Selling to Private Equity: The Math Behind the Second Bite

Most owners who start looking into selling to private equity hear about it the same way. A competitor down the road sold, somebody mentions a multiple of EBITDA, and a number starts rattling around in your head. That number is one of the least useful things to know about the deal. What matters is how a private equity firm actually gets to its price, what you own the morning after closing, and how the stake you keep can turn into a second payday years later.

Most owners have never had that walked through with them, and there's a reason. The people who understand it best are usually sitting on the other side of the table.

The Price Starts With What a Lender Will Lend

You'll hear that businesses sell for "a multiple of EBITDA." That's true in the way it's true that houses sell for a price per square foot. It describes the result. It doesn't tell you how the buyer got there.

A private equity firm, also called a financial sponsor, doesn't buy your company with its own money. Not most of it, anyway. It borrows a large share of the price, puts in a smaller check from its fund, and plans to pay the loan back out of your company's cash flow. That's a leveraged buyout, the "LBO" you'll hear about in meetings. It means the first question in pricing your company isn't "what multiple do companies like this get?" It's "how much will a lender put against this cash flow?"

Lenders answer that question conservatively. They look at how steady your earnings are from year to year, how much of them turns into actual cash after equipment purchases and taxes, whether a few customers account for most of the revenue, and how much of the business still runs through you. A company with predictable cash flow, a broad customer list, and a crew of managers who can price and run work without the owner can typically carry more debt. A company whose earnings rise and fall with one general contractor's backlog can typically carry less, even if the EBITDA on paper is identical.

That's why two companies with the same EBITDA can get very different offers. The multiple comes out the other end. You only get to it after a lender decides how much it's comfortable lending and the sponsor decides how much more it can afford to add on top.

The Napkin LBO: How a Private Equity Firm Builds Its Offer

Sponsors price deals with a model called an LBO model. The real ones run to dozens of tabs. On the back of a napkin, they work backward from the day the sponsor plans to sell:

1. Start with the plan. The sponsor projects what the business could earn four or five years out if its plan works: organic growth, better pricing, a real finance team, and acquisitions of smaller competitors. For a platform company, that plan can call for doubling or tripling earnings, often through acquisitions funded with more debt or equity.
2. Price the exit. It estimates what a buyer would pay for that bigger company at the end of the hold.
3. Subtract the debt still owed. What's left is what the equity would be worth on the way out.
4. Work back to today. The sponsor has a target return. Targets vary by fund, but on deals like these they are commonly around 20 percent a year or more. That target tells the sponsor how large an equity check it can write today and still grow into the exit number.
5. Add it up. The debt a lender will provide, plus the equity the math supports, is roughly the most the sponsor can pay.

That last step is the one to hold onto. The price is what a lender will finance plus a premium the sponsor can justify on top. The premium is paid in equity, the sponsor's and, as you'll see in a minute, some of yours. The sponsor stretches it only as far as its target return allows.

A discounted cash flow analysis, or DCF, reaches for the same answer from another direction. It estimates the cash the business will generate in future years and discounts it back to a value today at the rate of return an investor demands. We cover how the methods compare in how M&A valuation methods differ. When the assumptions match, the LBO and the DCF tend to land in the same neighborhood. When they don't, the gap is where the negotiating happens.

It helps to see what a return target means in plain arithmetic. Tripling your money over five years works out to roughly 25 percent a year. Doubling it over five years is closer to 15 percent. So when a sponsor says it needs the numbers to work, it usually means it needs a believable path to multiplying its check over the hold, and your company's cash flow and growth are the path.

Who Owns What After Closing

Here's a simplified example. It's hypothetical, the numbers are round on purpose, and it ignores fees, taxes, and working capital adjustments so the structure is easy to see. Say a private equity firm agrees to buy your company at a price we'll call 100.

• Lenders provide 55. That's debt the company now owes.
• The sponsor invests 25 from its fund.
• You roll 20, meaning you reinvest a fifth of your price in the new company instead of taking it in cash.
• You take home 80 at closing.

After closing, the new company has 45 of equity: the sponsor's 25 and your 20. The sponsor owns about 56 percent and controls the board. You own about 44 percent.

Look at who put up what. More than half the price was borrowed, and the company, not the sponsor, is responsible for paying it back. The sponsor's own check is a quarter of the price. Yours is a fifth. You took most of your money off the table, and you still own close to half of the equity going forward.

Now look at where the cash flow goes. Before the sale, what the business earned after expenses was yours to take out as distributions or reinvest. After the sale, a large share of it services the debt: interest first, and then principal, paid down year after year. The company is paying off the loan that was used to buy it. Every bit of principal it repays moves value from the lenders' side of the ledger to the owners' side, and you're one of the owners.

You'll hear people say private equity never loses. That isn't literally true. Deals miss their plans, and funds do lose money on investments. But it's easy to see where the saying comes from. The sponsor put in a minority of the price, the company's own cash flow repays the largest piece, and depending on how the deal is papered, the sponsor may hold a class of equity that gets paid before yours. The structure is built so the odds lean the sponsor's way. You can still do a good deal with private equity. You just have to negotiate the structure as hard as you negotiate the price.

