Participating Preferred Equity - Why "Step Ups" are a poor metric
October 29, 2021
by an investor from Harvard University - Harvard Business School in Houston Heights, Houston, TX 77008, USA
Lately, I've heard a lot of chatter in the self-funded search community - some are using the term "set up" when referring to the common equity split that preferred equity investors receive. Apparently the thinking goes: "if investors are funding 10% of a transaction with equity then those preferred equity investors should get a 2.0x step up (or 20%) in the form of common equity upon conversion".
Its unfortunate that misinformation like this is spreading. "Step Ups" are a concept developed in the VC world to evaluate successive equity raises (often in series) in relation to each other. It’s also a term used in traditional search for the deal equity multiple expected by investors in the search phase. This term has now been hijacked and misused. This is not a relevant metric for evaluating the terms of preferred equity for a individual self-funded search deal. In fact, this metric completely ignores the terms of the deal itself and only adjusts based on leverage as a % of the capital structure of the deal.
For example: for two companies, all else equal, one with a 6x purchase price and one with a 3x purchase price the "step up" required by the investors would be the same if the leverage was the same. You read that right - a 3x and a 6x acquisition with a 10% equity injection would both require a 20% conversion (2x step up). Of course, this runs completely contrary to the idea that investments should be evaluated based on expected IRR - because a 6x company and a 3x company (all other things equal) provide vastly different expected IRRs for the preferred investors.
Going even further - this metric also completely ignores expected growth, margin expansion or contraction, and even risk.
Participating preferred equity investments should be evaluated just like most other business equity investments - based on an IRR and in comparison to expected risk. "Step Up" is a very misleading and incomplete metric. Given the fact that it ignores most of the most important considerations in small business equity investing, its a wonder why its being used at all!
from University of California, Berkeley in Bend, OR, USA
from University of Texas at Austin in Austin, TX, USA
The reason you are wrong is because nobody evaluates a deal based on step-up alone. Any reasonably experienced investors considers at least purchase multiple and growth as additional factors. However, the reason you start with the step-up is that the rest of the deal is irrelevant if the step up is too low. If you pitch me a 1.0x step-up, I don't care what the purchase price or the growth opportunity is.