Equity Arbitrage – How & When Should I Disclose?

February 21, 2025

by a searcher in Chicago, IL, USA

Hi SF community, I have an off-market deal I quite like under LOI. I found a Buyer very interested in a quick exit and I negotiated a purchase price about 50% Fair Market Value.

I want to be open and honest in the friends and family round of raising capital, so the first few investors I spoke with (family members) I let them know that the acquisition will be around 50% FMV, but the Investor entrance tier is at 75% FMV. The thought is that through my sourcing and negotiation (sweat equity + minimal out of pocket expenses), I am generating substantive value, so it shouldn't matter to them that I'm getting a better deal (with significant risk mitigation from the low purchase price) – but I'm getting some push back.

As an example, let's say the FMV of a business is $5m, but I'm paying $2.5m. In this example, I'd be selling equity at a $3.75m valuation ($375k = 10% equity). Even at this entrance price, the investors stand to earn 20-30% annual ROI (we're currently rebuilding the P&L for proper add backs).

My question is... Should I be withholding this information to Investors, be abundantly honest, or just understand that friends and family not in the M&A world may not understand that this is more common than not?

Or... Am I totally off base in my thinking?

Reply by a searcher
from The University of Chicago in Stamford, CT, USA

I think this is just echoing Nathan, but especially when dealing with potentially unsophisticated family members, it feels a little slimy to charge them an arbitrary premium on coinvest. If you are so confident you can immediately flip the company for 100% FMV, why not build in some hurdles or performance incentives for yourself (similar to traditional search) to make it appear more like a reward for delivering returns, instead of instituting a late comer equity valuation penalty. Easier to explain why you are getting more while they are already receiving positive returns in their pocket, and also offer them some downside protection on an investment they are likely to see as much riskier than you see it.

Reply by a searcher
from University of California, Berkeley in Seattle Metropolitan Area, WA, USA

I'd venture to say that you believe you're getting a co at 50% FMV but ultimately the only market for a co is the one that's getting the deal done, so you're setting FMV. There's no markup, and as such, you'd be overcharging your equity investors at a higher rate. The pref/liquidation figures are more honest (pretty sure there are ethical and potentially legal problems with the terms laid out if this were a larger deal requisite of registration). Then whenever you do decide to sell, by all means, a good outcome for everyone and your work will earn you and your investors something you can feel good about.

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