Our CEO Zak Smith has written recently about "Taking a Second Bite of the Apple" for business owners, which happens often in company exits for a variety of both buyer- and seller-driven purposes.
The reasons to "roll equity" forward - retaining ownership in the new post-acquisition entity instead of cashing out - are many. And the potential impact of combining the possibility of:
- Increased revenue for the newly acquired/combined company
- Improved profitability from economies of scale and operational improvements
- Mutiple growth arising from (1) and (2).
...can yield some potent mathematical outcomes.
While all of that's true, today I'm going to focus on some of the risks and what to watch out for any time you're considering how much equity to roll in a potential merger or acquisition.
Liquidity Preference - Understanding the Capital Stack
Of all the complications of rolling equity, this is likely the most important: you must understand the post-acquisition capital stack of the company into which you're rolling equity.
Simplistically, this will take the form of:
- How much debt was used to finance the purchase of your business (and thus how much debt comprises the total value of the new company)
- How much equity remains, and what your share of that equity is
Generally speaking, lenders get paid first. For this reason, you must be confident that the company will have stable and predictable enough cash flow and growth to always service its debt. Your equity won't mean much if the business is taken over by its creditors.
That's not the only potential issue, though. Equity holders can also be ranked differently in order of liquidity preference. Private Equity buyers will often structure deals with preferred stock, meaning that (1) investment/equity returns might accrue first to pay a "preferred return", say 8-10%, to the PE firm before any returns are available for you as a relatively junior equity holder. Those annual pref returns will stack up over time, as well, meaning that (2) in a liquidity event where funds are available to pay off investors, those preferred investors will get paid in full before junior or common equity holders see a dime.
The above alone can have a substantial impact on your outcomes. While you may believe in the business and understand that future "second bite" exits can be at greater values than the initial exit, you have to understand how these issues can impact your ability to ever get paid again when that second bite comes around.
There are other significant issues to consider as well.
- Time Horizon & Illiquidity
- You need to have a shared understanding with your new business partners over the expected timing of any "second bite." It could be 4-6 or more years before even a positive outcome can yield additional liquid returns, so you need to make sure your first bite and continued income will cover you.
- You need to have a shared understanding with your new business partners over the expected timing of any "second bite." It could be 4-6 or more years before even a positive outcome can yield additional liquid returns, so you need to make sure your first bite and continued income will cover you.
- Reinvestment / Opportunity Cost
- In consideration of the above, never forget that nothing exists in a vacuum. Doubling your equity value in 7 years amounts to ~10.4% compounded annualized return. This is an outcome you should compare to the risk / expected return available from other investments if you'd simply taken the cash and diversified your investments elsewhere (assuming you have a choice).
- In consideration of the above, never forget that nothing exists in a vacuum. Doubling your equity value in 7 years amounts to ~10.4% compounded annualized return. This is an outcome you should compare to the risk / expected return available from other investments if you'd simply taken the cash and diversified your investments elsewhere (assuming you have a choice).
- Market Risk
- It's helpful to understand in the impact of specific factors, like increasing the multiple on EBITDA, would have on your exit or 2nd exit valuation. That said, real world outcomes are not based on one factor in isolation, but rather all of the factors combined. Thus, revenue/EBITDA growth and economies of scale (with improved multiples on improved figures) steer toward higher valuations, but weakening markets with multiple-compression across the board could offset those values on the flip side. This is to say nothing of all of the idiosyncratic risks that could thwart your business plan to achieve all of your goals.
- It's helpful to understand in the impact of specific factors, like increasing the multiple on EBITDA, would have on your exit or 2nd exit valuation. That said, real world outcomes are not based on one factor in isolation, but rather all of the factors combined. Thus, revenue/EBITDA growth and economies of scale (with improved multiples on improved figures) steer toward higher valuations, but weakening markets with multiple-compression across the board could offset those values on the flip side. This is to say nothing of all of the idiosyncratic risks that could thwart your business plan to achieve all of your goals.
- Business Plan / Growth Plan
- You need to be on the same page with your acquirer/new business partner about what exactly the plan is for growth after the first transaction. This will tell you a lot about the total growth capacity so you can begin to understand your risk-reward in rolling equity and sacrificing liquidity and guarantees in exchange for future growth.
- Equally important, strategic disagreements and mismatches can be hard-to-swallow post-acquisition, especially for an owner used to a degree of control in steering direction. You may or may not have board/controlling leverage after the deal, so you need to understand this landscape up front.
- Taxes
- We like to say the tax tail should never wag the financial dog, but that said taxes almost always weasel their way into becoming a factor in decision-making. While tax rates at Exit 1 are knowable, all future tax rates are unknowable. At large dollar figures, it's important to understand that more money later may not be quite as much money net of an unknown future (potentially much higher) applicable tax rate.
Important Questions to Ask and Answer
In summary, rolling equity can lead to exciting future possibilities, but there's a lot you need to understand going in before you make a commitment.
What will the capital stack and liquidity preference structure be after the deal? Where will I sit in the totem pole?
What is the future-exit time horizon?
What is the risk-reward of the equity roll vs available investment opportunities for cash?
What is the shared plan for business growth and improved valuation after the deal? What hurdles does growth need to clear to make sure your rolled equity still sees the intended future return?
It can be hard to look past the top line numbers and eye-popping projections, but it's important to take a sober look at the terms and conditions. Exit planning involves a lot of complexity, and I highly recommend working with a knowledgeable professional who can help you steer clear of the obstacles.
To learn more about the "why" and "how" of attempting to take a Second Bite of the Apple, check out Zak Smith's complementary blog post.
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