Equity Deal Structure (Updated)

April 8, 2023 | Issue #83

Big Deal Small Business: Equity Deal Structure (Updated)

April 8, 2023 | Issue #83

Happy Saturday! A bit of a denser read, so saved it for a weekend. Suggest reading with a cup of coffee.

My professional investing experience focused on restructurings & complicated deal structures, not clean, straightforward buyouts.

Those PE deals required creative capital solutions including preferred equity, junior debt, profit sharing hurdles, and more.

But why create all this complexity? Ultimately, deal structure is just a solution to a problem. The problem tends to be some variation of “how do we set up incentives in a way that aligns all parties?” The more parties involved, the harder it is to find alignment, so the more complex deal structures get.

Self-funded search deals are somewhere between very complex and very straightforward buyouts.

Today’s post lays out the “standard” self-funded equity structure and what incentives it is solving for. While there are other self-funded deal structures, this reflects what I’ve commonly seen. 

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Example Deal Structure

Before I get into the “why” of this deal structure, here is the basic deal structure itself.  

Searcher puts in 10-20% of the equity capital and investors put in 80-90%. NOTE — this is of the equity capital alone. Most self-funded deals are financed ~10-15% equity, 10-15% seller note, and 70-80% SBA 7(a) loan.

So the equity capital is just 10-15% of the total capital required — and the searcher putting in 10-20% of that 10-15%, which means they are putting in only 1-3% of the total deal’s capital requirement.

For their equity capital contribution, the investors receive preferred equity with an 8-16% annual compounded accrual rate (key word is accruing — this isn’t paid each year in cash like an interest payment).

The common equity is generally split as follows:

• Searcher receives 60-80% of the common equity: their starting 10-20% plus an additional ~50-60% of “sweat equity” or “promote”

• Investors receive ~20-40% of the common equity: their starting 80-90% less the 50-60% that went to the searchers

How does this work in practice?

• First, all cash distributions from the business go to the investors until they got their investment back plus their accrued return (which compounds each year). This is why their equity is “preferred”.

• Once investors have received a return on their preferred equity (the accrued amount) AND return of their preferred equity (the initial investment), then the preferred equity is effectively paid off.

• After that, every incremental profit dollar is split based on common equity splits. So after the preferred equity is turned off, the searcher gets 60-80% of any additional distributions.

Sometimes the searcher may have a “catch-up” i.e. their invested capital gets returned, with an accrued return, after the investors got all their preferred return. Think of it as a second layer of preferred equity sitting behind the investors’ layer. That way everyone is on the same total return from the moment the common equity splits kick in.

From a governance perspective, as the majority common equity shareholder, the searcher generally controls the company, which is a big part of what makes this structure attractive. Investors have customary minority shareholder protections and consent rights over searcher salary or new equity issuances.

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Deal Structure Considerations

Deal structure is a way to align incentives and to match capital structure with investment thesis. There are many considerations, but the four I focus on are 1) duration, 2) investor selection, 3) governance, and 4) profit sharing.

Below I explain how I thought through each consideration and how the self-funded deal structure met my needs.

Duration 

Duration refers to how long you intend to own the company. For my first SMB transaction, I wanted to optimize for duration flexibility. I planned to spend at least two years with my head down learning the business, and then re-assess if the deal looked like a shorter or longer hold period. My hope is to own it for a very long time.

By contrast, private equity funds or traditional search funds are generally focused on generating high returns over a shorter period, so their deal structures involve IRR or time-based thresholds. 

Holding company or permanent capital type funds are less focused on an exit – they care about total profits over a longer period, so they tend to focus on MOIC or profit-based thresholds. 

To make it more concrete, here are two scenarios: 

• Invest $100, exit in 5 years, and return $300 = 3x MOIC, 25% IRR 

• Invest $100, exit in 15 years, and return $1,000 = 10x MOIC, 17% IRR 

A private equity fund may prefer the first scenario, while a permanent capital investor would favor the second scenario.

There’s arguments & rationales for both preferences, but it’s important to reflect on what’s more attractive to you before you launch your fundraising process.

In my desire to optimize for flexibility, I landed on the self-funded structure’s hybrid solution between IRR and MOIC incentives.

The preferred equity I gave investors had a 10% annual compounding accrual, effectively defining a minimum 10% IRR for them before I make a dollar on my equity.

However, once I pay back the preferred equity, which I should be able to manage through internally generated cash flows (i.e. without needing a sale of the business), the accrual will stop.

After that, we could own the company indefinitely and split profits based on the common equity splits discussed above.

This allows me to focus on maximizing total profits and MOIC over a long hold period without focusing on IRR, but only once I’ve locked in that minimum IRR.

Investor Selection

I considered three types of investors: friends & family, individuals focused on SMB, and institutional SMB investors.

I would tread carefully when including friends & family in your equity fundraise for obvious reason.

