These are the juiciest of all term sheet topics because they tend to create the most misalignment between investors and entrepreneurs. Why? Well, for starters, to own preferred equity is to have a preference over ordinary equity, which implicitly creates misalignment. But there’s more, much more.

Investors often command preferred equity to gain protection on the downside. This protection is by way of their equity subordinating ordinary equity. So, if the company is wound up, the preferred equity holders receive payment before ordinary equity holders. (In most cases, there’s nothing left for ordinary equity holders.)

In addition to preferred equity subordinating ordinary equity, there are two other important considerations: preferred participation and liquidation preference. Preferred participation relates to an exit event where there is upside (it determines access to newly created value), whereas liquidation preference relates to an exit where there is downside (it reduces exposure to lost value).

Many instances of publicly listed preferred stock are non-participating. This means they don’t participate in the upside of ordinary stock. This lack of participation is accepted because the preferred stock is seen as debt since it includes a fixed periodic repayment and it subordinates ordinary stock (just like debt). So, like debt, it doesn’t participate in upside.

However, in private equity, preferred stock is usually fully-participating. That means that on an exit event (merger, sale, wind up, etc.), the preference equity converts to ordinary equity and gets full access to the upside. This is in addition to the fixed preferred dividend and the subordination rights. (Sometimes, the preferred equity will be partially-participating, which means that preferred equity holders will receive upside to a certain multiple of their original investment, but this is rare.)

As for the liquidation preference, it is a multiple that dictates the minimum return to preferred equity holders at an exit. So if the multiple is 1x (which it is 99% of the time) and I’ve invested $20m for 50%, then at exit I will receive at least $20m (if $20m is available). So, even if the exit event gives equity a value of $21m, I don’t just get 50% of that, but at least $20m. In effect, this creates a value decelerator for preferred equity; it can still be worth nothing, but it reaches nothing slower than ordinary equity.

You can clearly see that these preferred terms create significant misalignment with entrepreneurs whom hold ordinary stock. You often hear entrepreneurs say “why do you get all of the upside, but none of the downside”. The cheeky answer is “because we’re private equity”. The measured answer is that there is still downside; if the company is wound up and there is no equity value, then even the preferred equity holders are left holding the empty tip jar. However, that’s little consolation for entrepreneurs that have been taught by public equity markets that preferred equity is non-participating.

The answer to all of this is that these terms form part of an entire term sheet that needs to be prodded, poked and pulled in every direction until all parties feel comfortable. These terms allow investors to focus on certain aspects of a deal and entrepreneurs on others. For example, these terms can give entrepreneurs increased access to upside if they agree to take more exposure to the downside. It’s all about priorities.

A common term in a term sheet is the drag along right. A drag along right allows the applicable shareholder to drag all other shareholders into a sale of the business when they choose.

You may ask, why would shareholders disagree on a sale if it makes commercial sense. Well, there can be all sorts of extenuating circumstances whereby private equiteers and managers have opposing views. Private equiteers may want to cut losses if the business is flailing, whereas managers may want to make sacrifices to save face. Or, managers may not want to sell to a hostile bidder, whereas a private equiteer may not share the same emotion. Either way, the drag along right somewhat insures the private equiteer for differences in opinion at exit time.

For founders or managers partnering with private equiteers, they really need to be ready to leave the business at the behest of the private equiteer. It’s an unfortunate fact of life for founders considering a private equity deal, but it is necessary for private equiteers to know that they can take advantage of exit opportunities to achieve target returns.

On the flipside though, if it comes to exit time and the managers strongly disagree, they can be very disruptive to the exit process. If the potential acquirer needs the cooperation of management and staff to effect the transaction (very likely), then it goes without saying that management still have the final voice through their level of cooperation. So, like many terms in the term sheet, this is one that helps align interests rather than fully insure against a potential risk.

Short answer, they don’t. No one deserves preference equity; it’s simply another lever attached to the deal. If the vendor wants a higher valuation, then maybe I’ll pull this lever and demand my equity have preferred status. (See The value-based components of a private equity deal for information on the value of preference equity.)

The benefit of preference equity is that it subordinates ordinary equity in the case of a wind up or if at exit the returned cash is less than the cash invested.

