Why business owners pay a $20+ million consulting fee – and why that’s crazyJuly 21, 2018
More often than not a middle-market business owner will sell his/her company to a Private Equity (“PE”) firm. The sales price is, obviously, acceptable to the business owner and it is certain that it works for the PE firm. The PE industry exists to offer a superior return to their limited partners who provide capital to PE firms. Typically, this superior return is achieved by “buying right”: i.e., don’t overpay for the company – and then make basic changes the business owner could have made himself (with a little help). On average, the PE firm will sell the company again in three to five years often for double or more what they paid.
Let’s assume that the PE firm buys a $40 million revenue company with an EBITDA margin of 7.5% of sales, or $3 million, for $21 million – which would be a multiple of 7X. (7X reflects the fact the company is a good business but it has a slow rate of growth and some other issues, albeit relatively minor.) The PE firm makes changes, in particular in sales, marketing, product pricing, and operations to increase the rate of growth and expand the gross margin. As a result, in four years, assuming sales grow at 10% per year, revenues are now approximately $60 million. And the EBITDA margin has been improved to an industry-average of 10% of sales – or $6 million. Assuming the multiple only improves to 8X (actually it would be higher but I am intentionally being conservative), the PE firm will sell the company for $48 million – MORE THAN DOUBLE WHAT THEY PAID FOR IT.
PE firms will argue that their superior business knowledge and intelligence (yes, they are arrogant) mean they can make changes the business owner could not have. [They will also argue that they can provide capital for growth that the business owner does not have. However, this is an absurd point as growth capital is readily available, as debt not equity, and Stanton Associates can help the company obtain it.]
So, is it a fair point that the business owner could not have made those changes himself?
Business owners use outside experts sparingly. Owner/founders tend to be thrifty and they don’t like to spend money they don’t have to – which makes perfect sense and is a big part of how they became and stayed successful. But they do use certain consultants/advisors frequently: lawyers, CPAs, engineering specialists (electrical, mechanical, etc.), insurance brokers, medical benefits consultants, safety consultants for manufacturing operations, etc. On the other hand, they don’t want anyone telling them how to run their company. On this point, don’t worry: the PE firms will not tell the owner how to run the company (unless the owner stays on after the sale – and that often sad experience is the subject of a future blog). They will just buy the company and then make basic changes for their own benefit.
Most of the changes made by the PE firm are identified and implemented by “operators”: people with experience running companies whom PE firms have in their stable and whom they use to improve their portfolio companies. But consider this: expert operators, who aren’t in the pocket of a PE firm, are available to help the business owner for a consulting fee. Why not use them to help drive value creation? And then sell the company for the $ amount the PE firm would have sold the company.
How much should the business owner be willing to pay for this consulting?
Well, the cost of not paying anything, using the example above, is $27 million. Stanton Associates is a team of experienced, successful operators, who are passionate about driving value creation. I can guarantee that our fee will not be anywhere close to $27 million!
In fact, for most business owners, we are willing to do an initial consult without charge to gain the trust and confidence of the owner.
I’d love to hear what you think about this issue. Please let me know in the comments section below.
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About Stanton Associates
Stanton Associates is passionate about helping business owners unlock the value in their companies and keep it for themselves. We are different from most exit planners. Like others we help prepare the company for sale and guide business owners through the process. What sets us apart is our ability to drive significant value creation. It is our mission to ensure that business owners don’t allow to be stolen what is rightfully theirs. Members of the Stanton Associates team have been the CEO, CFO, COO, CMO and Head of Sales at many mid-market companies. We know what it takes to drive value creation prior to an exit.