PARTICIPATING PREFERRED EQUITY - WHY "STEP UPS" ARE A POOR METRIC
Lately, I've heard a lot of chatter in the self-funded search community - some are using the term "set up" when referring to the common equity split that preferred equity investors receive. Apparently the thinking goes: "if investors are funding 10% of a transaction with equity then those preferred equity investors should get a 2.0x step up (or 20%) in the form of common equity upon conversion".
Its unfortunate that misinformation like this is spreading. "Step Ups" are a concept developed in the VC world to evaluate successive equity raises (often in series) in relation to each other. It’s also a term used in traditional search for the deal equity multiple expected by investors in the search phase. This term has now been hijacked and misused. This is not a relevant metric for evaluating the terms of preferred equity for a individual self-funded search deal. In fact, this metric completely ignores the terms of the deal itself and only adjusts based on leverage as a % of the capital structure of the deal.
For example: for two companies, all else equal, one with a 6x purchase price and one with a 3x purchase price the "step up" required by the investors would be the same if the leverage was the same. You read that right - a 3x and a 6x acquisition with a 10% equity injection would both require a 20% conversion (2x step up). Of course, this runs completely contrary to the idea that investments should be evaluated based on expected IRR - because a 6x company and a 3x company (all other things equal) provide vastly different expected IRRs for the preferred investors.
Going even further - this metric also completely ignores expected growth, margin expansion or contraction, and even risk.
Participating preferred equity investments should be evaluated just like most other business equity investments - based on an IRR and in comparison to expected risk. "Step Up" is a very misleading and incomplete metric. Given the fact that it ignores most of the most important considerations in small business equity investing, its a wonder why its being used at all!