How does an equity step up work?
June 11, 2024
by a searcher in Toronto, ON, Canada
I know most funds give investors an equity step-up. If my fund was funded by investors, how would it be possible for every investor to get the step-up?
Example: I get 10 investors investing $1M each into a search. I then buy a company with an equity value of $12M, how would I then give them all 1.5x equity?
How would this work? Thanks in advance.
from McGill University in San Diego, CA, USA
For self funded, the mechanics work a little differently... there is no search budget to step up like you have in the traditional model. But the capital you raise from investors is preferred, which means you will be paying out a pref return each year until the capital has been returned back to investors. So, if investors wrote you a check for $300k, and the pref rate is 10%, you will pay out 30k per year. Once you start returning capital, the $30k payment will decline (but will still be 10% of the total balance). Once all the capital has been returned, the investors will start to receive 15% of the profits (10%, stepped up by 50%). Essentially, self funded searchers tweak the step up so investors can get a very healthy rate of return. Sometimes it's 50% and sometimes it's a lot more. Also worth noting that the pref rate is also higher with self funded deals than traditional as well###-###-#### % on average; sometimes higher, sometimes lower). There are many variations to this approach, but that's the general gist. At the end of the day, the returns have to be generous enough to make it a worthwhile risk/reward for the investor.
from Harvard University in Nashville, TN, USA
From the operator's perspective, you are using the investor's capital to then lever up on debt to pay for equity that now can be divided. Idea is to use high leverage to "free up" as much equity as possible so that even after you give away a step-up, you as the operator have enough equity leftover for yourself.
Unfortunately, this comes at a cost:
1) High debt service, which may encumber your free cash flow and reinvestment into the business, which in turn prevents you from increasing the revenue and future FCF.
2) Your PG on the debt
You may end up in the "messy middle" where you're stuck in purgatory: you're tied to a business with your own PG...yet you can't reinvest in the business to make more than necessary to service your debt.
One idea out of this is for you to negotiate a significant seller financing, which may be interest-only for the first 24 months, which you now have to accelerate and generate more FCF.