PRICING EXTERNAL EQUITY ON SELF-FUNDED SEARCH ACQUISITIONS
I've been thinking quite a bit about a tricky problem most self-funded searchers will encounter when raising external equity to close their acquisition ... how do you price the equity for outside investors? I don't believe "industry standard" exists on this question, so I figured I'd put a few thoughts out there to see what the community thinks.
(1) The transaction itself creates a very reliable valuation benchmark. That valuation is likely at the upper end of what's reasonable. After all, the seller chose you, right? If you're buying a deal for $1M and bringing 80% debt financing, the fair value of equity on the day you close should be around $200K. It might actually be less because of transaction costs. With that much leverage, it could be zero or negative if you are the only one in their right mind to pay what did. It's truly only worth what the next buyer would pay. If you got a screaming deal, it could be somewhat higher, but that's a tough sell. Wouldn't the seller have sold it to them? Without their offer in hand, it's not a real credible position.
(2) Personally guaranteed debt is still company debt, meaning it gets deducted from enterprise value to arrive at equity value. The debt is paid from company free cash from operations, meaning there's less cash flow available to equity. It costs all of the equity owners free cash flow that would otherwise be theirs. Most deals price based on EV/EBITDA multiples. The investor may not be assuming personal liability for the debt if everything goes sideways, but that doesn't mean the sponsor gets credit for the debt as if it were equity. Our best guess at the market value of the personal guarantee is to match the SBA's guarantee fee of 3.5% of the loan (which guarantees 80%). To account for that, you could price up the equity value basis to give the guarantor equity credit for their guarantee.
(3) Back-solving the equity price based on an investor target return using the sponsor's business plan (and corresponding DCF) is a recipe for disappointment. Of course the plan is to grow it. It's probably to grow it a lot. That's why both investors and sponsors want to do these deals. But, if all that growth is already priced in, there's very little upside remaining. I'm sure sponsors could sell this in certain situations, but I'd caution investors from paying (and sponsors from asking for) large multiples of a deal's fair value as calculated above in (1). However, it seems to be a setup for some ugly conversations down the road. Transitioning ownership is a fundamentally risky project, so pricing by projecting the deal's recent economic reality to the immediate post-transition future is a risky enough proposition.
(4) Certain other activities may create justifiable reasons to stretch the equity price above fair value for the benefit of the searcher. Some examples might be origination/finders' fees, reimbursement of personally-incurred deal expenses, equity incentive plans for the searcher and for key management, or a searcher's unique and highly bankable transition plan, Those likely need to be evaluated on a case by case basis.
Would love to hear your comments and structuring ideas for creating win-win formulas, especially simple ones.
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