M&A Monday: Investor Rights in an Independent Sponsor/Searcher Acquisition

When you raise from investors (or even rollover equity), you give up part of your independence. Here are some expectations you should have: A typical independent sponsor deal is funded using senior debt, seller capital (rollover/earnout/promissory note) and equity (hard cash). A rough (very oversimplified) example: Purchase price (plus expenses): $20M Senior Debt: $12M (around 3x EBITDA) Seller Capital: $5M Investor Cash: $3M This post will focus on the type of investors and what rights they typically request. The economic structure of investors in an independent sponsor deal is covered in other posts, including M&A Monday - How Does an Independent Sponsor Make Money? (Part III of III: redacted@elialbrecht/note/p###-###-#### ?utm_source=notes-share-action&r=3btsrx (and here is more information on Debt options for an Indy Sponsor: A Short Guide to Debt-Financing Options for an Independent Sponsor Buyer: https://elialbrecht.substack.com/p/m-and-a-monday-a-short-guide-to-debt?r=3btsrx&utm_campaign=post&utm_medium=web&triedRedirect=true). There are three types of investors. Each has its own pros and cons: 1. Institutional. These are funds. They often provide all the needed equity, but essentially take over the deal and pay some points, carried interest, and a board seat to the IS for finding the deal and bringing it to them. This essentially turns the IS into a broker. There are many Indy Sponsors who do this. 2. SBIC/Unitranche Lenders. Several lenders and debt funds can provide all of the debt and equity needed for a deal, but the Sponsor remains in a control position. Often, the lender will require a token amount of equity from the sponsor. 3. Friends and Family (and Fools). These are people in the Sponsor’s network who usually write small checks, but together can make up the entire equity portion of the deal. Of course, for those who have this network, they are the best investors. One point I tell all of my clients: When you raise from investors (or even rollover equity), you give up part of your independence. You are responsible for stewarding that person’s equity, and you must keep that in mind at all times. That can be hard for an entrepreneur. As such, the Sponsor has to give certain rights to the investors. The more money the investor invests and the more institutional they are, the more rights they will request. These are the common rights requested: 1. Economic. While this is for another post, the investor almost always has to be paid back first before the Sponsor gets paid much of anything. This is to align incentives for the Sponsor to be dedicated to greater growth. Some deals have mandatory distributions (however, the SBA does not allow this). 2. Board Governance. At a minimum, the investor will require board representation. Sometimes, there is a board flip in the event the Sponsor trips bank covenants or experiences other declines in the business. 3. Minority Protections. These are rights that belong to an investor that prohibit the company from taking certain actions. While these are heavily negotiated, ordinarily this includes some of the following: (a) making any changes to the certificate of formation/incorporation or changing the business purpose; (b) entering into affiliate transactions (other than the management agreement); (c) new indebtedness above a certain amount; (d) issuing new units/shares; (e) initiating and IPO; (f) entering into a sale transaction; and (g) dissolving the company. There are a few other more restrictive rights that a powerful investor may get: (a) approving a budget and any deviations; and (b) approving the executive hires and fires. 4. Other Rights. Customarily, investors get other rights, such as preemptive rights to prevent dilution, tag-along rights in a sale of equity, and certain rights in a drag-along scenario. Investors can be a major benefit to your platform. Often, they bring much more than equity; helping with strategy, connections, and credibility for future add-ons. A final note: This is a small sampling of the complexity of an investor deal. There are many more nuances and challenges (including tax issues). Make sure you are represented by good legal M&A counsel if you are bringing on investors. If you like this, please subscribe to the Substack where I post guidance and tips almost each week: https://elialbrecht.substack.com/