High-quality revenue is generally considered to be sales that are, profitable, sustainable, and predictable.  Businesses with high-quality revenue often trade at higher multiples than their peers with lower quality revenue, particularly when the buyer plans to continue to operate the business as a stand-alone entity.  That’s because it lowers the risk for the buyer, and there are often more buyers willing to bid aggressively in a well-run, competitive sales process.
This article provides some ideas that business owners may want to consider implementing, that can improve the quality of their revenue in advance of a sale and to increase their chances of a successful outcome, once in the market.

The highest-quality revenue comes from contracted sales with recurring revenue.  This type of revenue can usually be relied on by a new owner to generate cash flow which allows for the use of more debt financing and less equity to finance the transaction.  Longer contracts are better, assuming it generates profitable sales with reasonable pricing adjustment mechanisms and is with a reliable and stable payor.

Subscription revenue is also a very high-quality source of revenue and one of the reasons why Software as a Service (Saas) companies trade at such high multiples.  Anything a company can do to generate at least a portion of their sales as recurring service revenue will help drive value and the business’s marketability.  This is especially true in circumstances where the service is scalable, there is a low cost to service new customers and when the market opportunity is very large.

Lengthy customer tenure with very low customer churn rates is also generally considered to be a source of high-quality revenue.  All too often, companies emphasize programs and strategies to acquire new customers, and while important, retaining key customers is often more important when it comes to the value of your business when selling.  This is especially true in B2B companies where customers are difficult to acquire and costly to lose.

It’s often been said that you can’t manage what you don’t measure.  Companies that have a robust CRM (Customer Relationship Management) system in place to manage the entire organizations’ interaction with customers can address customer concerns early to improve retention.  They also help identify ways to increase sales with existing customers.  Taking this a little further, understanding your company’s Net Promoter Score (NPS), and the actions you can take to increase it, can drive value.  NPS is simply a tool that measures customer satisfaction and the likelihood they would recommend your product, service or company to someone else.

Simply putting more resources and a disproportionate effort in retaining customers that are growing rapidly can be an excellent way to grow the business.  However, it is important to make sure that this strategy is not taken to the extreme, as customer diversity is also an important component of revenue quality.  Whenever there are a lot of sales coming from only a few customers, a buyer will price the risk of defection into their offer.

Besides a diverse customer base, sales into unrelated markets, based on geography or market segments sometimes can be a driver of revenue quality.  However, there are limits to this strategy, particularly when diversifying revenue too thinly.  Focus should be directed towards markets that are not dominated by well capitalized competitors, and on the most profitable customers, products, product lines, etc.  The market should also be able to benefit from your business’s core competencies.

Most people understand that product, and/or product-line diversity can an important way to improve revenue-quality.  However, products and services that are low cost relative to the customers’ total expenditures are higher quality sources of revenue than the reverse.  Under these circumstances, customers tend to be less sensitive to pricing, and therefore gross margins can be higher.  Gross margins can be a proxy for high-quality revenue.

Some of the lowest sources of quality revenue are tender/bid business or a one-time project-related sales. In the case of tender or bid sales, it is also often the lowest margin.  Large-ticket, capital expenditure reliant business is difficult to predict, and volatile cash flow makes aggressive pricing for buyers a difficult proposition.
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Every business, regardless of the market it serves, has room to pivot and refocus on higher-quality revenue streams that will drive its value and marketability when it comes time to sell.

Most Private Equity deals in the lower middle market are structured where at least a portion of the sale proceeds paid to the seller(s) are rolled back into a new capital structure of the company, alongside the equity provided by the PE firm. This provides a source of financing for the Private Equity buyer and lowers the amount of equity they need to invest, but more importantly, it demonstrates that the target company’s founders, owners, and/or management are confident in the business’s future.  When combined with an ongoing role in the new partnership, it is an opportunity for the seller to contribute to the business’s future success without taking on all the risk themselves.  Of course, besides the fact that the seller does not receive “all cash” at the close of the transaction, it has many other financial, legal and, tax implications that should be clearly understood by the seller.

The first consideration that is usually top of mind with sellers, is whether the PE firm will take a majority or a minority equity position in the newly capitalized business.  Some entrepreneurs are accustomed to making all the key business decisions and can be uncomfortable in giving up control while staying involved.  On the other hand, many PE firms that participate in the lower-middle market are not able to take non-controlling positions, and those that do, only do so in special or specific circumstances.

From a practical standpoint, whether the PE firm has a major minority position (i.e. at least 25-30% ownership), or a majority, it will only be successful if both sides have a common vision and clear alignment on strategy.  The last thing a PE firm wants is to have a falling-out with legacy owners, based on a major disagreement on the strategic direction of the company.  While disagreements can occur during the common ownership period, it is important to get off to a strong start, so that those disagreements can be worked out respectively and amicably regardless of who is in ultimate control.

It is also important to clearly understand the respective roles and responsibilities of each party.  Most PE firms will say that they don't want to run the business, but what that means from a practical standpoint, can vary from firm to firm.  Rarely will a PE firm be a truly passive investor.  The best outcomes are usually where an entrepreneur is looking for the professional support and experience that is provided by a PE partnership, and where both parties are focused on building value for an eventual full exit.  Entrepreneurs need to be comfortable with the added reporting, planning, and governance that usually accompanies a PE deal.

One of the key benefits of rolling equity is that the lower risk for the PE firm can translate into a higher value the PE firm is willing to pay.  And of course, if during the period of common ownership, the capital and resources provided by the PE partner can help scale the business and build value, the value for the legacy owner’s rollover stake can be much higher when the business is sold down the road.

Often the PE firm will use some degree of leverage to finance the deal as well. While many business owners view debt as risky and have avoided its usage wherever possible, its use along with the shared risk taken by the PE firm can further enhance the legacy owner return on their rollover equity.  For example, if a PE firm structures the deal with 50% debt, and legacy owners agree to a 25% equity stake, funding the rollover portion requires only 12.5% of the pre-tax net proceeds.

A PE-backed business also can often negotiate preferred terms with lenders that legacy owners can benefit from. Furthermore, if the new business partnership is highly successful, legacy owners can sometimes benefit from dividend recaps, sale lease-backs of assets, or other refinancing deals that provide cash disbursements to all shareholders.

There are also often significant tax deferral benefits for the portion of the equity that is rolled.  Engaging an advisor that is familiar with the tax implications of equity rollovers in your jurisdiction is critical.  Normally the PE firm will be open to structuring a transaction to help reduce or defer taxes when it has a neutral impact on them.  There also could be significant tax implications if the deal is structured as an equity sale vs an asset sale.

The legal implications can be complex, and it is critical to have legal counsel that is experienced with PE rollover transactions and how they should be structured.  Besides the obvious legal implications of majority/minority positions, preferential voting and liquidity rights can be sources of consternation.  One way to ensure that the interests of the PE firm and the rollover equity shareholders are aligned is to structure the shares on a pari passu (equal footing) basis.

The key is finding both tax and legal advisors that have deep experience in getting PE deals done.  All too often, advisors without enough experience in rollover transactions with PE firms are so risk-averse and so protective of the sellers' rights, that a successful close is not possible.
Rounding off your “A” team with the marketing expertise and deal experience of an Investment Bank and/or M&A Advisor will help ensure you have multiple PE firms to consider rolling your equity with, by running a professional, competitive process and determining “what’s market.”