Preferred returns' cost of capital and its impact on management decision making

By William Fry

Jul 4, 2024

In Buying a Business

When raising capital to acquire a small business, it’s common for the investment to include a preferred return on the contributed capital.

A preferred return gives invested capital priority in receiving their initial capital and a certain rate of return before distributions are split with other share classes. The preferred return in an SMB deal is typically 8 - 12%, meaning investors must receive their capital along with an 8 - 12% preferred return before other share classes receive distributions.

Most often, a preferred return is cumulative and compounding. Meaning that if a preferred return is not paid off in a given period, it accumulates and must be paid out in future distributions before management can receive a majority of cash flow.

At this point, it may look a lot like interest on a loan. However, a preferred return is different in a few ways for SMB deals:

Any capital an operator or sponsor contributes to a deal, whether in cash or in deal expenses, is treated the same as cash invested by investors. This means the operator gets a preferred return on their contributed capital.
If the business goes under, the equity investment will be wiped out. Management isn’t personally liable for any equity invested or accrued preferred return.

In addition to giving the investors a rate of return prior to splitting distributions with other shareholders, the preferred return also ties a cost-of-capital to the equity investment. This encourages the owner-operators to determine what is the best use of excess cash: re-investing in the business or making distributions to pay down any preferred return?

To take a simple example, let’s assume that Jason is an operator who raised money to buy a collision repair shop. He offered investors a 10% preferred return on their $500K investment, and he plans to make quarterly distributions.

As he generates cash flow, he needs to decide what to do with the money. Does he hire additional techs? Buy another Lift ‘N Rake for $9K? Or distribute cash?

The preferred return helps him think about what to do. If he can invest in the business and grow the business at a 10% clip or greater, then he should allow the preferred return to accumulate and use the cash to double down on the business. He (and investors) will make more money by growing the business! If he can’t grow at 10% or greater, then the best use of excess cash is to distribute to shareholders and pay down the preferred return.

This is very similar to the math an operator should do when considering early repayments of an SBA loan.

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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.

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