You are the general counsel of a public company and your CEO calls to tell you that the board is thinking about putting the company up for sale. He wants to talk. There are many important considerations for the board and management team when selling a company, and one of those is whether to sell to a financial buyer or a strategic buyer. What are some of the first things you need to know about these different buyers?
Buyers’ Current and Future Goals
Financial and strategic buyers have different current and future goals and reasons for acquiring a target company. A financial buyer (for instance, a private equity firm) focuses on a company’s ability to create value and earn profits as a stand-alone entity (or possibly as part of a portfolio); as such, its principal concerns are a target’s cash flow and the future exit opportunities from the business. Indeed, financial buyers typically have a limited horizon for their exit strategy with a targeted return on their investment. Therefore, financial buyers may conduct more thorough and lengthy due diligence to properly evaluate the strength of the current management team and the target’s future strategies, development and financial stability.
On the other hand, a strategic buyer is interested in a target company’s fit into its long-term business plan, as well as the synergistic benefits that it foresees from acquiring the company (such as expanding into new geographic markets, creating new products, eliminating competition, or promoting greater efficiency within its own corporation). As such, a strategic buyer will focus on how the target company fits into its growth strategy and may be willing to pay more due to such synergistic considerations. Note that in a highly concentrated industry, the strategic buyer may have more antitrust considerations than a financial buyer that complicate the closing of the transaction.
Selling to Different Types of Buyers
Another important consideration for a target company is how the sale of the company will affect the business post-closing. A financial buyer is usually focused on its determination of the profitability of a business as it currently operates, meaning current management, structure and culture may be maintained. This typically means that the transaction is not an exit opportunity for the management team and key employees, who may be required to stay on with the company and may even be asked to make an equity investment. This can raise important conflict of interests issues for officers of the company and a potential “going private” issue that needs to be analyzed and should influence the manner in which negotiations are structured to keep the board and its negotiations independent of any management negotiations with the buyer.
A strategic buyer is interested in the target’s synergistic benefits, and therefore wants to ensure efficiency in the management and integration of the acquired business with its business as a whole. As a result, strategic buyers are likely to cut costs in various ways, including by laying off employees. The fact that a strategic buyer already has leadership in place before it makes an acquisition may mean that the target’s current management team will not be needed. This might be a benefit if the target’s management wants to exit the business, though the buyer may require a transition period from management, which typically ranges from several months to two years.
Remedies Available in the Case of a Contractual Breach by the Buyer
The target company’s board and management should also consider the remedies available if a buyer breaches its contract. Due to their typically larger size and greater access to capital, strategic buyers are more likely to provide specific performance – which allows a target company to enforce all of the buyer’s obligations under most circumstances – as a remedy for a contractual breach than are financial buyers. Financial buyers typically limit the remedies they provide to reverse break-up fees, in which the buyer monetarily compensates the target company in the case of a breach. Financial buyers may provide a commitment letter or guaranty from the buyer’s parent fund or contributing funds, which could provide a direct right of the target against such upstream entities. But the recourse is still typically limited to a financial remedy rather than specific performance. Thus, if deal certainty is important to the board and management team – except in the case of certain regulatory or shareholder outs for the buyer, or a breach by the target – selling to a strategic buyer might be preferable.
Much of the discrepancy in remedies provided by financial and strategic buyers lies in the fact that financial buyers pay cash but often employ leverage whereas strategic buyers are more likely to use cash, stock, or a combination of the two as consideration. Indeed, in deals with no leverage or stock, there is little distinction between strategic and financial buyers in this respect. Rather, the type of buyer only tends to matter in debt-financed deals – in such cases, financial buyers almost never provide specific performance as a remedy, whereas strategic buyers often still do.
Notably, in the current financial climate, financial buyers have a harder time securing bank financing than they did in the past. This has not only led to a decrease in financial buyers’ use of leverage, but has also provided an overall advantage for strategic buyers, as they now possess even greater relative access to capital as compared to financial buyers.
Which Type of Buyer is Best for Your Business?
There is not a clear answer as to whether selling to a financial or strategic buyer is the superior option. Rather, the answer is determined by the characteristics of the target and acquiring entities, as well as the preferences of the board and management team of the target. The characteristics of these two potential buyers are very different, and will influence how a potential buyer views a target, how the target should negotiate with the buyer, and the target company’s future success. As such, it is vital for the board of directors and management team to understand financial and strategic buyers’ current and future goals, how these goals will affect the business’ legacy and current employees, and how the buyer’s structure could determine the remedies available in the case of a contractual breach. The answer may even be that it benefits a target company to foster competition from both the financial and strategic sectors before making a decision – in this way, there are more options and an enhanced view of what type of buyer will best suit the target company’s goals.