Seller attitudes towards rolling over equity
January 14, 2020
by a searcher from Carnegie Mellon University - Tepper School of Business in Boston, MA, USA
I'm looking at an off-market deal where I expect the seller would want to maintain minority ownership (~30-40%) while stepping out of running the day-to-day operations.
We aren't at the stage of an LOI but I am thinking ahead to potential roadblocks, and a significant one is the use of debt. I can imagine that in a transaction that isn't purchasing 100% equity of the business, the seller has is in an unideal world where they lose control and have cash distributions dry up to facilitate debt service. (I know SBA is off the table here).
I know that other folks out there have made acquisitions where the seller maintained a minority stake and am curious (1) whether this emerged as a roadblock/hesitation and (2) how you got them comfortable with it and overcame it.
from Ohio State University in Chicago, IL, USA
- Seller is concerned about operating or owning a leveraged company when they may have been averse to debt before. We countered this by sharing a sanitized version of our model, explaining the credit profile of the Company, describing that we underwrite to certain covenants with a margin of error applied, and by showing that the covenants and debt service could be met under various scenarios including downside scenarios. It can also be particularly helpful if you pick a lender you have experience with or that has come well recommended especially when times are tough.
- Recently I ran into a roadblock where the Seller expected to continue to take distributions post-close. We should have explained earlier that the credit agreements often include a no-distributions clause. Our thesis was to reinvest in the business also, rather than to distribute the cash. It is better to be upfront about this and to make sure the Seller's expectations are managed. The key is to message that the shareholders will realize value together as the equity value of the Company grows rather than by taking distributions, excessive compensation, or related party rent as many small business owners seem to be used to doing.
- An operating agreement that provides the majority owner absolute discretion in material corporate decisions is important in my view. Minority shareholders could be hold-outs and block the sale or recapitalization of the Company unless you build the right protections for yourself. Perhaps the majority shareholder has more voting rights on the Board and/or the Operating Agreement includes drag and tag provisions. Negotiating the operating agreement can be a significant challenge, and I have lost one deal over it--mostly because the Sellers had unrealistic expectations with regards to their rights as minority holders and their counsel was not well versed in leveraged deals. In any case, the choice was clear to walk away rather than to allow a minority investor any sort of veto right. A control position means control.
from Cornell University in Novato, CA, USA