Understanding the bigger picture, the context of how deals are structured when Private Equity investors are involved in your business, gives you the best chance of making the most return in a future sale or liquidity event. You need to make sure you know what you’re talking about, the various terminologies and the impact of the terms, so you can negotiate a good deal – and ensure all your hard graft over the years doesn’t come to nothing (or not much). Put simply, when it comes to management equity and incentives, it pays to do your homework.
In this article you’ll discover three important thoughts to scrutinise:
- Why you might want a low subscription cost for your sweet equity
- Why you shouldn’t sweat the small stuff – and what the small stuff is
- How you can give yourself the best chance of getting into the equity
And to explain why these considerations are important, we’ll be using expert judgement from Stuart Coventry, CEO, Jamieson Corporate Finance – who’s delivered more than 200 UK transactions and who spoke on this matter on a PepTalks members’ webinar.
- A low subscription cost for your sweet equity…
The first issue that needs to be addressed when considering sweet equity is what price you attach to the shares. Although the Private Equity company is investing in your business, you are also the one buying the shares. Therefore, those shares need to be as cheap as possible, so you get the largest upside when you sell.
As a business owner you may have become accustomed to always talking up the value of your shares. Ironically, when a PE firm invests, whilst you will obviously be looking for a high overall valuation from the sale, due to the way a PE firm structures its investment in the new deal (e.g., it splits its investment into loan notes and ordinary shares), you may now need to negotiate a low price for your ordinary shares.
According to Stuart Coventry: “The reason it’s important is because if I did a deal with five sponsors, each offering 15% of the ordinary shares as the new incentive, they may vary the structure of their equity funds very differently e.g., the equity split could be 99% loan notes and 1% ordinary shares, or 90% loan notes and 10% ordinary shares. You still get 15% ordinary shares of the company, you are just simply paying ten times more for the ordinary shares by design of the new capital structure only. The cost of the ordinary share purchase is a sunk cost so the commercial principle we work towards is that you want to pay as little as tax efficiently possible for the ordinary shares, and therefore free up your reinvestment to go into the co-investment alongside the incoming investor”.
- Don’t sweat the small stuff
When negotiating your equity and management incentive deal, there are many aspects to it. Therefore, it’s important to focus your efforts on the ones that will deliver you financial returns in the future – as well as the ones which are likely to be flexible.
Historically, the coupon rate has been greatly contested, but these days the market has settled around a narrow margin – so, don’t focus your efforts here.
As Stuart Coventry says: “The variation of coupon rates is between 8 and 12%. Most deals we do, the coupon is 10%. So, you’re not changing it very much. Since 2010, I’ve not done any deals with coupons higher than 12% or lower than 8%. It’s important to understand what the coupon is. But, I would push up the equity % because the coupon spread being offered across bidders is probably not that great.”
- Think about getting into the equity
Another key point is that you need to be comfortable with your baseline business plan. You don’t want to work for your business, sell your business – and then the structure of the deal doesn’t deliver any future value to you. Although that sounds like the stuff of nightmares, it can happen.
Founders and senior managers need to be comfortable that they can deliver the forecast sales and profit plans they are presenting to investors – and that will get you to an equity valuation that you’re comfortable with. This avoids unrealistic growth projections or targets that you have to deliver on.
In Stuart Coventry’s words: “You’ve got to understand – what return does my business plan deliver the team? How much value or how much growth in my plan do I need to deliver to get into the future equity value? If you have to deliver everything just to break even, then there’s always a question mark. Therefore, you need to understand upfront the sensitivities of your business plan and capital structure being proposed”