What to consider for equity agreements?
September 25, 2024
by a searcher from University of Pennsylvania - The Wharton School in New York, NY, USA
I’m considering a deal where the owner wants to keep a 5% equity stake and serve as an advisor. I am creating a consulting agreement with a monthly cap on hours and expectations. The goal for the owner keeping the stake is to help with a growth strategy and lessen our debt burden. Has anyone done something similar? Any pros/cons and insights you can offer?
from Allegheny College in Philadelphia, PA, USA
You stated that your goal here is to have seller help with growth strategy and lessen debt burden. Rolling 5% equity will result in a rather small reduction in debt burden, so you want to weigh whether incentivizing the seller's performance with an earnout vs. rolled equity is best. If you choose a structure that allows seller to retain equity, then you should include language in the governance documents such as drag along provisions. You may even consider a call provision with a defined purchase price if certain growth numbers are not hit.
For the consulting agreement, if you are allowing the seller to retain equity, why cap hours? Capping hours in a post-closing consulting agreement sounds more in line with a transition consulting agreement where seller provides insight and guidance on the takeover of the business and receives a monthly payment in return (no equity)
The earnout option could hold back 10-20% of the purchase price and establish a sliding performance/growth schedule that says, "if we grow revenue [X]% then you will receive a payment of $[X]."
You are taking on debt and (I would expect) paying this individual a significant sum of money. This is your time to ensure the documentation is in your favor. Make sure you build a structure that benefits you in the transition, but also avoids you being stuck with a freeloading minority shareholder for the next 15 years.
Disclaimer: I'm an attorney, but not your attorney unless there is a signed engagement letter. I don't know all the facts so my comments might change if I learn more about the specifics of this transaction.
from University of Michigan in Detroit, MI, USA
(1) Seller will retain a minority equity position in the business going forward. This is dealt with in the operating agreement (or similar document). A 5% interest shouldn't entitle the seller to many rights. Perhaps the seller has some veto power over, for example, amending the organizational documents of the company. But otherwise, the seller should only benefit from standard minority protections such as preemptive and tag-along rights.
(2) Seller will become a contractor. This has nothing to do with his minority stake. You are free to negotiate the terms of his advisory role, as you see fit. Where does it make sense for the seller to help? How much does the seller want to be paid?
You don't need to do (1) to do (2) and vice versa. Although if you are relying on SBA debt, it makes sense to combine these two deal points. Otherwise, the seller would be limited to a 12 month contract at most.
Let me know if you want to discuss. DM me here or reach out directly at redacted We regularly work with searchers on these types of issues. Always happy to help.