Strategic vs. Financial Buyers: Distinctive Ways of Acquiring Businesses

The Buyers’ End Game Affects Suitability

As an owner considers the sale of a business, it is critical to identify the goals of the transaction and match those objectives with the most suitable prospective buyer. Many different kinds of buyers might be well suited to acquire the business. Buyers are often grouped into ‘strategic buyers’ and ‘financial buyers.’

Strategic vs. Financial Buyers

The term ’strategic buyer’ means any purchasing entity with an operating business. It includes both public and private enterprises. A strategic buyer may be a competitor, customer, or distributor. It may also be another market participant seeking to expand its business. The term ‘financial buyer’ includes those groups of buyers engaged in investing in private companies who are focused on return on investment. Financial buyers include private equity funds, hedge funds, venture capital funds, and family offices.

However, not all buyers fit squarely into one category. Some ‘hybrid buyers’ are traditional financial buyers. They have existing investments in the target business’s space. These hybrid buyers share traits of both financial and strategic buyers.

A business owner should expect strategic and financial buyers to approach the sale transaction in the following different ways:

• Approaches to valuation
• The sale process, timeline, and deal negotiation
• Business operations post-sale

Differing Approaches To Valuation

In early price discussions, a seller should expect to see both financial and strategic buyers submit an indication of interest with a valuation on the business that is tied to a multiple of earnings. These often rely upon the trailing twelve-month EBITDA of the target business or the free cash flow of the business. The multiple ranges proposed by various buyers in calculating their valuation are typically influenced by the industry in which the business operates, the margins and profitability of the business, cycles and trends of financial performance, and the perceived synergies that are available after the deal closes.

Strategic buyers can justify higher valuation multiples and, therefore higher purchase prices when they can identify areas where the combined business will be more cost-effective, efficient, or have greater opportunities in the marketplace going forward. In the deal negotiation process, strategic buyers often focus early efforts on identifying areas with cost savings, whether through reducing labor costs, consolidating operations, or gaining advantageous pricing from the combined purchasing power of the consolidated business. Determining the viability of these synergies is critical to the strategic buyers’ due diligence process and a fundamental factor in establishing the price they are willing to pay.

Financial buyers are typically focused on evaluating the target business without expecting significant synergies. In determining the price they are willing to pay, financial buyers focus early efforts on evaluating the profitability of a business and engage in a detailed review of the business’s financial performance, both recent earnings performance and trend changes. Most financial buyers rely upon the existing senior management team to continue to operate the business after closing at the same location and with the same workforce. Without the synergies that a strategic buyer can factor into the valuation process, financial buyers often offer lower multiples on valuation and, therefore, a lower purchase price.

Implications of the Sale Process

As the deal moves from the early stages of negotiating confidentiality agreements through to due diligence, contract, and, ultimately, closing, whether a buyer is strategic or financial will impact how they approach the stages and how the seller should respond.

As the first step of any deal, the potential buyer must sign a non-disclosure agreement (NDA). Such an agreement is critical for a seller to protect its valuable business assets, including its customer base, employees, and financial information, all of which will be disclosed during the due diligence process to allow prospective buyers to evaluate the business and formulate a position on the price. While it is customary to use a consistent form of NDA for all potential buyers, if a strategic buyer is engaged in a competitive business, the seller should be very careful in both crafting a tight NDA and developing a timeline for sharing highly sensitive information.

Many prospective buyers will negotiate to cut back and modify the language in the NDA. In these negotiations, it is important to understand the true damage that could result from sharing information with the buyer. A financial buyer typically will pose less of a threat than a strategic buyer. However, it is essential to know if the financial buyer is a hybrid buyer with other investments in the seller’s industry.

A seller should work closely with its advisors to ensure the terms of the NDA provide sufficient protection. Even with a good NDA in place, when dealing with a strategic buyer, the seller should consider staging the delivery of highly sensitive confidential information until a later point in the timeline of the sale process when it is clear that the prospective strategic buyer is committed to getting a deal closed.

Due Diligence Differs Among Buyer Types

Once the NDAs have been signed and the due diligence process is underway, the seller may find that strategic and financial buyers approach the scope and process of due diligence differently. As noted above in the discussion on valuation, a financial buyer will almost always be focused initially on financial matters and require detailed accounting information to confirm the financial picture presented of the target business and to develop models of projected profitability. A financial buyer typically engages outside accountants who may spend a number of days on-site with the target company to conduct the accounting due diligence. While a strategic buyer will also be focused on the financial performance of the target, they often prioritize due diligence of synergies and cost savings of the combined enterprise.

A seller will need to understand the financial ability of the buyer and the level of commitment by the buyer at the time the purchase agreement is signed. Strategic buyers are often able to represent that they have adequate cash on hand to close the deal at an early stage. In contrast, financial buyers may only be able to close the deal if they can obtain outside third-party debt financing. Without adequate protection and assurance that the buyer is a credit-worthy entity, a seller could end up signing a purchase agreement that is effectively a free option for the buyer to acquire the business.

Contractual protections when dealing with financial buyers may include a termination fee, i.e., ‘reverse-break up fee,’ which is a guaranty from an affiliated, credit-worthy entity, or the requirement that the financial buyer delivers commitment letters from its third-party debt financing sources. A selling business owner needs to work closely with their advisors to ensure the purchase agreement properly addresses these concerns.

Further, when a potential buyer requires third-party financing to close a transaction, the seller will need to understand the buyer’s realistic timeline to complete the financing process and how it will affect the timetable for the overall closing of the sale transaction.

Operational Approaches After Closing

A financial buyer is often more favorably viewed by those sellers who plan to continue working in the business after the closing. Often a strategic buyer will be factoring in reductions in employee headcount, changes in senior management, relocations of the business, or other operational changes that reduce costs. As discussed above, these ‘synergies’ are often the basis for allowing the strategic buyer to offer a higher price than its competing financial buyers. However, it is not only cost reductions that can form synergies, as the strategic buyer may also be able to deliver access to a broader customer base or geographic region that was previously unavailable to the target business.

A financial buyer, such as a private equity fund, is often expecting all of the key senior management employees to stay with the business with a time commitment that ties to the time period the financial buyer expects to hold the business. Because most financial buyers have a specific time horizon for their investment and do not intend to own and operate the target business indefinitely, they may develop strategies to align management’s financial rewards with the financial success of the future exit.

Financial buyers may require key executives to invest money alongside the financial buyer’s investors in the deal to have ‘skin in the game.’ Further, financial buyers commonly establish management equity incentives through options in a corporate structure or profit interests in a limited liability company structure to further incentivize management.

Differing Approaches

As a business owner moves through the sale process, it is important to keep in mind the original goals established for the sale transaction. Understanding the different approaches taken by financial buyers and strategic buyers can help a selling business owner set realistic expectations for each stage of the sale process and ultimately decide on the right partner to meet the overall objectives of the sale.

We think you’ll also like:

1. How to Conduct Due Diligence Before Buying a Business
2. Steps for Protecting Business Sale Confidentiality
3. Business Valuation Is More Art Than Science

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Selecting the Right Valuation Expert
2. How to Read a Balance Sheet – And Why You Care!
3. EBITDA and Other Scary Words

This is an updated version of an article originally published on April 3, 2015, and previously updated on April 22, 2019 and on May 4, 2022. This article was most recently updated by the Financial Poise Editors.] 

©2024. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.