Let’s look at an example. I invest $200m for 50% of a business as preferred equity, while management owns the other 50% as ordinary equity. If the exit equity value were $500m, I would receive $250m (all else equal). If the exit equity value were $400m (the same as the entry value), I’d get my $200m returned. However, if the exit equity value were $300m, in which case my equity would be worth $150m if it weren’t preferred, I would actually get my original $200m back due to the preferred status.

As you can see, this preferred status has real tangible value. No one really deserves this value by default; it is simply negotiated into a deal. Some people will use all sorts of baseless arguments to suggest why they “deserve” preference equity, but it’s all bollocks as far as I’m concerned. So, whether it’s a founder saying they deserve preferred status or other investors saying the same, be sure to understand the real value of this status and simply build it into the deal and your valuation.

The other by-product of preferred status is the coupon (interest payment) that preferred equity often attracts. See my previous post on coupons (Preference equity and convertible notes) to see a similar argument about how coupons affect value.

So, a typical deal may sound like… I’ll pay you $x for your business, of which $y is paid now and $z is paid if you meet next year’s EBITDA budget. The $z, which is predicated on future earnings, represents an earn-out. That is, the vendor has to earn that additional capital payment by hitting budget. I’ve written about earn-outs many times before, which you may like to visit before continuing:

• Are earn-outs fair… or just a product of private equity avarice?
• The value-based components of a private equity deal
• Unpaid earn-outs and discontented vendors

But, when the time comes and the business has exceeded its EBITDA target, where does the money come from to pay the vendor for the earn-out? If you’re buying 100% of the business, the vendor doesn’t really care where you get the cash from (as long as it is paid) because they no longer have an interest in the business. However, if the vendor is retaining a share of the business or if there are other shareholders remaining in the business then they will certainly care about the source of funding for the earn-out.

Let’s use an example. If I pay you $100m for 50% of your business, but $20m of that is an earn-out (so $80m up front), you may assume it’s all coming from my own pocket (or the bank’s). But, what if I suggest the company’s cash flow covers the earn-out? Well, since you will still own 50% of the business, you will essentially be paying $10m of your own earn-out.

Now, this isn’t necessarily a deceptive term suggested by the buyer; it’s simply a valuation play. Of course this structure would be disclosed upfront for you to analyse, so all I’m saying here is that it’s an interesting way to adjust value in a deal to meet conflicting expectations. In the above example, you would receive $100m if the business met budget, but theoretically $90m is from my pocket and $10m is from your own. As long as you think of it this way, there’s no issue. 

Earn-out payments for deals that were settled recently are unlikely to be paid as vendors see their businesses come under unprecedented pressure from the global financial crisis. As an indirect result, we’re seeing a lot of conjecture around the fairness of earn-outs. Vendors are asking, why are we carrying your future risk after we’ve absolved ourselves of the business’s future profits?

The apathetic response is one referring to legal terms, the agreed contract and the unfairness of life. However, having a remorseful vendor is a terrible outcome for a multitude of reasons. So,  it’s important to communicate the concept of earn-outs in a way that doesn’t portray unfettered avarice on the part of your firm. The lucky part is that earn-outs really do have their place and tend to be quite fair. Here are the two main reasons:

1. Firstly, the purpose of an earn-out is to align interests. We need alignment because there is significant influence and information asymmetry. That is, the vendor knows much more about the business and has much more influence on the business than the new owner has. So, the buyer needs some comfort that the vendor will help to facilitate a successful hand-over. 
2. Secondly, earn-outs can increase the value of the deal for the vendor. The reasoning is that the cost of capital for the average vendor is lower than the cost of capital for a private equity buyer. This means that a deferred earn-out payment may allow the private equity firm to pay more for the business, from the perspective of the vendor, while really paying the same amount from their perspective. This can help bridge the gap between value expectations, which is the cause of most problems in private equity deals.

With all of that said, the simplest way to communicate the fairness of earn-outs is in terms of risk and reward. An earn-out allows a buyer to pay a higher reward by reducing the risk. (The risk is that the vendor negatively influences the business, or doesn’t drive the business as hard, during the hand-over period.) I don’t for a minute buy the idea that an earn-out should protect the buyer from economic and market movements. They are risks in any business and the new owner should be solely responsible for absorbing the outcomes.

