In our modern economy, owners of family businesses are often selling their companies to private equity groups as an avenue for the owners to retire, rather than transitioning companies to the next generation. While business owners have many options for succession planning and sales, private equity groups are leveraging their resources to expand their market presence. Private equity groups combine access to capital with institutional knowledge on acquisitions while targeting family-owned businesses. While sales of family businesses to private equity groups can be mutually beneficial, these transactions can be stressful. This article will outline some key information on the process of selling a family business to private equity groups.

What are Private Equity Groups?

Private equity groups are investment groups that are comprised of high-net-worth individuals or groups of investors that pool resources. Private equity groups use different strategies to target, acquire, grow, and resell companies within a period of years to make a return on their investment. Private equity groups focus on the goal of maximizing profits and reducing their liabilities. Private equity groups vary widely in their approach, strategies, and reputations. An owner of a family-owned business should perform their own due diligence to understand who may be approaching them to buy their business.

What Businesses are Private Equity Groups Acquiring?

Private equity groups are actively pursuing family-owned businesses across many industries, including consumer products, manufacturing, professional and business services, and healthcare. As many business owners enter retirement, private equity groups have increased their presence in the markets. Many business owners are receiving unsolicited offers from private equity groups to sell their businesses. In general, private equity groups are targeting businesses with stable cash flow exceeding $5 million in annual revenue. Private equity groups seek family-owned businesses with stable management teams and customer bases. Private equity groups may have a particular interest in businesses with valuable assets such as real property, intellectual property rights, or businesses with barriers to entry such as special certification or licensure requirements.

Structures for Private Equity Groups: Stock Sale or Asset Sale?

One of the first decisions in any purchase and sale transaction involving a company is whether to structure the sale as a stock sale or an asset sale.

In a stock sale, the parties to the agreement are the owner who is selling the company and the buyer who will step into the shoes of the owner. The company remains actively engaged in business after the closing of the transaction. A stock sale involves a seller agreeing to transfer shares in a company to a buyer for monetary and other consideration in accordance with the terms of a written agreement. This structure has the advantage of transferring the assets owned by the business without additional steps, as the company continues to own the assets rather than transferring them to the buyer or the buyer’s newly formed company. For example, long-term contracts with customers stay in place without additional review and negotiations related to the assignment of those contracts. The stock sale structure is also usually preferred by the Seller for tax reasons. In addition, through negotiations liabilities can be transferred or limited for the selling parties. However, buyers may not prefer this structure because of tax implications and inheriting liabilities of an ongoing business. Consequently, a seller may be asked to provide more robust representations, warranties, and indemnifications in a stock sale.

In an asset sale, the parties to the agreement are the company that is selling substantially all of its assets to a buyer. The buyer can pick and choose what to acquire after careful review of the assets and liabilities. Private equity groups generally prefer the asset sale structure because it limits their liability and provides tax advantages to buyers. The private equity group will form a new company, often with complicated organizational structures and documents. Usually, the newly formed company will acquire the right to use the name of the family-owned business as part of the transaction. A seller can benefit in an asset sale from reducing their representations, warranties, and ongoing indemnifications with a carefully negotiated agreement that shifts the responsibilities to the buyer for performing their own due diligence on the assets.

What are the Steps of a Sale of a Business to a Private Equity Group?

Private equity groups engage in transactions that follow the typical steps of a purchase and sale transaction, but they differ in important ways. In general, a seller can expect a longer period of time from initial offer to closing, higher transactional costs, and post-closing involvement of the seller and key employees. The written agreements in a sale of a business to a private equity group will be much more detailed, lengthy, and heavily negotiated. The due diligence will be thorough and complete. The costs for both parties are more expensive, due to the detail and length of agreements and due diligence review. Private equity groups often include provisions in the agreements that have detailed post-closing rights and responsibilities of a seller due to their plan to purchase and resell within a period of time.

The business sale process usually begins with a Letter of Intent (“LOI”).  The LOI outlines the proposed purchase price, whether the transaction is a stock purchase or asset purchase, and key deal terms. While mostly non-binding, the LOI sets the tone and often includes an exclusivity period that prevents a seller from soliciting other offers. Private equity groups are more likely to have a more robust LOI that includes terms that protect their interests. The tone that is set from the LOI may be one that allows for negotiations and flexibility or may exhibit rigidity from the beginning. It is essential to have any LOI analyzed by an attorney knowledgeable in business transactions and familiar with the company’s industry.

After an LOI has been negotiated and signed by both parties, the parties will work to finalize a definitive purchase and sale agreement that will provide the timeline of the transaction and explicitly lay out the promises of both parties. Key provisions of a purchase and sale agreement include representations and warranties, indemnification terms, purchase price and adjustments, escrow holdbacks to cover indemnifications, and post-closing responsibilities. Private equity groups tend to negotiate these provisions aggressively, so skilled counsel is essential to protect a business owner’s interests.

