Structuring seller rollover equity?
April 06, 2024
by a searcher from University of Pennsylvania - The Wharton School in Bellevue, WA, USA
Want to pick the brains of this knowledgeable community.
What are some good ways to structure a small seller equity rollover (e.g. 10%), in particular with the goal towards giving the seller a path and visibility for the future sale of his rollover portion? I see two problems: 1) a math problem of the seller’s rollover equity value having a much lower value post-transaction due to the buyer putting debt on the company, and 2) ways to give upside to the seller for this rollover portion if the company performs well that does not violate SBA rules?
For the first problem, assume $5m purchase price (cash free and debt-free basis), stock purchase, and 10% seller equity rollover. That means the equity being purchased by the buyer is $4.5m ($5m * 90%). For this purchase, assume the buyer will finance 80% of that amount, so the buyer will contribute $900k (20% * $4.5m) and will finance $3.6m (80% * $4.5m) in SBA debt. This debt will now presumably sit on the company’s balance sheet. So the new equity value, on a 100% basis, post-transaction will be $1.4m ($5.0m enterprise value - $3.6m debt that has now been added to the company). So the seller’s 10% equity stake is now worth only $140k versus the $500k it was worth on a debt-free basis. Seems very unattractive for the seller.
For the second problem, barring another future sale of the company, how to give a path for the seller to exit out of his remaining 10% rollover if the company performs well and in a way that doesn’t violate the SBA rules? For example, giving the seller a put option to sell his remaining stake at a pre-agreed EBITDA multiple in X years makes sense, but will violate SBA rules if I am not mistaken.
In summary and taking into account the above, how does the structure and math work to make it attractive for the seller to rollover a portion of his equity (e.g. 10%) given the above math?
from The University of Chicago in Chicago, IL, USA
Currently I am talking to many lenders to understand new SBA rules allowing Partial Change of Ownership (PCO). Few unknowns are: If you buy 90% of X who is the lender giving debt to? How can X service the debt that is not on its books? Do have 90% of EBITDA to service the full debt? On top of that the issue of seller's retained 10% has lower value. as pointed out.
The math in the non-SBA deals that I have done works similar to what ^redacted mentioned. $3.6 M debt, $900 k Equity and $500 k seller note, then seller spends $90 k out of the $4.5 M cash and buys 10% of the $900 k. You can structure the $500 k so it does not increase debt-service.
I am currently working on an SBA deal. Our LOI called for seller buying 10% as described above (this to satisfy "other" requirements; 10% not requested by buyer nor seller). It turns out, multiple lenders first said Yes to the 10% until they reviewed PCO rules in details. Then multiple lenders said SBA will not approve seller buying 10% into buyer entity under PCO. Few days ago, we scratched the 10% from the LOI and hope to satisfy "other" requirements (which is non-seller, non-buyer requirement) in a different way.
The solution to your second question depends on answer to first question. It depends on whether seller is motivated by value-growth of the 10% or getting paid the $500 k. Also, you will have more options after SBA is paid off.
Happy to discuss more. I am also hoping to discuss directly with SBA.
from Harvard University in Lynbrook, NY 11563, USA
Let's take your facts and assume $1M in EBITDA, 5x purchase multiple, and that your debt has 10% interest. ROIC is thus 20%, or 2x debt cost, and seller's going to gain a lot from that leverage. Before leverage, seller's 10% share of earnings would have been 100k. Post leverage, interest cost at 10% 0f 3.6M is 360k, leaving 640k in earnings. Seller gets 64k of this, as opposed to 100k, so while seller's earnings are going down, they're far more than 20% of what they would be. True, leverage is risky, but it cuts both ways since if earnings increase equity gets all the increase, and to reemphasize, you bear more serious downside risk.
Obviously, the math varies depending on situations, but having the seller give a note for 400k and put in 100k, seems to sweet a deal for seller and not truly reflective of the economics.
Welcome input on this way of thinking about it from the wise folks here.