As discussed in Term Sheet Treatise, the purpose of a term sheet is to propose deal terms and value. But, another underlying purpose of the term sheet (for the private equiteer) is to secure exclusivity over the deal. The exclusivity clause, which is often the only legally binding clause in the term sheet, bars the vendor from pimping the deal to other competitive parties.

In some cases, vendors approach private equiteers to confirm a price offered by another party. The vendor doesn’t intend to proceed with the private equiteer; they simply want to ensure they’re getting a good price from the other party. Sometimes, this could lead to an actual investment, but sometimes pigs can fly too. It’s relatively safe to say that these situations always waste time; hence, the exclusivity clause.

Of course, the vendor can do whatever they want in practice, irrespective of what a piece of paper dictates. And even when the clause is legally binding, the fact is, there’s very little recourse for the private equiteer. However, term sheets are Darwinian in nature and have evolved to include breach fees within the exclusivity clause. If the vendor solicits the deal to another party within a predetermined period (often 45 days), they are asked to pay the fee. The vendor can wait for the period to lapse, but the fee still works as a great filter.

I say this because it verifies if a party is serious about a deal. And, suffice to say, a private equiteer only wants to deal with serious vendors. With that said, I also wonder how many deals fail due to the imposing nature of the breach fee. These fees can easily get into the millions of dollars, so they can be quite off-putting. But, you win some, you lose some. As your time in private equity passes and you become jaded by losing deals that were never deals in the first place, you won’t mind the odd false positive.

A term sheet is a letter of intent provided by a private equity firm to a target business. The purpose of the term sheet, apart from articulating an interest in the target, is twofold: 1) to outline the proposed terms of the transaction, and 2) to apply an indicative value to the transaction. The term sheet is rarely legally binding; it acts more as a letter of good faith between the parties. If all of the terms become agreed, the term sheet forms the basis for more detailed documentation, such as a redrafted Shareholders Agreement or Certificate of Incorporation.

It is important to keep cognisant of the affect a term sheet will have on existing documentation. Generally, if a term within the term sheet differs from an existing term between shareholders, then the expectation is that the new term from the term sheet will replace the existing term. Business owners, or other parties considering the transaction, need to understand that the term sheet becomes the proxy for the terms of the relationship and may affect their control over the business in the future.

The process of negotiating a term sheet, like most negotiations, is all about pushing and pulling. For each clause there will be wording that puts it in favour of the private equity firm, wording that puts it in favour of the potential investee, and wording that provides a relatively neutral position. It is rare that all clauses are written from a neutral position because different parties feel differently about different issues. So typically, parties will enter negotiations and attempt to have the issues they are most sensitive to written to favour their cause.

Term sheets have varied degrees of complexity, usually based on the stage of discussions and agreements already made in principle. Very simple term sheets where the private equity firm is in a weaker position may only include a few clauses outlining the valuation, deal structure and exclusivity. More advanced discussions may result in a term sheet with 15+ clauses and may discuss concepts such as right of first refusal, drag along rights, conversion rules, etc. In later posts I’ll discuss some of these concepts in more detail.

An interesting tidbit: when Buffett started his Buffett and Associated, Ltd. Partnership in the late ‘50s, he quoted his limited partners a 25% carry (although, I’m sure he didn’t use the term carry). By the time the partnership began investing though, it became a 50% carry above a 4% hurdle and a negative 25% carry on the downside. 

This meant if the partnership made a 20% return, Buffett would keep 50% of the 16% over 4%, which would be 8% of the overall return. However, Buffett didn’t take this payment; he reinvested it back into the partnership to compound upon itself. If the partnership made 4% for the year, there would be no performance fee. The surprising bit is if the fund lost 10%, Buffett would personally cover 25% of the loss below the 4% hurdle. So in this example, he’d pay back 25% of 14%, or approximately 3.5%.

This downside protection for the partners (or as I referred to earlier, a negative carry) was unlimited until all capital was lost. Can you imagine a private equity firm today structuring a fund like that? Buffett’s response to this risk was that he knew he wouldn’t lose money over the long term. Somehow, I suspect he wholeheartedly believed this and didn’t just sprout it for the sake of fundraising.

