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. 

Top 7 Rookie Buyer Mistakes

Buyer Be Aware 

by Terry Stidham

1.    Not Doing the Math

Let’s say you’re Company A, and you have your eye on acquiring Company B. 

Ideally, 1 plus 1 will equal 3 or something greater.

Then why does it often turn out to be more like 1 plus 1 equals 1.5? 

You need to understand what the combined companies will look like. Start with an analysis of the strengths, weaknesses, opportunities and threats of your company and the same analysis of Company B and then do a combined analysis, the ‘layering effect.’ What are the savings? What are the cross selling opportunities? What the threats, like loss of customers or key employees? Are there any legacy issues that can present problems?

Of course it’s easier to the analysis on your own company (though I am surprised at how often companies don’t) than it is do to it on an acquisition targets, especially a privately held one, but you can still get information on your acquisition target. There are sources like Factiva, Capital IQ, D&B, Google and then there are the industry publications. 

Have your key management speak to other people in the industry to help size up your target. This can help you get a sense of what the two companies really look like together. You also have the right at some point in the process to look under the hood and inspect the books, speak to customers, vendors and key employees. I have developed an in-depth confidential questionnaire to uncover the good, bad and ugly.

2.    Letting Emotions Drive the Deal

As CEO, you are undoubtedly passionate about your business. That’s to be expected and applauded. Getting emotional about completing a deal is different. The tendency is to get excited about the possibilities of buying Company B, and before you know it your enthusiasm becomes infectious, to the point where your key management does not challenge you about downside risks of doing the deal. Getting emotional can keep you in a deal that shouldn't go forward.

3.    Lack of Perspective

Losing perspective is about getting lost in the process. If you've invested a lot of resources – time, talent, money – exploring the deal, it’s easy to think that you have to go forward with the acquisition irrespective of the price you pay. Ask yourself why you want to buy Company B. In your analysis, does it contribute to the top and bottom lines? Do you gain a new distribution channel? Does it eliminate a competitor? Make sure that it is a well-founded rationale and a sound business case that is 
moving you forward, and not the sheer force of momentum. 



4.    Ignoring the Red Flags

There can be hundreds of potential red flags.  Don’t ignore them. Don’t try to justify them away. Dig deeper, ask questions, and if you aren't satisfied with the answers or can’t find resolution, walk away. Red flags are signals to pause or even stop. Failing to do so is often a byproduct of getting caught up in the deal or losing perspective. Don’t close your eyes to the red flags. 

Did Company B have unusual charges or losses that aren't adequately explained?

Does the predictive index (assessment) on the CEO show instability?

Is there unusually high turnover on its management team?

Are there troubles fulfilling orders? If so, why?

Are there cultural gaps or differences in competency levels that will make it difficult to combine people and departments from both companies?

5.   Thinking Inside the Box

Let’s say you see some red flags, or deal just does not make sense. It’s time to review your other options. What if you only bought part of company B? Or maybe it would make sense to partner with another party to do the acquisition.  What about a joint venture? How about structuring the deal where instead of buying Company B for $30 million outright, you pay $20 million upfront and $15 million in potential earn-outs?

It is important to understand your alternatives. I recently had a client who wanted to purchase a company to expand his distribution and increase his overall sales. 

I performed as assessment of his company and the company they were interested in acquiring.  The analysis showed that the client really needed 20% of the target company. Why pay for 100% of a company if you only need 20%?  I recommended that my client partner with one of the other potential acquirers. The end result is that the client paid 10% of the total purchase price for the 20% of the company that he needed.

6.    Not Placing Yourself in the Seller’s Shoes

Your interest and Company B’s are not aligned. You want to pay the lowest price possible and possibly structure the deal with a future payout; they want to get the best price possible—now! Obviously under that scenario you both can’t get what you want and can often stall or kill the deal.

Put yourself in Company B’s shoes to understand why they are selling. Is the CEO looking to retire or play a transitional role? Is Company B being sold at the height of the market? Are there negative trends in the industry that are eluding you?

7.    Failing to Make the Case for the Deal

Try to prove your key points as to why you should acquire Company B.  

Can the two combined cultures really work together or are the management styles and daily ways of operating incompatible?

Can you gain incremental customers or will they leave to go to your competitors?  

Can you really achieve your cost synergies

How will your people and customers fare during the acquisition? 

Can you structure a deal so that you don’t overpay? 

You need to run worst-case, middle-of-the-road case, and best-case scenarios for the acquisition. 

Being aware of these mistakes should help you avoid them. Align yourself with seasoned advisors and remember your real work begins once you complete the acquisition.