Self Funded Search - How to price the equity?
May 18, 2021
by an investor from INSEAD in Budapest, Magyarország
I’ve been approached by a self-funded searcher. The deal is the following for a food manufacturing company:
EV: USD 4m Debt: USD 3m Equity: USD 1m
Since the equity portion is small, he is looking for a single sponsor.
0.5m would be provided by the searcher and 0.5m from the investor (potentially me). He is offering a 20% stake.
Now I know it is all down to where we realize the exit, but still I’m wondering whether I should negotiate or just fold?
What is your experience in self-funded searches? Should I ask for###-###-#### and then offer time and IRR based vesting tiers?
from Harvard University in Colorado Springs, CO, USA
First, instead of considering what "your" percentage of the equity is, you should look at what the expected IRR of the investment is. So far, you've done nothing to contribute to the deal and, presumably, you'll be a passive investor--offering infrequent advice at best, so you should compare the potential return offered by the searcher with your other passive options.
Second, your $500k contribution is effectively 12.5% of the EV and the searcher is offering 20%. The difference between the equity/EV and final equity split is referred to as the "step up". In this case, you're getting a 60% step up. I suspect that if you do a search on this site about equity step up, you'll find that 60% is on the higher side for passive, non-PG LPs.
Third, there is a huge difference between self-funded deals and funded deals. The investments look very different, but both can be lucrative to the searchers and the investors. this being said, the mechanisms that are at work have almost no overlap. In the self-funded sphere, it's almost exclusively based on debt paydown with a smaller growth component. In the funded sphere, returns to both investors come almost exclusively through growth. If you'd like to dig into the nitty gritty, I can show you models of each.
Fourth, and probably most important is the market. Considering the risk that self-funded investors take and the amounts invested, your searcher is giving away more of the company than necessary to get the deal funded. Likely this is because of a desire for expediency. At those figures, I'm relatively certain that the searcher could get the deal funded at only 15% of equity by getting together a group of investors putting in $25-100k each and offering anything over 20% IRR/2.5x ROIC with a 3-5 year target hold period.
Now that I've explained my opinion of why I think your searcher's terms are fair, let's look at it from your perspective. I would advise you to ignore everything that any of us have said and to first decide if you're a "traditional" or self-funded type of investor. There's nothing wrong with either and as a self-funded searcher, I wouldn't hold a grudge against a "traditional" investor who wasn't interested in my "self-funded" deal, but I also wouldn't have bothered to approach that type of investor in the first place. There are very few who invest in both types of searches, so I would recommend that you reach out to ^redacted. He's a great investor and probably an even better person. He'll be able to help you decide for yourself which side of the fence you feel more comfortable on, then you'll know exactly what to do about this investment opportunity.
On a separate note, please pass on this advice to your searcher. Speak to a reputable SBA banker about whether the 20% will work out. Echoing what was said earlier regarding the SBA guarantee, at 20% common equity, the single investor will likely be on the hook for the PG, which most will balk at. Having even just one extra investor split the injection will likely make things okay in the eyes of the SBA.
from University of Iowa in Chicago, IL, USA
I see some other commentators mention you should be targeting ~30-35% IRR (which has been the "bible" floor return for many years and even advocated in the Stanford search guides). If you can get it, good for you, but frankly from my perspective as a self-funded searcher (and dependent on how I think the deal would perform) I would not give those terms to investors these days. I think with how easy it would be to cobble together <$1M in equity (e.g., family, friends, non-Search fund investors, etc.) he doesn't need to give you a 35% IRR or anywhere close to 50% of the equity. He doesn't even need to give preferred equity @ 8-12% rates...
You might want to float a structure where you have more of the front end equity (say 40%) with performance stipulations on either IRR or MOIC within a 5 year time frame. E.g., If he hits a 3.5 MOIC by Year 5 then your equity is diluted down to 20%. If he doesn't then you keep your higher equity split (this can be tranched in different years as well). I have no idea what the IRR return would be for the searcher on this structure so he may tell you to walk. But just an idea if having a higher equity stake is important to you in the beginning.