Another interesting fact about his partnership is that while he convinced his friends and family to part with almost $100k, he only contributed $100 to the fund. A private equity fund would rarely get off the ground with this lack of skin in the game, but after all, he probably had more than enough skin in the game by guaranteeing 25% of the downside.

As an aside, understanding the ventures that Buffett thought up and supported, I would say he’s more of a private equiteer than maybe even he would like to admit.

In a previous post, I talked about vendor financing. In this post, I am going to give a numerical example of how it may work from the point of view from a private equity firm. Let’s start with a few assumptions.

• My private equity firm is interested in buying TPE Healthcare
• TPE Healthcare has FY09 EBIT of $10m
• Based on previous analysis, I decide that the highest multiple I will pay is 7x
• The owner of TPE Health care wants $85m for the business

So, the highest price I can pay (and justify to my investors) is 7x $10m, which is $70m. However, the owner (or vendor) wants $85m. In preliminary talks I explain the concept of vendor financing and that it may help to get the deal done. The vendor wants to retire and I think TPE Healthcare is a great business, so we really want to come to an agreement.

I start with the idea of paying $50m initially and $35m in three years. The total is $85m, which the vendor wants, but the deferred $35m is worth less when considering a dollar today is worth more than a dollar tomorrow (let’s assume we don’t have a deflating value through currency trading). Say I use a 20% discount rate as the opportunity cost of my funds. (So, I’m inferring that I think I can invest my money for 20% elsewhere if I had to.) Discounting the $35m back to today’s money results in a present value of 35/(1.2)^3 = $20.25m. So the real value of the proposed deal is $50m + $20.25m = $70.25m, which is close enough to the $70m limit that I hoped to pay.

If we agree on this structure, I’ll pay $50m upfront with a combination of equity and debt. Then in three years’ time, hopefully the business is performing much better, and I can decide to pay the $35m in either cash or completely with debt (since earnings should be much higher). The risk, of course, is that the business goes backward and I can’t afford the $35m. In this case, I’d have to call on equity from the fund, which would be a very bad outcome. So, there is certainly risk with vendor financing, but it’s important to remember that the present value of the deal is still $70m, which I was fine with paying (as long as I believe in my discount rate too).

In deals involving the complete sale of a business, the owner (or vendor) can agree to a partially deferred payment. For example, if you wanted to buy my business for $100m, we could come to an arrangement whereby you pay $60m now and another $40m next year. Depending on who’s pulling whose levers, interest may be charged on the deferred payment. Also, there’s no rule to say it has to be paid in one year; it could be paid in instalments over three years, it could be paid in a lump sum in five years, or it could be paid when the new owner exits. 

In private equity, vendor financing is another way to make a deal achieve the separate goals of the vendor and the investor. For example, if the vendor wants to sell for $100m, but the buyer thinks that is too much, he/she can suggest a deferred payment in the form of vendor financing. This isn’t because the buyer doesn’t have the pesos, it’s to reduce the real value of the deal. Remember time value of money? So, if the vendor finance amount is due in five years, it’s obviously not worth as much as what the same amount would be if paid today.

One other thing to remember is that vendor financing isn’t the same as an earn-out. If the payment is at all contingent on future future, it’s an earn-out, not vendor finance. In the other case where interest applies, the rate can be any amount that the parties agree. The private equity firm will usually insist on a rate that makes the deal right for them on an economic basis (remember, time value of money).

Being a litigious world, legal documents (and legal fees) are ubiquitous in private equity. They may provide comfort for the potential investee, they may protect the interests of stakeholders, they may mitigate risk on the part of the private equity firm, or they may achieve any number of other objectives that legalese is designed for. For the most part, the documents are superfluous to real life needs, but paranoid and delusional lawyers will try to convince you otherwise. 

