In self-funded search deals, an equity step-up is a common way of calculating an investor’s minority ownership in a deal. Unlike a traditional search fund, where investors often own a majority of the company, in self-funded deals entrepreneurs own the majority of the acquired company.
Why? Well, in self-funded searches, the entrepreneur is responsible for sourcing the deal, negotiating with the broker and owner, arranging any debt financing, and ultimately operating the business. Given that they have put time, money and a personal guarantee into the equation, they often come away with owning anywhere between 51% and 90% of the acquired company.
Determining the Financing Needs for a Business Acquisition
Once an entrepreneur finds a business to buy, they first need to determine the total project costs of the acquisition in order to structure a deal. Total project costs include not only the purchase price of the business but also any SBA guaranty fees, transaction expenses, and working capital needed.
Take the below example. In this sample, the total project costs are $1.16M. They include the price of the business ($1.1M), some working capital injected at close to cover immediate expenses ($25K), transaction expenses like attorney bills ($15K) and the SBA Guaranty Fee (which is based on how large of an SBA loan you take out).
In order for a deal to get done, an entrepreneur must pull together enough capital to equal $1.16M. In spreadsheet models, this is called the “Uses”. This can include equity (or a “down payment”) injected by the entrepreneur, money invested by investors, a seller financing note, and/or an SBA loan.
To keep things simple, let’s say that you’ve arranged for the seller to hold a note equal to 5% of the total project costs and that you’ve worked with an SBA loan broker like Matthias Smith or Heather Endresen to get an SBA loan for 80% of the total project costs. In this scenario, you need to come to the table with 15% of the total project costs in equity, or $174K of cash.
Bridging the Gap with Investors
Now, it’s clear an entrepreneur needs to bring together $174K of cash at close. Keep in mind, this is just the money needed to close the deal. Very often entrepreneurs will want to keep enough of a personal buffer to be able to float the business if it shortly runs into a slowdown.
For purposes of example, let’s say that the entrepreneur can pull together $50K of cash himself and has found investors who are interested in putting in $124K to bridge the gap. The first question that will come to mind for investors is “how much of the business will I own?”.
Not So Good Solutions
Well, on first pass, you could make two arguments.
First, you could say that because the investors are putting in $124K of the $174K of equity, they deserve to own 71% of the company ($124K/$174K). If you suggested this, the investors would be very happy! They didn’t do any work and are only risking $174K for over two-thirds of a $1M business! But, it would be unfair to the entrepreneur. After all, they are personally guaranteeing a loan of over $900K!
On the other hand, you could say that investors are putting in $124K of the $1.16M of project costs, so they deserve to own 10% of the company. If you suggested this, the investors would be not so interested! They are the last in line to get paid out if the business goes south, and they may not see any distributions for the first few quarters. If they calculate their IRR or any other investment statistic, it won’t look much better than just parking money in a mutual fund.
A Better Solution to Determining Ownership
Enter the concept of an equity step-up. A step-up provides a sweetener, or discount, to investors. In the case of a 2x step up, it says that each dollar invested will be worth $2 in the equity calculation.
Going back to our example, at a 2x step-up the $124K would convert into 21% of ownership by investors ($124K x 2 / $1.16M). By structuring equity investments with a step-up, you can get investors to a point where you are offering a competitive return on their investment without giving up control or buying a job. After the close of the transaction, you will own 79% of a million dollar 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.
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