There are many factors that have a meaningful impact on the success or failure of a transaction, and the structure of a deal is certainly one of them.  The deal structure begins to take shape as parties determine what is in their mutual interest and what the strategy of the investment is post close.  They also consider what kinds of incentives the investors and managers are trying to create and what is financeable if they are looking for banks or other groups to participate.

 

Equity Classes

Equity investors use different classes of equity to arrive at a negotiated arrangement with all owners in a business.  For instance, an investor may choose to have downside protection in an investment by negotiating an equity security with a “preference,” meaning their capital would be repaid sooner then the rest of the equity investors.  Preferred equity can also have a return associated with it, so not only do the preferred investors receive their money first but they also achieve some level of return before more junior equity tranches or options. In this situation junior investors often times own a security with more economic upside to correspond to the additional risk of being junior in preference.

Options

Options play an important role in a deal structure too.  Management teams are often the beneficiary of options to achieve an amplified upside if the outside investors receive downside protection.  Ideally, these arrangements will be part of a broader, reasonable strategic plan.  In this example, each side can win such that the preferred shareholders receive a return before they are diluted by the additions of the options to the capital structure.

Employment Agreements

To me, the structure of a deal includes employment agreements which detail salary, benefits etc.  An employment agreement can provide the seller/executive the incentive they need to move forward with the partnership.  The “cause” language around how the seller/executive can be terminated ties back to the shareholder agreement if he or she has ownership or options.  Often these documents together detail how a seller/executive is paid out should they leave the organization under a number of different scenarios.  For-cause terminations usually require that equity be repurchased by the company at the lower of cost or market and not-for-cause termination dictates equity is repurchased at the higher of cost or market.  In almost all cases, the company is able to repurchase the equity in installments over a period of years.

Third Parties

Finally, third-party capital is a further consideration.  Banks have capital in the investment just like investors do and should be treated as partners.  If the situation requires more “patient” capital or deferred principal amortization because the company needs more cash to grow then banks will likely charge a higher interest rate and include other return enhancers to compensate for the risk.  A buyer might simply need some excess financial capacity to manage working capital within the month or season to help the company get by. In this case, a line of credit is a useful tool. Regardless, banks will look at the company’s ability to service the debt and interest payments using different ratios including my favorite the fixed charge ratio, measuring the company’s capacity to cover its financial obligations with cushion.  A measure of 1.0 to 1.0 means that your cash generation matches your cash obligations.  Riskier deal structures will require a higher cushion, often times up to 50% or 1.50 to 1.00.

 

The appropriate deal structure creates the right incentives for all parties and compensates each participant for the risks and rewards of an investment.  Each group should have something to offer whether its money or talent and, in the end, all parties need to feel respected and believe they have been compensated accordingly.

 

Jeffrey Kadlic

Author Jeffrey Kadlic

Jeffrey Kadlic is a Founding Partner of Evolution Capital Partners, a nationally recognized and award-winning private equity firm dedicated to driving small business transformational success. His passion is simple: arm and inspire entrepreneurs today with the operational leadership, capital management, and success drivers that competitive markets demand. He is a creator of Evolution’s Five Fundamentals, the systematic organizational change agent that transforms the challenges small businesses face into sustainable and profitable growth.

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