxim on preparing for tomorrow today most definitely applies to getting documentation ready ahead of time. The same applies to the preparation of the data that PE firms will request and how to safely present it to them in data rooms, business summaries, legacy tax documentation, and other formats.
PE investors will be focused on how your company will make use of the capital they provide in connection with a deal. Key focus areas include how the funds will help you grow revenue, boost your R&D, and give you access to new markets. Their focus comes from wanting — and needing — to know what steps you will take to grow your business and thereby enable them to make a good return on investment.
Questions and focus points can include areas that your company may not have considered. For example, you may face very detailed questions regarding the potential value created through non-financial activities such as corporate responsibility and sustainability programs. Your business’s debt capacity is another area that you may not have previously explored in the level of detail that PE firms are likely to do during negotiations.
Preparing documentation for all the areas mentioned above can be a simultaneously arduous and novel task in that most companies will not have experience with it nor know what level of documentation PE firms are likely to request.
An almost unavoidable fact is that your documentation will not have the required detail level in all areas at the start of negotiations. However, minimizing the number of areas where documentation needs to be updated has many positive side effects, including ensuring minimum disruption to the day-to-day running of your company during negotiations, as well as heightening PE firms’ confidence in your management team.
At the very minimum, most companies will need several months to prepare everything from scratch. If your company undertakes the task on its own, the required time will likely be longer.
Understanding the focus areas when negotiating with a PE firm is key to ensuring a constructive agreement is reached. Furthermore, reviewing the deal structure and gathering the necessary documentation ahead of time will reduce the stress and errors associated with preparing detailed documents. Through this process, companies will be able to establish a post-acquisition plan and envision future collaborative efforts with the PE firm.
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About Peter Ryan
Partner, Co-founder, & CPA
Peter T. Ryan co-founded Ryan & Wetmore in 1988 with business partner Michael J. Wetmore. Peter provides clients with the best strategies for success. His expertise extends across various industries. Peter obtained a Master of Business Administration in Finance from the University of Baltimore and a Bachelor of Arts in Accounting from the Catholic University of America.
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Rosie Cheng is a Finance Consultant at Ryan & Wetmore. She focuses on government contracting services and produces many of the firm’s government contracting newsletters. Rosie graduated from Georgetown University with a Master of Science in Management and from William and Mary with a Bachelor of Business Administration.
About Jack Ramsey
Jack Ramsey is a Finance Consultant at Ryan and Wetmore. He focuses on government contractor services as well as research and analysis of the economic, tax, and regulatory environment. Jack graduated from American University with a Bachelor of Science in Economics.