The Second Turn: Your Second Bite of the Apple

A private equity fund doesn't plan to own your company forever. Its own investors expect their money back, so a fund typically holds a company for three to five years, and in recent years often longer, and then sells it. That sale is the second turn, and it's where the stake you rolled gets paid. In the industry it's called the second bite of the apple.

When the company sells again, the math is simple. The buyer pays a price, the remaining debt is paid off, and whatever is left is divided among the equity holders by ownership, after any preferences the documents give one class over another.

Go back to the example. Assume the sponsor holds for five years, the company pays its debt down from 55 to 25 out of cash flow, and the business sells at the same multiple of earnings it was bought at. Here's the arithmetic under five hypothetical outcomes. None of them is a forecast or a typical result. The example also assumes you and the sponsor hold the same class of equity, there's no management incentive pool, and the growth comes without new debt or new equity.

• Earnings fall by half. With 40 of debt still owed on a company that sells for 50, equity is 10, and your share is about 4. Go much lower and the lenders take everything, leaving nothing for the equity at all.
• Earnings fall 30 percent. With less cash coming in, say 30 of debt is still owed. The company sells for 70, equity is 40, and your share is about 18, less than you rolled.
• Earnings stay flat. The company sells for 100. Equity is 75, and your share is about 33. You still come out ahead of the 20 you rolled, purely because the debt got paid down.
• Earnings double. The company sells for 200. After the 25 of remaining debt, equity is 175, and your share is about 78. That's nearly the 80 you took at closing, on a rollover of 20.
• Earnings triple. The company sells for 300. Equity is 275, and your share is about 122, roughly one and a half times your closing check.

In the doubling case, the sponsor's 25 becomes about 97, roughly 31 percent a year in this example. That upside, if the plan works, is what the sponsor is paying for.

Look at how far apart those outcomes are. The same debt that multiplies the upside on your rollover multiplies the downside too. In this example, the second bite rivals or beats the first only when earnings double or triple. It is not a sure thing, and the result in any real deal depends on the business, the market when it sells, and the terms you signed at the first closing.

At the second turn you usually get a choice. You can cash out the whole stake, or you can roll part of it again into the next owner's deal, which sets up a possible third bite. Many owners split the difference: take most of it in cash and leave a piece in. Which makes sense depends on your age, how much of your net worth is still tied up in the company, and whether you want to keep working for the next owner. Some buyers at the second turn will ask the management team to roll a portion, so go in expecting that request.

There's Always a Bigger Fish (and Why We're Called First Turn)

Who buys the company at the second turn? Usually a bigger fish. By then the business has grown, added locations or acquisitions, put in real systems and a management bench, and it isn't an owner-run company anymore. That makes it interesting to buyers who wouldn't have looked at it five years earlier: a larger private equity fund (a sale from one fund to another is called a secondary buyout) or a large strategic acquirer. Larger, more established companies generally draw more buyers and often command higher valuations than they did as owner-run businesses, which is part of how the second turn can be worth more than the first.

The second buyer has its own plan, its own lenders, and its own exit in mind. It grows the company for a few more years and sells to an even bigger fish. That's the third turn. There's always a bigger fish.

That chain is where our name comes from. Every one of those later turns is a sale between professionals. A fund selling to another fund has a deal team, lawyers who do nothing else, and bankers who know every buyer by name. The first turn is different. The seller is a founder or a family, usually selling the only company they've ever owned, for the first time, across the table from people who do this every week.

We're First Turn Capital because that's the sale we represent: the founder and family owned business going through its first turn. It's usually the most lopsided table in the chain, and it's the one where the decisions carry forward. The class of equity you roll, the terms attached to it, and the size of your stake all follow your rollover into the second sale and, if you roll again, into the third.

Selling to Private Equity Versus a 100% Sale to a Strategic Buyer

You don't have to roll anything. Plenty of owners sell 100 percent of the company, and for plenty of them it's the right call. Here's how the two paths compare.

A 100 percent sale, most often to a strategic buyer (a larger company in your industry), typically means:

• Most or all of the price in cash at closing, less escrows and any earnout.
• A clean break once the transition period ends.
• Sometimes a higher headline price, when the buyer can count on cost savings or cross-selling from combining the two companies.
• No second bite. Whatever the business becomes after you leave, the upside belongs to the buyer.
• Less say over what happens to the name on the trucks, the people, and the way things get done.

A private equity deal with rollover typically means:

• Less cash at closing, because part of your price stays in the company.
• A second payout that depends on how the business performs and what it sells for later.
• Several more years of work, now alongside a partner, a board, and a budget.
• Capital to grow: equipment, new locations, and acquisitions you couldn't have financed on your own balance sheet.
• Concentrated risk. A big piece of your wealth is still in one company, and that company now carries debt.

Neither is better in the abstract. An owner who wants out, wants certainty, or has most of the family's net worth in the business may be better served by the clean sale. An owner with energy left who believes the company could be much bigger may be better served by the rollover. It's the same argument we made about business exit planning: the owners with the most options start before they're ready to retire, and a rollover only makes sense if you're willing to stay for the next chapter. For a closer look at how the two kinds of buyers think, see private equity vs. strategic acquirers.

