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Deal Structure for Private Equity Financing

Deal Structure

Terry Stidham

Earlier this week we talked about how Private Equity could be an alternative to bank financing.

You need to know going in that there will two important parts of the deal –

1.    Amount of capital financed

2.    Terms/ Conditions

Answer these key questions before seeking financing from PE:

·         How much do you need?

·         How will the capital be used?

·         How soon and over what time period?

·         In what form of equity are you willing to structure?

·         What are you willing to give up in terms of control?

All private equity (PE) deals employ equity in some form, but the actual deal may use one or more instruments ranging from common stock to convertible debt. Investments may be made up front or over a period of months or even years.  

The PE investor will assess your funding needs and propose a funding structure. The final structure will be determined through discussions of how a business relationship can be built that meets your company’s funding needs and the PE firm’s need to ensure the success of your business, and their investment.

The Issue of Control is a key consideration one must make when using financing from PE. Business owners who have devoted years to building a business can find handing a majority stake over to an investor very daunting, yet many deals require just that: As a rule of thumb, most PE deals involve a 40 to 65% equity stake. If the investor takes a stake of less than 50%, the conditions tied to that stake are likely to be more rigorous so that the investor can protect its investment and ensure that it has the ability to direct the firm to extraordinary returns in the long run. Once the equity stake is above 50%, the terms are likely to be less stringent as the investor will have a voting majority on the board. In either case, the deal will also involve board seats and management interaction to ensure that the investor can actively mentor the business owner to a successful outcome.

Whatever the level of equity involved, business owners are likely to end up wealthier and businesses are stronger after the deal. PE firms do not invest unless they are confident in a company’s ability to grow. The capital it provides is the fuel that helps to make that growth happen which, in turn, raises shareholder value.

The math is simple: a smaller share of a large and rapidly growing company is worth more than 100% of a small company. And even if voting control is given up, the investors will most likely be committed to growing your vision and keeping the senior management team intact. You and your team have created the success to date and is the number one asset that the investor values most. PE will provide the funding to cash flow the growth and provide management tools and expertise to fill the gaps.

Many deals involve one or more of the following instruments:

·    Common stock. While equity stakes are often taken, common stock offers less protection for the investor than preferred stock and is therefore rarely the first choice.

·    Convertible preferred stock. Preferred stock that converts into common stock, usually upon an initial public offering (IPO) or the sale of the company. The preferred stock can be either participating (it gets a regular dividend) or non-participating (no dividends are paid).

·    Convertible debt. A PE firm may seek to start the investment out as a loan that is convertible into preferred or common stock upon certain events.

The ultimate structure of the deal will depend on a number of factors and may include some or all of the equity forms above, as well as a variety of terms and conditions that are based on the circumstances of the deal and the needs of your company

Another factor to consider in the structuring of the deal is timing: when the funds are received. Generally it depends on what they are needed for; for example, funding for an acquisition will be tied to the timing of the purchase. However, funding for a management buyout may be staged over time to ensure that the senior manager being bought out remains committed to the company’s future for some fixed timeframe.

Investors will aim not only to build your company in the short run, but also to sell or liquefy their investment in the long run. Most funds raised by PE firms have a 10 year time horizon and are generally more patient than venture capital funds. Typical liquidity events include selling the company to larger player in the marketplace, going public, or being bought out as the company raises substantially more equity and debt capital in the future. There are some traditional wealthy family funds that don’t have any particular time horizon and consequently may stay in the investment so long as it’s making economic sense to do so.

Most investors will consider an exit strategy at the time they structure a deal. Others will work to have a long run relationship with the intention of remaining a business partner until the day that a firm with much larger resources is required to take a company to the next step. In that case, the original PE firm may stay on as a minority shareholder or the new partner may buy out the first firm’s interest.

Another Key Consideration when seeking private equity is finding the right balance between realizing your vision, gaining outside help in terms of financial and executive experience along with a team that you can work with. You are more likely to create a successful deal if you seek a PE firm that shares your vision and has the resources to implement.

Contact us today to discuss your situation and what you need to do next to get in front of the right PE group for you business needs.

 

Terry Stidham,  Managing Member and Founder of Target Search Group. Mr. Stidham is a Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment.  He has served as the head of entrepreneurial organizations as well as Fortune 500 companies.  He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions.