How to Navigate Investor Capital (Part 1)
Welcome to the latest edition of SMB-Transactions.
Many self-funded searchers are interested in raising money from investors. They want to know what terms to offer, what contracts to draft, and what laws apply.
These are all important questions. And we will reach them. But before getting wrapped up in the how, let’s first look at the why.
Why should you raise money from investors?
To state the obvious, it comes down to money and advice.
You need additional capital.
When buying a business, you need to understand your sources and uses of capital.
We’ve touched on this before when looking at the purchase price.
For a small transaction, your sources and uses may look like this:
So far so good. But what if you don’t have $145,000 to contribute?
You could partner with another searcher. But perhaps you don’t want to. After all, if you and your partner each contribute 50% of the equity capital, you are giving up 50% of the business.
That’s a lot of control to relinquish. You’re no longer the boss, which is a large part of what makes self-funded search so attractive.
So, as an alternative, you could raise 50% of the equity capital from investors but retain a 91% stake.
Wait, what?
Confusing, right? Let’s look at the numbers.
When partnering with another searcher, equity is generally split based on the capital that each partner brings to the deal.
In contrast, investor equity is calculated as a percentage of enterprise value, often with a negotiated step up (typically between 1.5x to 2x.5x).
What accounts for this difference?
Sweat equity.
There is a lot of value the searcher brings to a deal in addition to mere capital. When working with investors, searchers are compensated for sourcing and closing the deal, operating the business, and personally guaranteeing the SBA loan.
In essence, the searcher is contributing more than just capital to the deal. Calculating investor equity splits based on a percentage of enterprise value captures this reality.
You may also run into the need for more equity capital when closing a larger deal.
SBA loans are generally capped at $5,000,000. As a result, when buying a business above this threshold, you will need to find other sources of capital. Investor capital can be used to close the gap.
For larger transactions, your sources and uses could look like this:
The same equity split math would result in:
Before you rush to raise investor capital, there is no such thing as a free lunch. Investors will require a preferred return (priority on distributions) and some amount of control over the business.
We will address terms and structure in Part 2.
You want additional capital.
Self-funded searcher deals are highly leveraged. SBA loans often account for between 75%-90% of the capital stack.
On the one hand, leverage is what makes self-funded searcher deals so attractive. That leverage buys you equity. You get to put a fraction of the purchase price down and walk away with most of a company.
On the other hand, leverage increases risk. Debt payments are fixed irrespective of company performance. The higher the leverage, the less your business can suffer a downturn.
You can use investor capital to de-risk a deal in two ways:
Deleverage. You can rely on less debt. Less debt makes your business less sensitive to drops in revenue.
Working capital. You can increase your working working capital cushion. Having more cash on hand may help during the transition period.
You want experienced advisors.
Buying a business is hard work.
Many of my clients tell me that operating a business is harder work.
There is a lot you will not know. New problems to tackle. Challenges to overcome.
Even if you are an experienced CEO, there may come a time when you're in desperate need of advice. And depending on who they are, investors can be an invaluable source of advice.
Just make sure you choose your investors with that requirement in mind. After all, investors come from many walks of life.
If you want to bounce ideas of people who have been there and done it, seek out experienced main street business owners rather than, for example, family and friends (even if those family and friends have deep pockets and are willing to invest).
That is not to say that there isn’t a place for family and friends. Just be cognizant of the role you want your investors to play and select on that basis.
As stated above, in Part 2 of this series, we will look at investor terms and structure.