Once all parties sign the purchase and sale agreement, the due diligence period begins, which can be more rigorous with private equity groups. Sellers should expect deep scrutiny of their financials, contracts, operations, employment matters, insurance, and legal compliance.  As discussed later in this article, strong preparation pays off during the due diligence period.

At closing, ownership transfers, payments, and adjustments are delivered as provided in the purchase and sale agreement. However, post-closing considerations frequently set private equity transactions apart. Many private equity buyers ask sellers to take rollover equity. Rollover equity means the seller reinvests a portion of the sale proceeds into the buyer’s newly formed entity, which will own the assets of the business. Private equity groups can reduce their costs to close by making rollover equity a part of the purchase price. Private equity groups can also increase their opportunities for success by tying the seller’s ultimate purchase price to the seller’s performance during the post-closing period while the business is prepared for a second sale. This can be a difficult decision for business owners and produce the most stress, as family-owned businesses where owners have always worked for themselves will have a period of time when they may become an employee for the first time in their lives. Keeping owners of family businesses invested in future growth during a period of transition and change can be a significant financial incentive when the business sells again. As part of the structure of the rollover equity, buyers may request consulting agreements, employment agreements, and non-compete agreements to keep the knowledge and relationships in place or protected after closing. Employing advisors who can address these issues and protect a seller’s interests is critical to a successful transaction.

What Should a Business Owner Do Before a Sale?

Consider hiring advisors, tax professionals, and attorneys prior to soliciting an offer, while there is time to focus on the options and implement advice. Thoughtful planning can preserve significant value. Waiting until an offer arrives often means missing opportunities and increasing stress. There are two crucial steps to take before soliciting an offer. The first step is to understand how a sale of the family business will be taxed and take advantage of techniques and strategies to reduce future taxes. The second step is preparing a seller’s due diligence in advance to avoid surprises.

Many tax strategies are no longer available after a business owner begin soliciting offers for purchase. In order to maximize the choices and provide flexibility, a seller should seek advice on the tax implications of a future sale well in advance of the time at which a business owner may actually wish to sell their business.

An internal due diligence review will reduce the stress on a family business during any future transactions. A seller should gather items on a typical due diligence list, organize the information, ensure the information is complete and accurate, and review the information with professionals to identify issues. By examining a company through a buyer’s eyes, a seller can position themself to negotiate well and smoothly transition the company. Lack of prior planning and surprises during a due diligence period are typically unpleasant and can result in early termination of a deal, reduction in purchase price, or business owners having to take extraordinary efforts to manage emerging issues.

Business owners should engage with professionals prior to any discussion with a potential buyer to reduce taxes to the extent possible, reduce the stress on a business during the due diligence period, and maximize the results from the sale of a family business.

What Matters Most Beyond the Sale Price?

For most family business owners, the sale price is only part of the equation. Most business owners are significantly concerned about their management team, their employees, their customers and the community, tax implications, the legacy of what they have built, and their risks and personal liabilities. It can be difficult to make the decision to sell, and many buyers miss maximizing their own profits because of these concerns.

Particular concerns should be discussed early and often with advisors and potential buyers. If reducing taxes is important to a business owner, they should engage with their tax attorneys and CPAs to understand the estimated tax from the sale of the family business and options for reducing taxes. If retaining employees matters to the business owner, this should be included in the transaction from the LOI to the purchase and sale agreement, to post-closing agreements. A seller can ask for and negotiate commitments from buyers on workforce retention, benefits, and culture as part of the sale transaction. If a seller is concerned about ongoing liability, discuss the structure of the sale, focus on insurance and contingent liabilities during the internal due diligence review period, and include provisions in the written agreements between the parties to reduce exposure after closing.

Finally, a business owner should consider what “legacy” means in the sale of a business. Whether legacy means preserving the company name, honoring community commitments, or keeping key employees or family members involved, a seller should raise these priorities early in the process and ensure they are included in written agreements. As a final note of preparation, family business owners should consider what their lives will look like after the completion of the transaction and how their retirement will be a continuation of their legacy. If a business owner is not retiring into a next chapter where their time and energies will be as fulfilling as the business, it is unlikely the process will feel successful.

Selling to a private equity group can be a rewarding transaction when a family business owner has the right advisors and preparation. With careful planning and foresight, a seller can protect what they have built, maximize the results from a sale, and provide liquidity to secure new opportunities and a new legacy.

This article summarizes aspects of the law and does not constitute legal advice. For legal advice with regard to your situation, you should contact an attorney.