Equity deals: the good, the bad and the ugly
Equity-funded deals usually involve sellers being offered some or all of the deal value in the form of equity in the buyer’s business. When you’re offered equity, it’s important to realise that not all equity is the same.
The best equity
This is senior stock with high levels of liquidity. If you can negotiate the buyer’s most senior series of preferred stock, then you are doing well. If you’re offered this stock with some extra contractual clauses that improves its liquidity, then you should, potentially, bite the acquirer’s arm off for the deal.
This best equity will enable you, as the shareholder, to receive proceeds of a sale of the business before holders of less-valuable stock.
Preferred stock (shares) are senior to common, ordinary shares in a business sale when preferred shareholders must receive back their preference, usually their original investment amount, before the common shareholders receive anything.
Special contractual additions, such as investment rights and voting rights not offered to common stockholders is another attribute of the ‘best equity’. In addition, co-sale decision-making rights and first refusal rights in the event of a sale will also increase the value of your equity.
The ‘good’ equity
Good equity is the stock that offers some of the above perks, but perhaps not all. This equity is superior to common stock, carrying no special contractual rights, but is less appealing than the best stock you could receive in exchange for all or part of your business.
The ‘bad’ equity
This is the stock that you really should be avoiding in an equity deal if at all possible. If a seller offers you common stock with absolutely no special rights, you may wish to turn you back on the deal. This stock may have limited liquidity, due to the fact that is subject to contractual restrictions alongside all other plain common stock.
So, as a quick summary, here’s some of what to look for in the equity you are being offered:
Liquidity - this means you are more likely to receive a payout from the stock than holders of other, common shares in the same company. Often, if a business is sold, a set amount of proceeds will flow straight to the holders of the premium stock first.
Unique contractual rights - look for additions to the contract that will afford you the right to have a say on things like transactions, future financing rounds, a co-sales. Also, the right to be able to sell shares to investors when the next financing round takes place is a bonus.
Event or time-based redemption rights - This is the right to force the acquirer to redeem your equity at a certain pre-specified value at a future date.
One important reason why an equity payout may be a better option
Being amalgamated into a larger commercial entity on a fair equity basis will often mean an instantaneous lift in the paper value of your business. The simple fact is that, for several reasons, the bigger the business the higher the earnings multiple upon sale.
Added to which, the combined earnings of the merged businesses will often become proportionately higher once post-transaction cost savings occur. This often results from the removal of duplicate departments i.e. accounting. Or from reduced overheads i.e. shifting operations into one premise.
Larger businesses, particularly those where the management is separated from ownership, attract more buyers.
How to negotiate a better equity deal
Get your timing right
Analysts believe that one of the best times to agree upon an equity-funded sale is after a acquirer’s business has completed a Series A funding but before they have closed Series B. This means that you maximise your chances of enjoying a liquidity event in the near future, that will see you receive some actual cash for the shares you have agreed to accept.
Know all you can about the acquirer’s business
This is a no-brainer. You need to ensure that you are well-informed about the business in which you will be accepting equity. Does the founder have a successful track record? Does it have healthy cashflow? Is the business likely to attract investment and/or buyers in the near future?
Make sure you have gas in the tank with which to negotiate
Entering into an equity deal when you are in desperate need of a buyer will not provide you with much leverage for your negotiation. Make sure you are in a strong position before trying to haggle for better quality equity and stand your ground. If you have other interested buyers on the table, even better.
Ask for all the information you need in writing
You should be provided with written details of how much of the company you will own and the full terms of the deal. If the acquirer is at all backwards in coming forward with information about the deal, the contract, or even its own financial situation, it may be time to back away from the deal.
As a seller, an equity-financed acquisition may seem like the poor cousin to a full cash buyout, but providing you negotiate a good deal, it doesn’t need to be this way. In fact, a stock deal does enable you to benefit from the future successes of the acquirer’s company and from the higher earnings multiple on the combined business. This could prove very lucrative, providing you are not in a rush for cash and you managed to negotiate the right terms and contract.
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