Platform or Add-On: It Changes the Deal

Not every private equity deal looks like the example above. A lot depends on whether your company would be the platform or an add-on.

A platform is the first company a fund buys in a new strategy, the base it plans to build on. The platform's leader usually stays on as CEO, rolls a sizable stake, and gets the full second bite, because the growth plan is built around that company.

An add-on, also called a bolt-on, is a company bought by a platform the fund already owns. Add-on sellers often take more cash at closing and roll less, or nothing at all. If you do roll, you're usually rolling into the platform's equity at the platform's current value, so you share in the second turn, but part of the growth is already priced in.

Which one you qualify as depends on your size, the depth of your management team, and the fund's strategy. Some funds build platforms around smaller companies. Most look for larger, established earnings, and the line moves from fund to fund. A well-run process will generally test both. The same company can be one fund's platform and another fund's add-on, and the offers can look very different.

Where the Fine Print Works Against You

This is the part owners tend to hear about only after it's too late to change. An unsolicited offer from a private equity firm can come with a perfectly reasonable rollover. It can also come with conditions in the operating agreement that make the equity you rolled far less yours than it sounds. Read these terms closely:

• A different class of equity. The sponsor may invest in preferred units that get their money back, sometimes plus an accruing return, before common units see anything. If your rollover is common and theirs is preferred, the second-turn math above tilts toward the sponsor. Ask for your rollover to sit in the same class, on the same terms, as the sponsor's money.
• Vesting on equity you already paid for. Rolled equity is purchase price. You gave up cash at closing to get it. Some drafts still attach vesting or forfeiture terms to it, the kind that belong on incentive equity granted to new managers.
• Leaver provisions. If you leave or are let go, the company may have the right to buy back your units. The question is at what price. "Bad leaver" terms can allow a repurchase at cost, or at the lower of cost and fair value, and the definition of a bad leaver is sometimes broader than owners expect.
• Who sets the value. A call right at a value determined by a board the sponsor controls can let the majority buy you out at its own number.
• Dilution. A management incentive pool, new equity issued to fund acquisitions, and fees charged to the company all come out of the value available to common holders. Preemptive rights let you buy in to hold your percentage.
• Drag-along without protections. The sponsor will want the right to require you to sell alongside it at exit, which is standard. What matters is whether you get the same price and terms per unit, and whether you have tag-along rights if the sponsor sells part of its stake without you.
• The tax treatment of the roll. A rollover can often be set up so tax on the rolled portion is deferred, commonly under Section 721 (contributions to a partnership or LLC) or Section 351 (contributions to a corporation) of the Internal Revenue Code. Both have conditions, and whether your deal qualifies depends on how your company and the buyer are organized. Structured wrong, you can owe tax on value you never received in cash. Your CPA and tax counsel should confirm the structure before the letter of intent is signed.

None of these is unusual, and several are reasonable in the right form. What turns them into traps is agreeing to them before you have a competing offer or someone in your corner who has seen how they play out at the second turn. If a firm has already called you, start with what to do when a buyer contacts you out of the blue. Our rollover equity guide goes deeper on each of these terms, and the private equity recapitalization guide covers the deal from start to finish.

Versus a Business Broker, Your Lawyer, or Your CPA

Owners who get an offer like this usually call the people they already trust: their attorney, their CPA, and maybe a business broker they've heard from. Each of them has a real role. None of them is typically set up to run the sale process itself.

• Versus a business broker. Brokers do good work selling smaller companies, often to individual buyers, through listings and wide marketing. Structuring a recapitalization with a private equity sponsor, building a list of platforms and add-on buyers, and modeling a rollover through its second sale is a different kind of engagement. We compare the two directly in business broker vs. investment bank.
• Versus your lawyer. You need an experienced deal attorney. Your lawyer drafts and negotiates the purchase agreement and the operating agreement, and a good one will catch many of the terms above. What a lawyer usually isn't there to do is model whether a 20 percent rollover at one price beats a 100 percent sale at another, or to go create the competing offer that gives you the bargaining power to change the terms in the first place.
• Versus your CPA. Your CPA is critical on tax structure, on getting ready for the quality of earnings review, and on the numbers a buyer will test. Running a buyer process and negotiating deal economics is a separate job.
• Versus going it alone with the one buyer who called. You get one set of terms, written by the party that benefits from them, and nothing to compare them against.

What tends to go wrong isn't that any of these advisors does their job badly. It's that each one handles a piece and nobody runs the sale itself. That's where we come in. We manage the process from the first conversation through closing: valuing the business the way a lender and a sponsor will, finding the platforms, add-on buyers, and strategics that fit, modeling every offer's rollover under good and bad outcomes so you can compare them side by side, and negotiating the economic terms alongside your attorney and CPA rather than around them. Our team has worked on both the buy side and the sell side of these transactions, and we've seen where these terms tend to show up.

If a private equity firm has already called, or you're starting to wonder what your company could become as a platform, talk to us before you sign anything. Talk to an investment banker about your options, or start with a directional look at what your business might be worth.