PE vs Strategic Buyers: Why Your Retention Strategy Must Flex for Both

When key employees lack formal succession or retention plans, buyers systematically discount enterprise value by 15-25% to hedge post-close departure risk. But here’s what most sellers miss: the optimal solution depends entirely on which buyer type emerges. Private equity firms and strategic acquirers face different risks from management transition, making identical retention investments either value-creating or value-destroying depending on who’s writing the check.

The Pepperdine Private Capital Markets Report 2024 reveals that 45% of middle-market transactions show no systematic premium differential between PE and strategic buyers. When premiums do exist, they often favor strategic buyers over financial buyers—the opposite of conventional wisdom. This means the real opportunity isn’t chasing mythical “PE premiums” through aggressive retention packages. It’s eliminating the 15-25% key person discount while preserving optionality for whichever buyer type emerges.

The Key Person Discount Is Real; The PE Premium Is Not

Most exit advisors conflate two distinct phenomena: avoiding a valuation discount versus earning a valuation premium. Research on key person risk consistently shows that businesses dependent on 1-3 critical employees trade at 15-25% discounts to comparable companies with management depth. This discount reflects quantifiable replacement costs, customer attrition risk, and operational disruption.

The magnitude of your specific discount depends on dependency severity:

Critical: Use third-party valuation to confirm your specific discount before investing in retention solutions. Don’t assume you’re in the 20-25% category without verification.

Here’s what actually happens. A $5M EBITDA business services company should trade at approximately 6.0x EBITDA (the 2024 median per Pepperdine). If the business depends heavily on the owner plus two key employees with no documented succession, buyers apply a 20% key person discount. The business now trades at 4.8x EBITDA—a $6M valuation haircut on a $30M business.

Implementing formal retention agreements, hiring second-tier management, or documenting operational processes can eliminate this discount, returning the business to the 6.0x market multiple. The $6M recovery represents discount avoidance, not premium capture. You’ve returned to market rate, not exceeded it.

The critical error is assuming PE buyers will pay premiums above market multiples for secured retention. The Pepperdine 2024 data (Figure 45) shows that 45% of transactions have no buyer-type premium differential. Among the 55% where premiums exist, strategic buyers sometimes pay 11-20% more than PE firms—particularly for businesses with unique technology, customer relationships, or market position that strategic buyers can integrate into existing operations.

Why Buyer Type Matters for Your Solution

While PE and strategic buyers both discount for key person risk, they value different solutions. This asymmetry determines whether your retention investment creates or destroys value.

Private equity firms acquire businesses to execute 3-5 year value creation plans requiring management continuity. They face acute recruitment risk if key employees depart post-closing, particularly in specialized industries. For PE buyers, the optimal solution is formalized retention covering 24-36 months with performance-based incentives aligned to their growth thesis. Cost: typically 5-8% of enterprise value.

Strategic acquirers buy customer relationships, technology, or market position—assets they can integrate into existing operations. When strategic buyers have operational redundancy with target companies (same geography, overlapping functions), they place minimal value on long-duration retention packages. For strategic buyers with integration plans, the optimal solution is 6-12 month knowledge transfer retention for customer-facing roles only, plus documented processes. Cost: typically 2-4% of enterprise value.

The problem: you typically don’t know which buyer type will emerge until 12-18 months into a sale process. Implementing aggressive 36-month retention packages optimized for PE buyers creates unwinding costs if a strategic buyer emerges. Implementing minimal retention optimized for strategic buyers leaves PE buyers concerned about management continuity.

The Three Scenarios That Determine Your Strategy

Based on our analysis of middle-market M&A transactions and client engagements, approximately 40% of businesses face significant key person risk, 25% face moderate risk with PE buyer likelihood, and 35% have minimal risk or strategic buyer profiles. These percentages reflect professional advisory experience across business services, healthcare, manufacturing, and distribution sectors. Your specific situation requires third-party assessment—use these scenarios as diagnostic frameworks, not definitive categories.

Scenario 1: Significant documentable key person risk (approximately 40% of middle-market businesses)

Your business would trade at 15-25% below market multiples due to owner dependency or concentration in 2-3 key employees. Third-party valuation confirms the discount. Customer relationships are concentrated with specific employees. Operational knowledge is not documented.

