There are many factors that have a meaningful impact on the success or failure of a transaction. The structure of a deal is certainly one of them.
Deal structure really begins with what the parties believe is in their mutual interest and what the strategy of the investment is post-close. Equity investors use different classes of equity to arrive at a negotiated arrangement with business owners.
For instance, an investor may choose to have downside protection in an investment by negotiating an equity security with a “preference,” which means that their capital would be repaid sooner than the rest of the equity investors. Preferred equity can also have a return associated with it so that not only does the preferred receive their money first, but they also achieve some level of return before more junior equity tranches or options receive a return.
Options play an important role in a deal structure, too, and management teams are often the beneficiary of options to achieve an amplified upside if the outside investors receive downside protection. Ideally, these arrangements will tie in with a reasonable strategic plan.
Employment agreements
To me, the structure of a deal includes employment agreements that 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 the seller/executive has ownership or options.
Often these documents together detail how and if a seller/executive is paid out and at what value should they leave the organization under a number of different scenarios. For-cause terminations usually state that equity is repurchased by the company at the lower of cost or market and the not-for-cause termination states that 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.
Capital requirements
Finally, third-party capital, which often includes banks, is a further consideration. Banks have capital in the investment and should be treated as partners. If your situation requires more “patient” capital or deferred principal amortization because the company needs more cash to grow, then you should expect a higher interest rate and other return enhancers to compensate for the risk.
You might simply need some excess financial capacity to manage working capital, which can be done with a line of credit. Regardless, banks will look at your ability to service the debt and interest payments using different ratios, including the fixed charge ratio, which measures 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 up to 50 percent or 1.50 to 1.00.
The right 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 it’s money or talent, but all parties need to feel respected and compensated accordingly.
Jeffrey Kadlic is co-founder and managing director at Evolution Capital Partners
