Equity structures in self-funded deals
November 22, 2019
by a searcher from INSEAD in Nürnberg, Deutschland
I'm in the process of launching my self-funded search in Germany. To prepare initial talks with investors, I want to better understand how a typical equity structure for self-funded deals looks like.
Of course, the unglamorous life of restricting one's diet to canned ravioli and instant ramen is rewarded with higher searcher equity. However, I found only very limited information on the actual deal structure of self-funded acquisitions with outside investors (e.g. with regards to searcher equity shares, vesting, hurdles, preferred equity etc.).
I'd be incredibly grateful for any advice on relevant materials and/or personal experience.
Thank you very much for your help!
Benedikt
from Babson College in Boston, MA, USA
A couple things to bear in mind. (1) All investors will ask for the largest share of equity that you'll agree to. (2) The typical 31% IRR hurdle rate for traditional search fund is to compensate the investor for the risk of providing search capital AND (3 ) providing acquisition capital AND the fact that (4) the searcher isn't required to provide a personal guarantee on the Senior debt using his personal assets.
So, in the case of a self-funded search, the only residual risk to the investor is that of the acquisition capital. This warrants a market-clearing IRR. In a traditional deal, the searcher's upside is capped###-###-#### % Shadow equity vested in 3 tranches) and the investor syndicate is not capped (unlimited upside). This is simply because they signed on to underwrite the traditional searchers risk of finding nothing, while still earning a salary. They are paying the searcher an advance "deal fee" This typically only earns the searcher a 7-9% share of shadow equity for closing a deal, the rest is an "earn-in" management incentive allow investors to achieve a 31% IRR on invested capital. This searcher often never really "owns" any of the business.. NOW, when you find the deal on your own, AND no investor has purchased an option (right of first refusal) to provide the acquisition equity, then you have far better market conditions in which to sell shares of your acquisition. The key difference is no investor has bought a call option, nor has any investor underwritten your opportunity cost (i.e. no one paid your salary whether you find a deal or not). Now the situation depends largely on what other investment options your pool of investors have available to them, given their own personal situation (net worth, liquidity, deal flow network, etc.).
So to get to the heart of your question, what remains....Who signs the personal guarantee on the Senior Debt? If it's you, then the investor risks nothing more than acquisition capital, and such an investment should return little more than 7-9% in the form of a preferred return, this is because you are taking on the lions' share of risk (essentially the risk of personal bankruptcy, in all likelihood), and after you have been compensated for this risk, there's just not as much compensation left for the investor. Now, if as in a traditional search fund, the investor (or syndicate of investors) will relieve the searcher of the personal guarantee (however given their net worth, their risk of loss would not likely result in personal bankruptcy), then they should be compensated for removing the risk of personal bankruptcy from the searcher, and this should provide for an expected (not preferred) return of up to 25%. KEY POINT: the reward (% return, as a function of equity share) for taking on the personal guarantee must be far higher for the searcher, because this guarantee is much riskier for the searcher due to his (likely) lower net worth than the investor.
As with anything, the larger your potential pool of investors (the demand) for your investment (the supply) then the price per share you can extract (the percent of equity you retain) will be higher. The challenge can often be that investors are aiming to invest for a pre-conceived return target....either because they achieved this once before, or its what they have become accustomed too, or because they have such a mandate from an employer/client. Some investors think a 10% return is great, other don't get our of bed for less than 20%. So it might be smart NOT to begin sourcing equity from investors who invest in traditional search funds because they may be psychologically anchored on a 31% IRR hurdle, and a smaller equity portion for you. Also, wealth doesn't always correlate with sophistication (in a specific investment arena). Meaning, there are lots of investors who made money in their businesses, are getting into the market for private placement investments, and you could be their first experience (in actuality). These folks may be mentally anchored on the types of returns on equity they had as owner/operators or even "absentee owners". Don't flinch in the "confidence game". Know your target return (or geographic preference) for being self-funded. Ensure your target is higher than that of a traditionally funded searcher (otherwise, why take the extra risk?). Talk with dozens of investors, and withhold judgement until you've seen enough to separate the knowledgeable investors from the rest. Those who aren't knowledgeable investors may still be of value to you as operational advisers pre/post-closing. You also may want to find investors who normally invest for smaller IRR's. A word of caution however, this means you'll source investors less familiar with your type of investment, so this may require you to educate them more, and to have a larger list of potential investors so that enough are willing to invest. This all takes time, and that time will come at the expense of sourcing and due diligence with attractive targets. You need the balance where your time is best spent to determine what allocation will maximize the VALUE of your equity, not the SHARE of it. Ultimately, keep in mind the cash flows (periodic and terminal) that satisfy your strategy.
