Profitable, well-run businesses with $1 million or more in earnings before interest, taxes, depreciation and amortization that are run by non-owner management teams make strong candidates for buyouts by small private equity firms. These buyouts could be total or partial. What happens for the business owners after a buyout depends on the terms of the buyout agreement and whether the buyout was partial or total.
Private equity is the investment of equity in private companies. Private equity, or PE, firms buy a significant stake or purchase the entire company. These firms focus solely on driving underlying financials which indicate a firm’s success, including net income and return on investment. A PE firm may buy out a portion of a growing firm’s stock to participate in the company’s growth. PE firms also do turnaround investments in which they purchase a financially troubled firm at a steep discount and restructure the company to drive profitability and cash flow.
In a partial buyout, one or more partners in the private equity firm takes a role as a director on the target’s board of directors. They typically request monthly financial and general operational reports to remain abreast of the target’s performance. Often firms will help connect companies to partners, suppliers and similar companies and individuals who can help the firm continue or accelerate its growth. In general, private equity firms stay out of the day-to-day management of those companies that perform well.
If an owner maintains majority ownership and the company’s performance takes a turn for the worse, the private equity directors may advocate replacing management to return the company to a healthy growth trajectory. If those actions do not stem the downturn, the PE firm will take more aggressive actions to protect its investment. The level of aggressiveness depends on its relationship with the owners, the ongoing communication level, market conditions and limits specified in the buyout contract.
When private equity firms purchase a company, they typically install a new executive management team to replace the one that left. They create a business plan that they share with the new CEO and COO and use to monitor their performance. For troubled firms, PE firms may install an interim turnaround management team to slash costs, improve receivables conversion to cash and lay off personnel. The closer company performance meets or exceeds written expectations, the less day-to-day involvement the PE firm will have. PE companies may put analysts, finance staff and human resources personnel onsite to identify and make changes.
PE Firms may pay owners a lump sum in a full buyout. However, often PE firms provide a small-business owner a large portion in one lump sum with the remainder structured as a consulting agreement, installment agreement or earn-out. In an earn-out the PE firm will pay the seller an additional sum if the company hits certain targets. Through these arrangements, PE firms often maintain relationships with previous owners for two to five years.