The following list is a very brief summary of the legalese that graces the desk of a private equity professional:

• Confidentiality or non-disclosure agreement:  used in many other industries, but in private equity, they’re mostly used to provide comfort when providing sensitive information. So, before sharing competitive secrets or financial information, investees may insist on this type document being executed by both parties.
• Offer letter or term sheet: this document presents high-level terms, conditions and expectations of the proposed deal. Most of it won’t be legally binding, but it will attempt to converge the expectations of each party to decide if there’s a deal to be done. It may also include a clause to sign the potential investee up to a commitment whereby if he/she pulls out, a break fee will be applicable.
• Transaction documents: this will set the legal framework for the new business structure and the purchase of shares and/or assets in the existing structure. Many of the terms in this document will build upon summarised terms that the offer letter first presented. Negotiation of the transaction documents will occur until executed and settled upon when cash changes hands.
• Employment and management contracts: as I’ve said ad nauseum, private equity is about backing the right people. With this in mind, it is important to get a solid commitment from your top managers through new employment contracts. These contracts will have terms that favour the private equity firm (such as non-compete clauses) and the manager (such as option package details).

There are many other documents that cross tables in the private equity world, but the fours groups above cover the majority. I’ve only scratched the surface of their purpose and contents, but in the coming weeks, I’ll explore them in more detail.

Writing about sizzling steak brings back so many good memories of my time in the States. But, alas, I’m talking about the other stake; the type of stake private equity firms take in companies.

Unlike typical venture capital deals, private equity firms try to take quite significant stakes in their investees. Expansion deals involve smaller stakes because the existing (and continuing) owner/manager retains his/her equity. Buyout deals involve much larger stakes because incoming management aren’t wealthy enough to buy anymore than a few percent. (If they were, they’d probably live-out their days on the Seine.)

 But, there’s a reason why the stake owned by a private equity firm sizzles and the stake of the management team doesn’t (or at least not as much). Private equity firms look to control their risk by commanding strict terms on their invested equity. To make the deal appear somewhat fair, they provide the management team with other incentives on the upside. The outcome of this is that if the business develops lemon-like qualities, the private equity firm won’t suffer as much. Whereas if it ripens into a plum, the management team will benefit a little more. 

The underlying objective of this is for the private equity firm to limit the fallout of a bad investment, while still benefiting from a good one.

In practise, preference equity or hybrid instruments help manage risk. In rocky times, like we’re experiencing now, the higher ranking capital will be returned before lower ranking capital. So even if you own 50% of an investee and the current value (determined in the recent round of valuations) is below your initial investment amount, you will be allocated 100% of the equity if it’s on a preferred basis. This is sizzzzzling for the private equity firm (from a risk control perspective) and a bad day for the other owners. But, of course it’s only a bad day if an exit is triggered and this situation is realised, which we’re all desperately trying to avoid. And in good times of course, the management team has the ability to realise a much higher return with their upside incentives.

This is a follow on from my post about the amplifying effects of diminishing sales, which was just a simple explanation about how a 20% earnings drop could lead to a 60% value drop. A likely consequence of this phenomenon is that a plethora of vendors under earn-out agreements will now be counting their chickens and discounting their eggs. Whereas not long ago they had visions of majestic chateaux on la Côte d’Azur, they now mostly have visions of decimated pension funds and impossible earn-out targets. 

There are a number of ways to look at unpaid earn-out targets, some optimistic and some pessimistic. Firstly, unpaid earn-outs can still be a boon for private equity firms because, in an absolute sense, they’re paying less for the business than otherwise (although, in a relative sense they could be paying a higher multiple if earnings fall enough). However, this is only beneficial if sales return to budgeted levels and a track record of maintainable earnings is restored. 

Unfortunately, the probable reality is that maintainable earnings have dropped and earn-outs may not have been large enough to protect private equity firms. The saving grace is that this should be a short-term issue for great businesses and they should be able to pick up market share and return to status quo. But, this is reserved only for great businesses; it’s all about product/service differentiation, financial discipline, low-moderate gearing, a dynamic management team and a proactive private equity partner. Without all of these qualities, investees may find these are tougher times than expected.

With all of that said, this is business and business is cyclical. I could insert many clichés here about wheat and chaff, men and buys, good and bad apples, etc., but there’s not much point dwelling. The most beneficial take away is that private equity firms must always invest in the best businesses if they want to maintain reputation and edge.