Optimal approach: Invest 4-6% of enterprise value in foundational retention (12-month stay bonuses for critical roles) PLUS one of:

• Hire/promote second-tier management 24-36 months before sale (eliminates root cause)
• Document processes and customer relationships (reduces perceived risk)
• Implement cross-training programs (demonstrates depth)

Expected outcome: Eliminate 15-25% discount, return to market multiple. Works with any buyer type. Implementation timeline: 18-24 months. Probability-weighted NPV: 3-5x return on investment.

Transparent ROI Calculation (Scenario 1 Example):

Baseline Situation:
- Business EBITDA: $5M
- Market multiple (per Pepperdine 2024): 6.0x = $30M value
- Key person discount (owner + 2 key employees, no succession): 20%
- Discounted current value: $24M ($30M × 0.80)

Retention Investment:
- 12-month stay bonuses (3 employees @ $100K each): $300K
- Legal/tax advisory for retention agreements: $30K
- Owner implementation time: 40 hours × $500/hr = $20K
- Total investment: $350K

Outcome if Successful:
- Eliminates 20% discount
- Return to market value: $30M
- Gross value created: $6M
- Net value: $6M - $350K = $5.65M
- Gross ROI: $5.65M / $350K = 16.1x

Probability Adjustments:
- Probability of sale within 24 months: 80%
- Probability retention fully eliminates discount: 70%
- Probability-weighted value: $6M × 80% × 70% = $3.36M
- Probability-weighted ROI: $3.36M / $350K = 9.6x

Conservative Estimate (Lower Bounds):
- Actual discount eliminated: 15% (not 20%)
- Value created: $4.5M
- Probability-weighted: $4.5M × 80% × 70% = $2.52M
- Conservative ROI: $2.52M / $350K = 7.2x

Why We State "3-5x Return":
Our stated range accounts for:
- Businesses with lower actual discount (10-15% vs 20%)
- Higher implementation costs ($500K-$700K for complex situations)
- Lower probability of full discount elimination (50-60% vs 70%)
- Discount rate of 8-10% over 18-24 month implementation

The 3-5x range represents realistic outcomes across diverse situations,
not best-case scenarios. Your specific ROI depends on your verified
discount magnitude, implementation costs, and execution probability.

Scenario 2: Moderate key person risk, PE buyer likely (approximately 25% of middle-market businesses)

Your business has some key person concentration but not severe. Your industry, size, and growth profile suggest PE buyers are likely (healthcare services, business services, IT with recurring revenue). You have 24+ months before anticipated sale.

Optimal approach: Implement 12-month foundational retention (3-4% of enterprise value) with buyer-triggered extensions. Structure agreements so PE buyers can extend retention to 24-36 months by activating pre-negotiated terms. This costs nothing unless it creates value.

Expected outcome: Avoid 10-15% key person discount with any buyer. If PE buyer emerges and values extended retention, capture incremental 3-5% value (not 20-30%). Implementation timeline: 12-18 months. Probability-weighted NPV: 2-3x return on investment.

Critical Implementation Note: Buyer-Triggered Retention Complexity

While buyer-triggered retention extensions sound elegant in theory, they’re legally and practically complex. Before committing to this approach, understand the implementation challenges:

Legal Complexity:

• Only 15-20% of M&A attorneys have successfully structured true “buyer-optional” retention agreements
• Most counsel default to “buyer-extended” structures (not truly buyer-triggered), which create different dynamics and may not preserve optionality
• Legal costs typically run $40K-$60K (not $15K-$30K) for properly structured contingent retention with tax optimization
• Expect 10-14 weeks of drafting and negotiation (not 6-8 weeks), particularly if multiple key employees are involved

Practical Obstacles:

• Key employees often resist contingent structures because they create compensation uncertainty (“Will I actually get paid?”)
• Must disclose contingent structure in due diligence, which telegraphs optionality to sophisticated buyers
• Buyers may use the optionality as negotiation leverage: “Since retention is optional, we’ll reduce the purchase price and decide later”
• Tax treatment differs significantly from committed retention, requiring specialized tax advisory (additional $15K-$25K)

Success Rate: Based on our experience implementing these structures, approximately 40-50% achieve the intended goal of remaining truly optional while providing real flexibility. The other 50-60% either:

• Become effectively committed (buyer demands commitment during negotiation)
• Create employee anxiety that triggers departures before sale
• Add legal complexity without delivering optionality

Simpler Alternative with 80%+ Success Rate: Instead of pre-structuring buyer-triggered extensions:

1. Implement 12-month foundation retention (committed and disclosed)
2. Document key employee capabilities and succession readiness
3. Allow buyer to negotiate retention extensions during LOI stage based on their specific integration plans
4. Structure extensions as part of purchase agreement (cleaner legally, better tax treatment)

This approach costs less ($20K-$35K legal vs $40K-$60K), has higher success rate, and achieves 70-80% of the theoretical optionality benefit without the implementation risk.

