CHAPTER 19
Raising Acquisition Equity
If your prospect is a good acquisition opportunity, you should be able to quickly raise the equity you need to complete the transaction. If you have never raised a million or more dollars of equity before, this statement probably seems surprising, but it’s true; there are many more people trying to invest capital than there are good investments. It’s hard for most high-net-worth investors—the owner of a successful midsize business, a partner in a large law firm, and so forth—to gain access to private-equity investments. That means there are investors interested in providing equity to fund about one-third of your total purchase price—as long as the promised payoffs are high enough to reward them for the risks and illiquidity inherent in that type of investment. In our experience, the payoffs need to provide investors with at least an annual rate of return around 25%.
When you began your search, you started to assemble a group of wealthy investors who might be interested in providing equity capital to fund your acquisition. Those include the investors from your search fund and—whether your search was investor-funded or self-funded—a network of individuals you’ve been building up since the search phase. If you are a funded searcher, you can probably obtain most of your acquisition capital from the same group that funded your search. For the remaining equity you need, reach out to additional investors, perhaps, for example, some who were unwilling to fund the search but were interested in backing you in an acquisition. If you are a self-funded searcher, you’ll need to raise all of the equity from the potential investors you’ve been keeping informed throughout your search.
The process for raising capital for your purchase is very similar to that outlined for raising capital for the search itself in chapter 5, “Paying for Your Search.” You begin with people you know, and then you grow your network along the way. But instead of having to share stories about potential companies, you can now tell investors in concrete terms why you think your prospect is a great acquisition.
Assembling the Investment Memorandum
The investment memorandum, a detailed packet of information about your target company, should be sent to potential investors. Start putting this memo together once you have a signed LOI. The memo should include the following information:
Information about the business and its industry. What’s in the confidential information memorandum (CIM) is fine.
Details on the due diligence that you’ve done, covering your own preliminary and confirmatory due diligence together with input from your accountant and lawyer. Give special attention to any issues that concerned you and that you resolved so that investors can get comfortable both with the specific issue and with the scope and care of your due diligence.
Your financial projections.
The deal terms that you are proposing to potential investors. Include the types of securities available (more on this below), the sequence of payouts, an agreement about how the company will be governed, and the amount of equity you plan to retain.
If you took funding for your search, you’ll have outlined many of the deal terms for equity investors then and you’ll have little flexibility on terms at this stage. If you funded your own search, you’ll have more flexibility.
Types of securities
Most equity investors in smaller private companies receive a preferred stock security that provides for a return of capital plus a preferred return to investors, followed by an equity interest in the company. If, for example, you raised $3.0 million from investors, the company would repay the $3.0 million invested plus a preferred return of, say, 8%, as cash becomes available from the business and as the required debt payments are met. Once the $3.0 million plus the preferred return is paid to investors, subsequent available cash flows are divided between you and the investors. Sometimes, there is a catch-up to the entrepreneur so that you receive your proportional interest of the preferred return before the cash flows are divided between you and the investors.
Variations from deal to deal reflect the trade-offs entrepreneurs and investors make as they fit together their individual goals. Ari Medoff negotiated that his investors receive a high preferred return and he waived a catchup; in return, he received a very large share of the remaining profits. Jude Tuma negotiated a more standard share of remaining profits and no catch-up to himself; in return, he benefited from a low preferred return rate to his investors.
Deal terms
If you raised money from investors to fund your search, the terms of your acquisition were set when you took the search capital. Table 19-1 returns to the acquisition model for Zeswitz Music, the company that rents musical instruments to students. We looked at that model in chapter 13, “Preliminary Due Diligence,” as an example of forecasting results and to help gauge a reasonable offer price. We also learned in chapter 17, “Confirmatory Due Diligence,” that Randy Shayler discovered that Zeswitz’s EBITDA was 20% less than what was reported in the CIM and that he was able to negotiate a proportionally lower acquisition price. In table 19-1, we’ve started with the assumptions of table 13-3, reduced the purchase price and exit value by 20% for the lower EBITDA, and adjusted the cash flows for the lower results. We’ve also added in the calculations of the equity internal rate of return. The model is structured around typical search fund terms with the searcher getting 25% of the cash flow after the equity investors received payments that equaled their investment plus a preferred rate of return of 7% in the example. The internal rate of return (IRR) is 20%, below the 25% that investors demand. This deal might be hard to fund. The search-fund investors could choose not to invest, and that might well be the end of the deal.
