Model template for stepped up conversion of search capital?
August 05, 2021
by a searcher from University of Pennsylvania - The Wharton School in Oakville, ON, Canada
Dear Fellow Searchers,
I was wondering if there is any model template (spreadsheet format or otherwise) for search capital financing that can be shared. Although, I started as a solo searcher, I have got some interest from some of the my known investors and I was wondering about the best possible way to structure a proposal in terms of financing the search. I am particularly interested to understand the conversion of search capital into acquisition capital on a stepped up basis (eg. 150% of actual investment), in the event of successful identification of the acquisition candidate.
I would really appreciate if any of you could share it or point me in the right direction on how I can obtain it.
Thank you and kind regards,
Abhishek
from Northwestern University in Chicago, IL, USA
Let's say you raise $1,000,000 of search capital and find a deal. Let's also assume that you've spent all of that $1,000,000 by the time you find the deal. At the time of close, that capital will be worth 50% more: thus, the $1,000,000 will now be worth $1,500,000.
Now, let's say that you buy a business for $20,000,000 and use no debt (so the deal is entirely equity financed). Let's also assume there are no fees. Thus, you will need to find $20,000,000 to pay the sellers. This capital will come from the second fundraise that you run for the deal.
So one more assumption, let's assume that none of your search investors want to participate in your deal, and you raise your deal capital from a new investor. In this case, that single investor would fork over $20,000,000. However, for purposes of issuing shares, you would include the $1,500,000 of stepped-up capital in the ownership math. Thus, the new investor would only be issued $20,000,000 / $21,500,###-###-#### %) worth of securities, and the search investors would be issued $1,500,000 / $21,500,000 (7% worth of securities). These securities are pari passu (i.e., the same seniority). This is the key lesson here: new investors will suffer dilution from the step-up. Even though the new investor contributed $20,000,000 worth of capital, they will only receive securities that are worth ~$18,600,###-###-#### % x $20,000,000). Thus, it is critical that you find a deal where a sizeable amount of your search investors want to participate; otherwise, your gap investors may end up suffering a material amount of dilution, which may deter them from wanting to participate in your deal.
Happy to answer more questions or clarify anything that isn't clear.
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Including a S&U table and high-level cap table for your reference as well:
Sources:
Remaining Search Capital $0
New Investor Equity $20,000,000
--
Total Sources: $20,000,000
Uses:
Purchase Price to Sellers $20,000,000
--
Total Uses: $20,000,000
Securities Issued:
NEW INVESTOR
$20,000,000 / $21,500,000 = 93% of securities owned; 93% x $20,000,000 of PF equity value = ~$18,600,000
SEARCH INVESTORS
$1,500,000 / $21,500,000 = 7% of securities owned; 7% x $20,000,000 of PF equity value = ~$1,400,000
from The University of Chicago in Chicago, IL, USA
My suggestion using same numbers used by Tim.
Step-1: Form a NewCo owned 100% by Search Capital Provider (SCP) with search capital of $500,000. Assume 100 shares.
Step-2: Now comes in $5,000,000 of equity from one or more Equity Providers (EP). SCP can be part of EP.
Step-3: NewCo gives/sells 87 shares to equity providers (EP). 87%=5,000,000/(5,000,000+1.5*500,000), where 1.5 multiplier is the 150% step-up.
In the above approach, it does not matter whether the original $500,000 from SCP is used up or not.
Note: I have ignored searcher equity. For following comment, please remember I am not a CPA nor a tax advisor. Corrections are welcome.
I have read other posts on SF that suggests searcher "gets" x% at start and more later. "Getting" something of value for nothing, very likely, will result in ordinary income to the searcher, including constructive receipt for "getting" x%. There is a way to get around this.