Equity differences between traditional and self-funded search?

May 19, 2024

by a searcher from INSEAD in Washington, DC, USA

I've seen several threads that have 'qualitative' comparisons between traditional and self-funded searches. Are there any benchmarks on how much of a difference you can expect in the equity if you did a self-funded vs. traditional search?

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Reply by a searcher
from Rice University in Dallas, TX, USA

Thanks for the tag, ^redacted‌. When it comes to traditional search funds, the typical equity structure of 25%-30% with performance benchmarks that has already been described is quite common. However, as a self-funded searcher, there are several additional factors to consider when bringing investors on board. To fairly compensate the investor while recognizing the searcher's substantial efforts, an equity step-up mechanism is highly effective. You may already be aware of how this works, but it could possibly help others to understand the process. Here's a scenario: You have a $5 million business acquisition on the table, with an investor contributing $1 million. By applying an equity step-up, the investor’s contribution is effectively "stepped up" to determine their final equity stake. For instance, in a 1.5x step-up scenario, the investor would receive 30% equity (1.5 times their $1 million contribution divided by the $5 million purchase price), leaving you, the searcher, with 70% equity. If you go with a 2.0x step-up, which is currently the most common, the investor ends up with 40% equity, and you retain 60%. In a 3.0x step-up scenario, the investor’s share rises to 60%, leaving you with 40%. This step-up mechanism ensures that both parties are adequately rewarded for their contributions and risks. It’s a balanced approach that aligns interests and incentivizes performance. To further attract and compensate investors, structuring preferred returns can be very appealing. Typically, this involves offering a preferred equity return rate of around 10% on the invested capital, although this can vary slightly depending on the specifics of the deal. This preferred return is paid out before any profit sharing begins, providing investors with a reliable return on their investment. If you have 5% for a down payment, the SBA rule changes regarding seller notes can improve your equity position without taking on additional investors. When utilizing SBA financing for a self-funded deal, achieving the best cash-on-cash return often involves a strategic approach. One effective method is a 5% down payment coupled with seller financing, which includes a minimum two-year standby period for any payments made to the seller. This structure can significantly enhance your return on investment while also providing the necessary capital to complete the acquisition.

Reply by a searcher
from University of Maryland at College Park in Annapolis, MD, USA

Thanks for the tag ^redacted‌. As has been discussed here, generally "traditional" search funds are between 80/20 and 70/30 deals, with vesting schedules and performance hurdles. Self-funded searches where the senior debt (NOT the purchase price) is under the SBA limit of $5MM are completely subject to negotiation as the amount of equity raised is typically small relative to the deal size and the personal guarantee. Often when you are going to a third-party investor for a personal guarantee they will adopt the position that the guarantee is "same as cash" so searchers should use this same strategy to negotiate stronger equity positions. Some searchers I have see use a 70/30 split (in the investor's favor) until the capital is repaid, and then flip to 70/30 (in the searcher's favor) thereafter. There is plenty of room to negotiate equity splits that are more aggressively in the searcher's favor, particularly when it is a single or just a few angel investors who don't have extensive knowledge of the search industry and are just looking for a solid return on investment after they have received their return of investment. Be well-prepared with IRR and MOIC calculations when you go into the negotiation. All of that being said, if the senior debt is still greater than $5MM and SBA is not an option (even after using every strategy available such as seller subordinate debt, seller equity rollover, 3rd party mezzanine debt, raising more equity, etc.), be aware that you will fall into a different bucket served by a different class of investor. Compared to a SBA deal, the LTV and credit analytics will be more conservative, you will need to bring more equity, and your personal guarantee argument won't hold as much water. Equity investors in those larger deals tend to be more sophisticated and demand a controlling interests in the deal. Still there are many ways to be creative, but know that it is a very different negotiation from a typical SBA deal. Finally, remember that the USDA has a similar mandate to the SBA but for rural-based businesses, and they offer loan programs larger than $5MM and with extended amortizations.

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