What is a preferred return in a small business acquisition?

For acquisition entrepreneurs looking to raise investor capital to fund a business acquisition, the concept of preferred equity can be confusing at first. One common piece of any investor-funded acquisition is a preferred return.

A preferred return (often called a “pref”) refers to a claim on profits given to investors. In the event of an 8% preferred return, all preferred shareholders would receive an 8% return on their invested capital before common shareholders receive any profit distributions or proceeds from a sale.

Once the preferred return is satisfied, the split of excess profits varies based on the negotiations during fundraising. In self-funded search deals, this split is often calculated based on a step-up. The general structure of how distributions and proceeds are handled is typically called a "waterfall".

What does a waterfall look like for a business acquisition?

When a business acquisition has equity investors involved, they are typically getting participating preferred stock. Practically, this means that the investors get a preferred return on their investment and the repayment of that investment before distributions are made to common shareholders, of which they are as well (e.g., “participating”). In most structures where searchers invest their own capital, they too will receive participating preferred stock.

Once the preferred return and repayment of invested capital have been satisfied, the resulting distribution structure is based on a step-up. You can read more about that here. In today’s market, the average deal results in the searcher owning 60-90% of common stock. In other words, the searcher will get the lion’s share of distributions and proceeds once the preferred return and invested capital have been paid.

What happens if a preferred return cannot be paid?

There are some instances where a preferred return will go unpaid in one year. Perhaps the business fell on hard times and all capital is needed to keep the ship afloat, or perhaps the management team believes the best return on capital is to put every dollar back into growing the business.

The exact mechanics of whether this decision can be made vary based on the operating agreement and subscription documents signed by investors, but generally there are a few ways preferred returns are handled.

For the below example, let’s assume that there is $100 of preferred stock with an 8% preferred return. In the first year after the transaction closes, the management team does not pay the preferred return. What happens the next year?

What type of preferred return is most common in self-funded search deals?

From our experience, the most common approach to self-funded search deals is cumulative, non-compounding preferred returns.

How does the preferred return change over time?

As the invested capital is paid down, the preferred return rate will stay fixed but the amount being owed each period will go down as well. You can think of it almost as “interest” owed to investors. The purpose is to guard investors against low returns and to attach a cost of capital to force the management team to consider whether it’s a better use of money to pay back preferred shareholders or reinvest into the business.

What is the average preferred return?

With today’s rising interest rates, most self-funded search fund deals are seeing preferred returns between 10 and 12%.

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.