Strategic and financial buyers have different characteristics when purchasing a business, and as a seller, dealing with each has its advantages and disadvantages.

The current deal environment is very robust, and financial buyers have raised a lot of private equity dollars that couldn’t be fully deployed when the economic downturn hit. That money is still out there and now financial buyers are under pressure to put it to work.

In addition, strategic buyers are sitting on record amounts of investable cash, much of which is earmarked for acquisitions, says Kevin W. Bader, an associate at MelCap Partners, LLC.

“It’s a really good time to be a seller,” says Bader. “And if you’re looking to maximize your chances of success in a sale, you want to reach out to both types of buyers.”

Smart Business spoke with Bader about the differences between strategic and financial buyers and how each approaches buying a business.

What is a financial buyer?

A financial buyer is typically what you think of when you hear the term ‘private equity.’ Financial buyers are institutional investors who pool their money together to grow through acquisitions. They raise a fund that typically has a 10-year life put together for the purpose of investing in a portfolio of companies.

The first five years is typically the investing stage, in which they make several investments to establish or supplement the portfolio. They’ll then grow those businesses by bringing in resources such as alternate sources of capital, improved financial disciplines, or increased operating efficiencies.

The second five years is the ‘harvest’ phase, in which they hopefully have a larger and more profitable business to sell to another private equity group or to a strategic buyer who sees value in the company.

Financial buyers typically maximize their returns by leveraging the assets of the companies they acquire, which minimizes the amount of equity investors have to put in at the outset.

Many times in a leveraged buyout, financial buyers will require that they have a controlling stake in the business. However, there’s often an opportunity for the seller to co-invest back into the new business alongside the buyers, in effect rolling over some of the equity. If the investment is successful, the seller has a portion, usually a minority stake, which gets sold down the road. We call this a ‘second bite at the apple,’ and it can be a very powerful wealth creation opportunity for the seller.

What is a strategic buyer?

Unlike financial buyers, strategic buyers are not in business solely to buy other businesses. Instead, they can often operate in a similar industry, or in the same industry, as a selling company. Their mandate is to grow the business by acquisition if it makes sense, but they also have a core business to run.

Because of the business cycle we’ve just come through, operations are typically getting better across the board and strategic buyers are doing better with fewer resources. We’re seeing that strategic buyers are being very active in M&A because of the excess cash they have on their balance sheets and the pressure they have to show a return on that cash for their shareholders.

Strategic buyers create value by realizing synergies through acquisitions because of their similarities with the target and the ability to eliminate redundant functions. Sometimes this can mean they’ll pay a higher price than a financial buyer will, but this is not always the case. Often, strategic buyers use less leverage than a financial buyer, which can create a cleaner and quicker deal for the seller. In addition, a strategic buyer will typically hold the business indefinitely, so there’s no pressure to sell in five to seven years.

It’s possible that the new company, beyond a transition period, would employ the seller, but there’s definitely a change of control and the seller may have concerns over what happens to its employees. Depending on the synergies and the overlap with a strategic buyer, there can sometimes be less of a need for the company’s employees, as opposed to a financial buyer.

Why would businesses choose one type of buyer over the other?

One consideration is confidentiality, another is the speed of the deal. Regarding confidentiality, strategic buyers can often be from the same small industry and there could be concern over word getting out about the sale prematurely. However, confidentiality agreements can cover those risks.

With regard to speed, strategic buyers — if they’re big enough or have enough cash on their balance sheet — may be able to close more quickly because they may not need a bank to get a deal done. However, strategic buyers might need a little more hand holding to keep them moving along in the sales process because they also have a business to run and don’t solely focus on acquiring companies.

From a sale standpoint, reaching out to both types of buyers allows you to cast the widest net possible in order to identify the best buyer for you and your business.

Kevin W. Bader is an associate at MelCap Partners, LLC. Reach him at (330) 239-1990 or kevin@melcap.co.

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Published in Cleveland