When raising equity finance, management teams are always keen to limit the proportion of equity which is sold to an incoming investor. The typical conversation of how much equity is for sale, and the implied valuation, can be difficult. There is often a gap between what the potential investor needs to achieve their required rate of return and what the management team intend to sell. How can that gap be bridged?
As a general principle, it’s always worth bearing in mind that the shareholding structure immediately post-investment does not have to be the same as the division of value on exit. Investors are always happy to see the management team being properly rewarded for driving the growth and value of the business. There are numerous ways to achieve this, but a recent transaction we were involved with made very successful use of a reverse ratchet mechanism.
In that case, an incoming shareholder acquired 25% of the business. The consideration was mostly paid on day 1, with a contingent element based on performance deferred for three years. In addition, the acquiror agreed to a mechanism for adjusting their shareholding, and increasing that of the management, should the business surpass an agreed valuation target. The adjustment was capped at 10% of the business, leaving the investors with at least 15%.
That business is now performing very well post-investment, and looks likely to exceed the valuation target when the assessment date arrives. The management team will have had the benefit of an additional incentive and will retain a substantial shareholding. The acquirer is happy, they will have generated a return well above their target level, even with their reduced shareholding, and they retain an interest in a business which is moving forward apace. All parties can have their cake and eat it.