Self-Funded Search Investors Terms: What are your thoughts on Put Rights?

I’d love to get the opinions of both investors and searchers regarding put rights in self-funded search deals.

To be clear, by a “put right,” I’m referring to investors having the right to sell their shares back to the company on a best-efforts basis at some point in the future – a way for minority investors to ensure an eventual exit from their investment.

In two recent deals we reviewed, Main Street Capital Network investors (we are a syndicate of 150+ SMB investors—individuals, family offices, and funds) discussed put rights extensively. Both deals had them, but there were some questions regarding mechanics and enforcement mechanisms, so it would be great to learn how others view this. Below are some initial thoughts, but I would very much appreciate feedback from other investors and searchers.

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Should investors have a put right?

They are becoming increasingly common. I’m assuming this is because more finite-life private equity funds are entering the space, and more deals are being made that include investors outside the searcher's immediate personal network.

As an investor, I believe there should be a mechanism to ensure I receive my investment returns at some point. Still, I have heard searchers argue that this effectively turns the investment into a debt-like instrument.

If investors have a put right, how should it be structured?

When does the exercise period start?

I most commonly see an exercise period that begins five years after the transaction closes, presumably because most models market an IRR based on a five-year exit. The next most common start I see is 10 years post-close, which allows the exercise period to begin after SBA debt is paid off.

I think five years is a little too soon, but there is no need to wait until the SBA debt is completely paid off.

How long is the put exercise period?

I think it’s critical for the exercise period to last at least several years after it starts. Suppose there is only a short window to exercise. In that case, investors have to hope that at the exact point the exercise period begins, the business isn’t at a low point in the cycle, the searcher isn’t frontloading expenses in anticipation of the put exercise period, credit markets aren’t tight, etc.

How is valuation handled?

This is the trickiest part. I’ve seen several methods used, but I think some version of the following makes sense:

1. Use the multiple the deal was consummated at as the default valuation, which will be applied to TTM EBITDA at the time the put is exercised

2. Either the company or the investor can challenge the valuation with an independent valuation expert, which the challenger must pay for (in cyclical or project-based businesses, TTM EBITDA may not be representative of the business's long-term earnings power, or if EBITDA has changed significantly, the old multiple may no longer be relevant)

Limits

It should be made clear that the company will repurchase the shares on a best-effort basis. Investors cannot exit the position if the business is facing financial distress or cannot borrow money to repurchase shares.

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