September 30, 2019

Ensuring the ‘Second Bite’ is as Good as the First

When all else is equal, founders selling their business will want to emphasize certain qualitative factors in scrutinizing prospective buyers

Calvin Neider, Co-Founder and Managing Partner, Clearview Capital

The hardest decision most founders will ever have to make is whether or not to sell their company. The most overlooked decision – assuming they do decide to sell — is to whom.

For those simply looking to retire, the choice is usually black and white, as price alone can be the sole consideration. When that’s not the case, harder-to-quantify factors are critical to avoid “seller’s regret.” But the fact that roughly 40% of all selling CEOs leave their new employer within six months suggests that many are indeed ignoring these more subjective factors.

Examples of founder discontent are easy to find, particularly in tech circles. Kevin Systrom’s departure from Instagram (acquired by Facebook), Mark Lore’s exit from Quidsi (Amazon), and Julie Rice’s resignation from SoulCycle (Equinox) represent just a few of the more notable breakups. But even in optimal circumstances, any change of control can bring tension as founders acclimate to new processes, new priorities, and new power structures.

To be sure, Silicon Valley’s “serial” entrepreneurs are quite distinct from most small- and middle-market CEOs. Among the latter — founders who typically built their companies over an entire career – valuations matter but other factors can be equally important. Rare is the CEO, for instance, who is unconcerned about how a potential deal could influence their legacy in the community or what a sale will mean for existing employees, post close. These more qualitative concerns are only magnified for those seeking a private equity commitment, alongside which the founder will co-invest. When things go well, they’ll often be rewarded with an opportunity for a “second bite” of the apple; they’ll regret overlooking due diligence that should’ve occurred before the first bite.

Finding alignment

For the uninitiated, a second bite of the apple – at least in private equity – refers to a business owner’s opportunity to secure multiple realizations from the same assets. An initial sale will typically provide a liquidity event and allow founders to “de-risk” and diversify their wealth. A subsequent sale — when the initial investor exits – then offers founders another liquidity event, which can be more rewarding than the first. If it’s a sponsor-to-sponsor deal, entrepreneurs may have yet another opportunity to rollover more equity and repeat the process again.

The appeal to sponsors is that when business owners share both the risk and reward, it aligns interests to the benefit of everyone. The draw to business owners is often multifold. Beyond freeing up personal wealth concentrated in the business, many will also use a sale to establish a succession plan. Even if retirement remains in the distant future, many business owners will seek out a PE investment to reinforce the company’s competitive position and invest in its growth. Whenever a CEO seeks to remain with the company, though, it usually reflects a combination of each of these factors.
The caveat, however, is that it requires due diligence on the part of sellers to discern who can follow through on their commitments and those with a track record that may suggest otherwise.

The devil in the details

At the very outset, sellers can gauge the commitment of prospective buyers just by analyzing how they seek to structure the deal. How large of a stake is available to executives? Are equity incentives in place for other executives and employees? And are sponsors willing to work with the seller to optimize the tax efficiency of the transaction? These are all questions sellers should be asking, but can be overlooked amid the exuberance of a runaway bid.

Perhaps most important, though, is the nature of the equity that will be rolled over. It can seem like picking hairs at the beginning of a relationship,
but if the management rollover consists of common equity, whereas the financial sponsor’s stake is made up of convertible preferred or even super-voting stock, interests aren’t really aligned.

Know your partner

Few would argue that it’s difficult to differentiate between sponsors through management meetings alone. The vernacular is nearly interchangeable, promises often similar, and even the names of firms start to sound the same as founders navigate the broader PE landscape. But when they
open up the hood to understand the unique philosophies and cultures of the respective firms, as well as the more detailed investment theses being proposed, the differences can be stark.

At the highest level, investment philosophies typically reside on a spectrum between “value” and “growth,” and can be further subdivided by the sponsor’s approach to specialization, be it a generalist strategy or a far narrower scope that entails a prescriptive operational playbook. Again, these are important considerations to understand whether investors will be “cutting” their way to profit growth or investing in initiatives to grow the top-line. These distinctions aren’t obvious either. Most CEOs will gladly welcome assistance when it comes to acquiring assets or even filling out complementary roles across the management team. A specialist that merely airdrops an operating partner into the business, however, may seem less agreeable when it undermines a CEO’s authority and reflects a coming power struggle. It’s the difference between a partnership culture and ownership culture.

Doing the work

When executives are on the other end of a transaction, as a buyer, they’ll leave no stone unturned in scrutinizing potential targets. But the same level of due diligence should go into analyzing prospective buyers. Track records alone can provide cues around their ability to grow companies
and manage risks. Volatile performance, for instance, should be a red flag and can provide clues around the likelihood that a second bite will even be available.

CEO references are critical. Did the investors do what they said they would do? What were the constructive ways they contributed to growth? Where were they more hands off? Where did they butt heads with other management teams? How did they act when the inevitable unforeseen
challenges occurred? These are all important questions to understand the culture of a firm. And referrals from deals that went sideways are going to be far more revealing than the homeruns.

Some buyers may bristle at the scrutiny, a reaction that should also set off alarm bells. It represents a twist to Shakespeare’s old proverb about relationships, that “there’s small choice in rotten apples.” This is especially true for founders looking to partner with PE. Because those with designs on a second bite, will want to be certain that their first bite leaves a good taste in their mouth.

Cal co-founded Clearview in 1999, and brings 38 years of capital markets and growth-investing experience to lower middle market companies.

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