Equity call options: the right to buy out investors

When an entrepreneur purchases a small business; there are two ways an entrepreneur can finance the acquisition, debt or equity. With equity, the financing structure can be quite complex, particularly when it comes to structuring the ability to buy out the investors at a future date. Thus, this blog aims to explain the investor buyout options in small business acquisitions.

How do you buy out investors?

After a stretch of time, many times, business partners or investors in a small business acquisition will likely to be bought out of their position. There are many reasons why a partner may not want to continue on with their investment in the acquisition:

1. Wants to pursue other investments

2. Has a liquidity need

3. Conflict with other investors/partners

On the other side, many entrepreneurs may ultimately want to buy out their investors from the cap table. Perhaps they want to have greater economics in the business, or they want to be able to take the business in a different strategic direction.

Fortunately, there are three common options used in buy and sell agreements that allow investors to have their position bought out at some point in the future. The three common buyout options are equity call option, equity put option and forced buyout schedule. The main focus of this blog will be on equity call buyout options. An equity call buyout option gives investors or partners the option to sell their shares (at fair market value) back to the company.

When is an equity call option granted?

Equity call options are detailed in the financing docs for an equity raise. These equity raises could be for businesses that operate as partnerships, corporations, LLCs, etc. Moreover, these equity raises could be used for Leveraged Buyouts (LBOs) and Management Buyouts (MBOs). Within the term sheet for the capital raise, legal language details that all or some of the partners have a call option on their equity ownership.

Below is an example of legal language for an equity call option:

“Provided that the Class A Members have received aggregate cash distributions under the LLC Agreement in an amount that is equal to or greater than the amount of their Class A Preferred Return (as defined in the LLC Agreement) plus their Class A Contribution Amount (as defined in the LLC Agreement), in addition to all other distributions payable to the Class A Members under the LLC Agreement (such distributions in the aggregate, the Company has the right to cause all (but not less than all) of the Class A Members to sell all of their Class A Units to the Company for Fair Market Value (as defined in the LLC Agreement) thereof on the exercise date of the call option.”

In the above example, the value for the equity call option, provided certain requirements are met, is that the company can force the Class A Members (i.e., investors) to sell their shares back to the company at fair market value.

What are the Pros and Cons?

The positives to having an equity call option built into the investment docs for a small business is that if investors are adamant on wanting out of their investment, the equity call option gives the management team a legal way to buy investors out of their position. More importantly, that investment will return a fair market value for the investor (i.e., an investor is not losing money because the investment was sold at a deep-discount).

Another positive is that it provides a path to owning a business without silent partners as these options are viewed by investors as a benefit to them. In other words, the equity call option gives an investor the opportunity to capitalize on their gains if certain metrics have been hit, while giving the management team the ability to use cash reserves to buy out remaining parties.

Why would an entrepreneur want to call equity owned by investors? For some, they simply want to own more of the distributions of the company and believe that using cash to buy-out investors is the best allocation of their capital. For others, they may want to take the company in a different direction than the existing investors. Buying them out prevents disputes over strategic decisions and growth targets.

A couple of negatives to an equity call option is that investors may not want to be bought out or they may prefer a higher return on their investment than to have a built in call option. What happens with equity call options is that they have a built in premium; therefore, a company or fund will more than likely lower an investors preferred rate of return to include the equity option.

When can an Entrepreneur Call?

The most common answer is, it depends. Contracts between investors and a business are specialized to that specific business. For example, what is written in a contract for investors in a fintech company may be completely different from what is written in a contract for investors in a car wash business.

However, there are two basic frameworks: time period and return based.

Time Period

Time period is the simplest framework and within the framework it states that starting X date (say five years from signing the contract) investors have a right to their equity call option. From a management perspective, this is easy to understand and keep track of because once the contract is signed and money has been exchanged then management knows that it doesn’t have to worry about returning capital to investors until X date (at the earliest).

It is important to note that with a time period framework, the time period needs to be set a few years after projected return of capital because otherwise the investor will have essentially made a 10%-12% “loan” with no collateral. In other words, these investors are taking on a significant amount of risk and want the opportunity to gain in the “promote” years. Promote years are when the investors receive a step-up share of the business's proceeds.

Below is an example of a promote written in an offering sheet:

“Upon the completion of payments to the holders of the Class A Units of all (i) Class A Preferred Return and (ii) Class A Contribution Amounts, the Company shall make distributions in accordance with the Final Distribution Waterfall (otherwise known as the “Step-Up”) which is as follows: 30% to the Class A Members in respect to their respective Class A Units, and 70% to the Class B Members in respect to their respective Class B Units.”

In this case, the investors will want to share in the 30% of cash flow distributions for a year or two before potentially being bought out by the Class B members (i.e., management team).

Return Based

The more complex framework is return based. Complexity is increased because the equity call option is typically decided by a specific metric or metrics. These metrics in turn have to be defined so management and investor expectations are aligned. A common metric used is when an investment hits X Multiple on Invested Capital (MOIC) (e.g., an equity call option isn’t allowed until investors have a 3x MOIC). If MOIC is not used, then another metric often used is Internal Rate of Return (IRR).

A return based framework is beneficial to investors because it allows a bit more protection; however, this framework is more common in larger deals.

What are mechanics?

Amount

Within the buy and sell agreement (offering sheet) there may be other specifications for an equity call option. For example, are all investors given the equity call option? Or is there a minimum percentage or a maximum percentage to how much investor equity can be bought out at a time? Or does each investor need to be bought out via pro-rata?

These are specific mechanics within the offering sheet to determine the buyout amount. With pro-rata (each investor needs to be bought out on a pro-rata basis) the underlying economic argument is that management can’t provide a liquidity offer to some investors and not others. Note that the pro-rata requirement will be required for all investors in that specific share class (assuming the company has a dual-class share structure)

Price

There are two methods in determining the price of a buyout. One way is through a fixed multiple approach to determine the per-share buyout price. 

An example is Enterprise Value (EV) to Earnings Before Interest Tax Depreciation & Amortization (EBITDA). To calculate the price per-share using an EV/EBITDA multiple, one must take the average EV/EBITDA of the industry and then multiply it by the firm's EBITDA. The resulting number is the firm's enterprise value. Then take the enterprise value and add cash, subtract debt, subtract preferred stock and subtract minority interest, which equals equity value. Then take equity value and divide it by shares outstanding to get price per-share. Below is an example of how to apply the fixed multiple approach:

For fair market value, one option is to go to the open market and see what the share is selling for. However, given the majority of small business acquisitions are private; hiring a third-party valuation expert may be beneficial to determine the price of each share in the company. The third-party experts will run a variation of models that include:

• Capitalization of Cash Flow Method.

• Discounted Cash Flow Method.

• Seller’s Discretionary Earnings Method.

These models will have outputs that the third party will use to determine the price of shares in the business.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.