M&A Monday: Breakdown of a Closed Deal (Part II)

In Part II, we discuss the investor structure. This Buyer put in $50k and owns 80% of the business.

This M&A Monday we continue our breakdown of a closed Independent Sponsor deal earlier this year. I have closed dozens of deals this past year. Each is unique and has its lessons. This was the acquisition of a home services business in a very competitive industry. In Part I, we reviewed the structure we chose (stock purchase with F-Reorg), pricing the deal (~3x EBITDA; two promissory notes, SBA Pari Passu financing), and challenges we faced: https://x.com/Eli_Albrecht/status/1792652638149853603

In this Part II, I will describe the equity and financing side of the deal. The buyer put in $50k of his own money and after closing owned 80% of the business.

Here is the capital stack including investors:

The Sponsor acquired this business at a low multiple (see Part I) and decided to raise from various individuals in his network. He had seven investors.

Sponsors often ask me whether they should raise from a bunch of small investors or a couple of anchor investors. While raising from an anchor investor has advantages (i.e., the certainty of close, mentorship, credibility with seller), Sponsors get better economic terms and control from having many small investors. Additionally, sometimes anchor investors walk prior to closing putting sponsor in a tough spot. At that point it is very hard to replace a large investor. My recommendation is usually to raise from smaller investors.

Recall from Part I, the Sponsor used parri passu SBA 7a debt from Bruce Marks (First Bank of the Lake) to fund 75% of this transaction, even though it was well over the $5m SBA 7a limit.

Investor Terms: The investors received a 1.818x step up on their ownership and a 12% preferential return. This is approximately in line with market terms. The preferential return is a bit higher than market and step up a bit lower than what I am seeing in self-funded deals. Often if the pref is higher, the step up is lower and vica versa.

Even though this buyer was an independent sponsor, because this deal qualified for SBA debt, we structured it as a self-funded searcher deal, whereby the Sponsor gets “credit” for the full SBA loan and investor equity is determined by dividing into the enterprise value (EV) (e.g., if investors put in $1m of a $10m deal, this gives investors 10% as a starting point). In this deal, investors put in 11% of the EV. Investors then usually get a step up of between 1.5 and 2.5 times of that 11%. In this case the sponsor wanted to have 80% equity, so he landed on a 1.818x step up.

Preferred return means the percentage return that investors have to receive annually before the sponsor starts to receive any distributions. This means investors have to receive their money back plus 12% annually (usually, non-compounding) before the Sponsor starts to receive distributions. This lowers the investor risk and gives investors first money out.

Thus, the waterfall looked like this (abridged):

First, to preferred investors, until they have received their capital returned plus 12%;

Second, return of Sponsor’s invested capital; and

Third, 80% to Sponsor, 20% to investors in accordance with fully diluted ownership.

There was some discussion about whether to give the Sponsor a “catch-up” in step 2, but, the Sponsor decided to just receive his return of capital ($50k) and not receive a full catch-up. Sponsor’s economics were already so good that he was okay with foregoing the catch-up.

We ran the investor process in three steps, (i) outreach with a deck, (ii) equity term sheet, and (iii) signed operating agreement. First, the Sponsor created a deck and started having discussions, then we drafted and sent out non-binding equity terms sheets that outlined the economic terms and management rights. Finally, those terms were drafted into a more extensive operating agreement that was approved and signed prior to closing.

Since the sponsor secured the business at a healthy valuation, had significant leverage, and a high pref for investors, the investor returns were projected to be very good (projections should be taken with healthy skepticism).

Finally, a few notes:

Sponsor Preferred. Sponsor put in $50k of his own money. There was some debate about whether his investment should be considered preferred equity (thus entitling him to a 12% pref on that $50k), but the Sponsor decided to not take any pref equity, only common.

Sponsor acquisition fee. I encouraged the sponsor to take an acquisition fee at closing. While Indy Sponsors usually take a 1%-2% of enterprise value at closing to compensate them for the diligence and getting the deal structured, self-funded searchers generally do not. Indy Sponsors have dramatically different ownership economics and the Sponsor gets a lower percent of fully diluted ownership (their deals are structured entirely differently) and they receive more fees. Because this was structured as a self-funded deal, Sponsor did not take an acquisition fee.

Investor Rights in the Operating Agreement. The investor's rights were contained in the operating agreement. This was negotiated with the investors. The Sponsor was the sole manager and controlled day-to-day decisions, and controlled the exit scenario. It contained customary drag rights, tag rights, and rights of first refusal for transfers. The most controversial provision in this deal was a Call Right in favor of the Sponsor. This provision stated that after 5 years, the Company could buy out the investors at the then fair market value. The rationale for this was the Sponsor wanted to be able to buy out his investors and own the business outright. This is controversial because it could cap the upside for investors.

A call right is usually accompanied by a put right in favor of investors. A put right means investors can force the company to buy back their shares. Sometimes sponsors agree to this, but three things are negotiated: (i) price of the put right buy back, (ii) timing of when the put right can be exercised, and (iii) how long the company has to pay out investors.

Go back and read this post on other issues that should be negotiated in an investor term sheet: https://x.com/Eli_Albrecht/status/1699762140339441754

This deal was an amazing result for my client. He acquired an amazing business making over $3m in EBITDA, put $50k of his own money in the deal, and ended up owning 80% of the business.