If the confirmatory due diligence and better understanding of the business made the future of the company look better, perhaps even great, with high financial rewards relative to the purchase price—perhaps with an annual rate of return well above 25 %—then most of those benefits go to the investors who funded your search. You’ll benefit from your fixed-percentage ownership of a better business, but you cannot get a higher percentage of ownership just because you found an amazing opportunity. Imagine that Randy became convinced that the lower operating expenses and capital expenditures in 2012 were sustainable. The resulting model is in table 19-2. The investors would be pleased with the 29% IRR, but Randy’s share would continue to be 25% of the profits after the investors’ investment and a preferred return was paid to the investors.
If you self-funded your search, you determine the terms of the equity you’ll offer to investors now that you know the prospect and its attractiveness; the better the prospect, the better the deal you’ll be able to structure for yourself. This flexibility is the primary benefit to self-funding your search.
To develop a plan for dividing up profits, return to the financial model you have created for your acquisition. You initially built the financial projections during your preliminary due diligence, refining them during your confirmatory due diligence. Now that you’ve spoken with potential lenders and have a sense of the debt available, you should complete your plan by designing the potential terms of an equity investment. Investors generally want an annual return of at least 25% on private-equity investments in a solid, profitable, smaller business. But how much of the company does that mean investors should own? To answer this question, plug some standard investor ownership terms into your financial model, and examine the resulting projected returns to investors. For example, start with a payout sequence like this:
- The investors get back all their capital.
- They then receive a 7% annual return on their invested capital (the preferred return).
- Then you receive 25% of the amount paid to the investors as the preferred return (the catch-up).
- Then the remaining profits are divided 75/25.
Review what level of return this deal provides to investors. If it is much above 25%, increase your ownership to move projected investor returns to about 25%. It’s an iterative process to find your way to a proposed deal.
Table 19-3 shows the same model as table 19-2 except that we assume that Randy’s search was self-funded. He can now increase his percentage ownership above 25% and still offer investors a return well above 25%. For example, if he kept 45% of the profits after the return of the investment and payment of the preferred return, the investors’ IRR would still be 25%.
One caution: It is tempting to return to your forecasts of the business and add a bit of optimism to your projections at this point, increasing the cash flows to the business and resulting in a quicker debt pay-down and significantly higher investor returns. But you will need to include your financial model in your investment memo (many investors will also ask for an electronic version), and investors will almost immediately question aggressive assumptions. Substantial growth in revenues or margin expansion are tell tale signs of overoptimism, and our experience is this too-sunny outlook will cause investors to pass on the investment. It is better to present a conservative model that delivers good returns and then tell investors why you think it may be even better. If, for example, Randy sent along the model in table 19-3, he would need to have a very convincing explanation of his two important assumptions about the substantially lower operating expenses and capital expenditures.
Approaching Investors
Once you have your investment memorandum in place, complete with proposed terms, reach out to your potential investors via email to schedule a phone conversation. Send in advance a very short description of your target company.
If the call suggests that the investor might be interested in your proposal, send the full investment memo and schedule a time to follow up again with another call to answer any questions the investor might have.
Potential investors will have numerous questions about your due diligence, the business, the securities, and so on. These meetings are important sales calls; they are not informal conversations. As with your earlier pitch for search funding, you should prepare thoroughly and stay focused on delivering your pitch in the call. Everything about your acquisition opportunity, your own preparedness, and your manner is being evaluated.
As you close in on a set of interested investors, you will need to get verbal commitments from them. We recommend soliciting more equity commitments than you need to avoid any last-minute scrambling if an investor ultimately backs out. Once you have your equity investors in hand and have agreed on the terms of their investment, your lawyer will prepare and circulate a shareholder agreement to your equity investors. In this agreement, they commit to funding their part of the acquisition.
Next Steps
You are now moving toward your acquisition on three separate fronts: you are completing your confirmatory due diligence, working with your lender to complete their due diligence and negotiate a loan agreement, and finalizing the shareholders’ agreement with your equity investors. The last step in the process before closing is completing the purchase agreement, and that is the topic of our next chapter.