I only included friends who are professional investors. Many of my friends work in private equity, venture capital, or hedge funds and are well-attuned to underwriting risky transactions.

By contrast, I did not attempt to raise money from friends who worked in tech. They have capital to invest, but I didn’t think I could adequately educate them on the risk profile of a levered SMB buyout. (This is obviously painting with a broad brush, but lowered the odds of me adding unneeded tension to a friendship.)

Individual SMB owners were the backbone of my investor group because I wanted a bench of experienced operators who would take my phone call when things invariably went wrong. Now that I’m a little over a year into my deal, I can affirm that this was the right choice — the current & former SMB operators on my cap table have been invaluable sources of support & mentorship. The individual SMB operator/investor community is tremendous, so I would recommend leaning in here if you’re a self-funded searcher. 

I did not include any institutional investors (i.e. funds or family offices) due to size constraints and duration constraints. Institutional investors need to deploy more capital at a time, so are more active in $3M+ EBITDA deals, whereas I was focused on the $750K to $1M EBITDA range. 

Further, unless you focus on family offices with their own capital, institutional investors tend to require shorter duration deal structures because they must also return capital to their investors.  

Governance 

While there is a long list of governance items to negotiate, these are five big ones to consider: 

• Hire/Fire CEO  

• CEO Salary 

• Incur Debt 

• Issue Equity 

• Sell the Company 

This is a negotiation and tends to turn on how much the searcher/CEO will own in the business. In my deal, I had sufficient skin in the game and ownership to maintain control of Hire/Fire CEO, Incur Debt, and Sell the Company. 

I didn’t negotiate to have control of equity issuances. I think the CEO having full control over new equity & dilution risk would be unfair to minority investors. Instead, we set up a fair system where I can issue equity as I choose, but minority investors have the right to participate pro-rata (basically maintaining their ownership % if they want).

One thought — you could consider including a small (~5%) profit interests pool that you have discretion to give out to key employees or new hires without any investor approvals.

Similarly, I didn’t attempt to negotiate control over my own salary given the obvious misalignment — I just set it at a reasonable cost of living for myself with automatic 5% annual increases. The goal is to make money on the equity, not the salary.

By contrast, control over Hire/Fire CEO and Sell the Company was most important to me.

In my PE job, our portfolio company CEOs effectively worked for the partners of my PE firm, just like I did. Part of my goal in entrepreneurship through acquisition was to become my own boss. Ending up in a deal structure where I’m an employee (rather than a partner) of my investors would not accomplish that goal.

Instead, the self-funded deal structure I used protected investors through incentive alignment and minority shareholder protections while not requiring I give up outright control.  The end result is a partnership deal structure, not a employee/employer model.

Profit Sharing 

This is the economic deal you negotiate with your investors, which we discussed above. In private equity or hedge fund world, this is referred to as “carry” or “promote” i.e. the share of investors’ profits that the private equity fund gets to retain in exchange for doing the work. 

No hard and fast rules here clearly, but as described above, I have generally seen ~50-60% of equity being allocated as “sweat equity”. This extra equity compensates searchers for putting the deal together, taking dead deal expense risk, operating the business full-time, and taking personal guarantee risk on the debt.

To size this percentage, I created a simple, conservative 5-year scenario — one that includes growth, but nothing crazy either.

Based on that, I figured out what profit share I needed for the transaction to have been worth five years of my life given the opportunity cost, risk, and long-term upside potential. If that math implies a massive profit share that no investor would stomach, either you are paying too much for the business or the business is too small.

Then, look at it from the other side — investors likely need to be able to return a ~35%-40% IRR in a reasonable base case assuming SBA-style debt profile. This is your equity cost of capital in a highly-levered deal structure.

Run your deal math to see how much sweat equity the investors can afford to give you while still receiving a returns outcome that is interesting to them.

There should be overlap between those two angles of math (i.e. an ownership % split that is worth your time while still being interesting to investors). The goal is to land in that box. If there isn’t an overlap, you are likely overpaying for the business (or something else is wrong with the deal structure).

Keeping in mind that acquisitions and capital raising are a repeated game, I also didn’t try to maximize my profit share. I tried to find a fair split that adequately compensated me and my investors for everyone’s respective contributions. I didn’t want investors to feel like I squeezed them for every last percentage point of equity. 

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Conclusion

The classic self-funded deal structure gives investors a minimum IRR threshold while providing the searcher with indefinite runway to drive MOIC. It provided me with sufficient governance to make me a partner to investors, not an employee. The profit share was sized to make the deal worth my time, effort and personal risk.  

Hope you found this helpful. For thoughts or feedback, just hit reply to this email or post/DM me on Twitter. 

Thanks, 

Guesswork Investing 

P.S. I run a local building maintenance contractor in Seattle, WA that focuses on single family residential & commercial properties. To the extent you know folks in the RE industry in Seattle (particularly property managers), I’d always appreciate intros.