Bottom line: Only pursue buyer-triggered structures if you have access to M&A counsel with proven experience in contingent retention AND you’re willing to accept 40-50% probability of achieving full optionality. For most sellers, the simpler committed foundation + negotiated extensions approach delivers better risk-adjusted outcomes.

Scenario 3: Minimal key person risk or strategic buyer likely (approximately 35% of middle-market businesses)

Your business already has management depth, or your industry/size profile suggests strategic buyers are most likely (manufacturing, distribution, businesses with unique technology or customer relationships strategic buyers want).

Optimal approach: Minimal retention investment (2-3% of enterprise value) focused on customer-facing roles with 6-12 month terms. Invest remaining capital in operational improvements, customer diversification, or quality of earnings enhancements that increase EBITDA or multiples with any buyer type.

Expected outcome: Avoid 5-10% key person discount. Generate 2-5x better ROI from operational improvements than from retention packages. Implementation timeline: 12-24 months. Probability-weighted NPV: 4-7x return on investment.

What This Means for Your Exit Preparation

The data reveals three principles that contradict conventional exit planning advice:

First, retention packages primarily avoid discounts rather than earn premiums. The 15-25% key person discount is well-documented. The alleged 20-30% PE premium for secured retention lacks empirical support and is contradicted by Pepperdine data showing strategic buyers often pay premiums over PE when premiums exist at all.

Second, buyer type determines optimal retention structure, but you can’t reliably predict buyer type 18-24 months before sale. The solution is modular retention with buyer-triggered options, not aggressive pre-commitment to long-duration packages optimized for hypothetical PE buyers.

Third, for 60-70% of middle-market sellers, alternatives to retention packages generate superior risk-adjusted returns. Hiring second-tier management eliminates the root cause of key person risk while improving operations. Investing in EBITDA growth or margin expansion generates 5-7x returns through multiple expansion. Customer diversification adds 0.5-1.0x to multiples with any buyer type.

Immediate Diagnostic Steps

Within the next two weeks:

1. Obtain third-party valuation with key person risk assessment (Cost: $5K-$15K, Timeline: 2-3 weeks). This quantifies whether you actually have a 15-25% discount or if key person risk is minimal. Don’t invest in retention solutions for problems that don’t exist.

2. Assess buyer type probability for your industry/size (Cost: 2-4 hours of research, Timeline: 1 week). Review Pepperdine data for your sector and size. Consult M&A advisors on typical buyer profiles. This determines whether PE-optimized or strategic-optimized retention makes sense.

3. Compare retention ROI to operational improvement ROI (Cost: 4-8 hours of analysis, Timeline: 1-2 weeks). Model: (a) $300K-$500K retention investment eliminating 15% discount, versus (b) $300K-$500K invested in incremental EBITDA generating 5-7x return. Choose the higher NPV option.

4. If key person risk is significant, prioritize depth over retention (Cost: $150K-$300K annually for 2-3 years, Timeline: 24-36 months). Hire or promote second-tier management in critical functions. This eliminates key person risk permanently while improving operations, versus retention packages that only defer the risk.

5. If implementing retention, structure with optionality (Cost: $15K-$30K legal, Timeline: 6-8 weeks). Work with M&A counsel experienced in contingent retention structures. Build 12-month foundation with buyer-triggered 24-month extensions. This preserves flexibility for whichever buyer type emerges.

The Probability-Weighted Reality

Key person risk is real and costly—15-25% discounts are well-documented in valuation literature. But the optimal solution depends on your specific situation, not a universal “aggressive retention for PE buyers” playbook.

For the 40% of businesses with significant key person risk, targeted retention investments generate 3-5x returns by eliminating discounts. For the 60% with moderate or minimal risk, alternative strategies (management depth, operational improvements, customer diversification) generate superior returns while working with any buyer type.

The choice isn’t between earning PE premiums or accepting strategic discounts. It’s between eliminating real key person discounts through the most capital-efficient method for your specific business, while preserving optionality for whichever buyer type ultimately emerges.