In the end, being self-funded takes more time and more (of your own) money. However, many of the things that take extra time (developing investor networks) can be done prior to committing full time to a self funded search (i.e., in the evening, after your day job). This includes developing an inter-mediated search network of brokers and "river guides" as this sort of work is easily done via email and doesn't included a responsive outbound marketing campaign. Do this while still at BCG. If you could conceive of taking a night class, planning a wedding, starting a family, being a leader in a volunteer organization, or anything similar, then you have time to set up your search prior to running it full-time. You can develop investors, river guides, marketing material, websites, etc. while still collecting a check. If you have done all this, and all that is left is to leave your day job and focus full time on adding a proprietary deal stream then you have already mitigated most of the risks that a traditional search fund was designed to do. For all that, you get 61%-100% of the equity, depending on the your acquisition target, its market variables, and your capital structure.
Remember, when Seller's finance part of the deal for a 5-7% annual return on principal they only get recourse on the business itself, not your assets....so unless an equity investor is the one (instead of you) signing the personal guarantee to give the Senior lender recourse.....why on earth would you given them anything more than a preferred return of 8%? If an investor wants more, then they need to buy at least 20% of the equity and take on a personal guarantee. And even if they do, if they ask for a share that your projection tells you would give them more than a 25% IRR then you just go to the Seller and offer him a higher interest rate to finance a greater portion of the deal.
When you have a syndicate of investors you will often see one investor lead it, and he will negotiate for the syndicate. This is fine for a traditional search, but you should avoid dealing with a syndicate (think of it like an "investor union", with a "union rep"). Divide and conquer. Let market forces dictate the IRR (never the % share) that you accept acquisition equity under. When you control 51% of more of the equity, most investors will want a preferred return, unless they have strong confidence in you as an operator. Usually they will not want to sign a personal guarantee if they cannot replace you. Nor will then even want to invest where they might have to fire a CEO (you) who walks away with 49% equity in the business (albeit on the hook for a personal guarantee on the Senior debt) and leaves them to find a replacement CEO which only there own equity as incentives for him/her).
This all means that if you want to own a large share of equity as a self-funded searcher, then you must (1) find a deal with the highest Debt/EV ratio possible with a suitable Debt service coverage ratio (also a proxy for equity IRR)....to minimize the outside equity needed (2) provide as much equity from yourself/friends/family as possible (3) source the residual outside equity from a disparate group of investors who's individual contribution doesn't warrant a personal guarantee, nor does it represent so large a check on their part that they require control in the form of more equity, or gets funds from a syndicate with a leader who will exert control over management. Ideally, you want to offer a preferred return (locking in their return at the risk of your own return). This sort of deal is preferable for a simple business model (which increases the pool of potential buyers), or one where the searcher already has expertise (which limits the pool of businesses).....two issues that a traditional search fund with lower Debt/EV ratio's and greater management oversight in the form of a Board of Directors, might mitigate.
Aligning yourself (type of searcher) with the market (method/form of search vehicle) and the business (size of acquisition target) and the type of deal structure (partial/full control, majority interest, or minority interest) will ensure the your personal rate of return is maximized, given your personal opportunity costs, and the expected net present value of your share of cash flows to equity (periodic and terminal).
from University of Oxford in San Francisco, CA, USA