The Sell Side: PE Buyers Have One Job (And It Isn’t Yours)
By Kevin Vela
In our first installment of this series, we talked about what it takes to be ready to sell – clean corporate records and a tight data room, as well as the advantage that comes from doing that work on your own timeline instead of a buyer’s. Now I’d like to turn our attention to one of the most common words thrown around by M&A professionals: “market.”
In our last post, I explained that “market” terms get defined by buyers, not sellers – and how that asymmetry shapes everything from your holdback terms to who controls an indemnification claim after closing. This post is about a specific category of buyer that operates that asymmetry at an institutional, and very sophisticated, level: private equity (PE) buyers.
If you are selling your business to a PE-backed platform or directly to a PE fund, there is something you need to understand before you sign anything: PE buyers are not your partners. They are return-maximizers by design, and their goals and yours are not the same. In many cases, they are in direct conflict.
This is not a character judgment; I know a lot of great people who work for PE firms. It’s simply a structural fact. Understanding it is critical for you as a seller.
How PE Works (broadly speaking)
A private equity fund raises capital from institutional investors – pension funds, endowments, family offices – and promises them a return. The fund has a fixed life, typically ten years. The general partners (the PE firm) make money in two ways: a management fee on committed capital, and carried interest, which is their share of the profits above a certain return threshold.
That carried interest, usually 20% of profits above an 8% preferred return to the investors (so the investors first get back their investment + 8%), is the number that drives every decision a PE buyer makes. They are not trying to build a great business. They are trying to generate a multiple on invested capital within a defined time window. They want to provide returns to their investors so that they can (a) make money via their management fee and carried interest, and (b) ask their investors for more money for their next fund. The better the returns, the more they make now, and in the future.
Thus, when you sell to a PE firm, you are not selling to someone who is going to steward your business the way you did. You are selling to someone who will optimize it for a sale to the next buyer, usually within three to five years.
That isn’t inherently bad. But it means their incentives are not always aligned with yours. This is manifested in the deal structure.
Your Earnout Is a Line Item in Their Return Model
When a PE buyer proposes an earnout, they are not doing you a favor. They are managing their own risk and, in many cases, directly protecting their return at your expense.
Here’s how it works. A PE fund’s return is measured as a multiple of invested capital – how much they put in versus how much is returned at exit. Every dollar of purchase price they pay at close is a dollar of invested capital. Every dollar they defer into an earnout is a dollar they don’t have to fund upfront, which means a dollar that doesn’t count against their entry multiple.
If they can structure the deal so that a meaningful portion of the price is contingent on post-closing performance, they’ve done two things at once: they’ve reduced their day-one capital outlay, and they’ve shifted the risk of that portion of the price back to you. You are now a partial financier of your own acquisition.
In a PE-backed buy-and-build strategy, the platform is acquiring multiple companies and integrating them. Post-closing, the buyer controls the operating environment. They control the resources allocated to your business, the decisions about how it’s run, and how its performance gets measured against your earnout metrics.
So what does this mean to you? Here’s an example. Let’s assume you sold your software company for $50M. $25M in cash at close and $25M in earnout. Assume your earnout is tied to revenue performance over the next five years. Your business was growing at a blistering pace of 50% YOY, and the agreed-upon revenue metrics only needed 15% growth per year. The $25M in earnout seemed to be well within reach.
Post-close, the PE platform buys another software business that was similar to yours, and decides that selling your customers the new software is more lucrative than selling yours. Your sales growth slows to a crawl. There’s now a better chance that your software gets retired, than that you hit the revenue metrics. You’re not getting any of the $25M earnout.
You see, when a purchase agreement includes an earnout, it almost always includes “operating covenants” – promises about how the buyer will run the business during the earnout period. Sellers want these covenants to be protective: operate the business in the ordinary course, consistent with past practice, in a manner designed to achieve the earnout.
Buyers push back on that language. They will tell you that seller-protective operating covenants constrain the buyer’s ability to integrate the business into the platform. They want flexibility. So they negotiate the covenants toward language that sounds reasonable but means something very different in practice – something like “operate the business in a manner consistent with the primary purpose of maximizing the long-term value of the platform.”
Read that carefully. The buyer is no longer obligated to run your business in a way that hits your earnout. They are only obligated to run it in a way that serves the platform. Those two things can point in opposite directions – and when they do, they have a contractual basis to do exactly what benefits them.
We’ll go deeper on this in Post 4, including an actual court case where a seller took this exact fight all the way to litigation and what the outcome tells us about how these covenants get interpreted. For now, the point is this: the operating covenant is where your earnout either gets protected or gets hollowed out, and most sellers don’t focus on it until it’s too late.
Rollover Equity: Do Your Diligence
Many PE deals include an offer for the seller to “roll over” a portion of their equity – instead of taking all cash at close, you keep a stake in the combined platform and participate in the upside when the PE firm exits.
This is often presented as a sign of alignment. “We want you to win alongside us.” In some deals, with the right structure, it can be.
But rollover equity in a PE deal is not the same as equity in your own business. You are now a minority investor in a PE-controlled entity, governed by documents you didn’t draft, in a waterfall structure that was designed by the PE firm’s lawyers. The returns on your rollover equity depend on how that waterfall is structured, what the exit looks like, and whether your class of equity actually participates in a meaningful way.
Ask the same questions about your rollover equity that you would ask before making any investment, because that’s what it is. What class of equity are you receiving? Where does it sit in the waterfall? What counts as a liquidity event? Who is ahead of me? What are the drag-along rights?
Frequently, sellers roll over millions in value as part of a sale. Think about how much diligence investors do when they invest millions of dollars in your company, and think about the “preferred” nature of their investment. Why aren’t you getting the same?
Think carefully about whether the rollover is actually in your interest, or whether it’s a mechanism for the buyer to defer more consideration while giving you the feeling of continued upside. Those are not the same thing.
This Isn’t an Argument Against Selling to PE
PE buyers are sophisticated, well-capitalized, and they move fast. For many founders, a PE transaction is the right outcome – a clean exit, a strong price, and a buyer who knows how to scale what you built.
The point isn’t to avoid PE. The point is to understand what you’re walking into.
PE buyers have done this many times. They have a model, and the model works – for them. Your job, with good counsel, is to negotiate the terms that protect your interests within that model: specific earnout metrics, seller-protective operating covenants, defined limitations on post-closing integration decisions during the earnout period, and rollover equity that you actually understand before you agree to take it.
The LOI is where most of that gets won or lost. By the time you’re in the definitive agreement, the broad strokes are already set, and the buyer’s leverage has grown considerably.
We’ll come back to all of it in the final post in this series. But start here: when a PE buyer tells you that your earnout aligns your interests with theirs, ask how.
This is Post 3 in The Sell Side, a blog series for founders and business owners navigating M&A. Start with Post 1: Preparing for an Exit.
Questions about your M&A process? Reach out to us at Vela Wood – this is what we do every day. And don’t forget to check out our M&A glossary.
About the Author(s)
Kevin Vela
Kevin is the managing partner at Vela Wood. He focuses his practice in the areas of venture financing, M&A, fund representation, and gaming law.
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