We investors often talk about the value gap.
The Value Gap is the difference between the price you’ll take and the price we’ll pay. Deals go ahead once the gap is small enough for one side to capitulate.
Typically, the value gap is reduced by way of negotiation. But in private equity, the value gap is mostly reduced by (a finely crafted) perception. To create this perception, we focus our attention on term sheets and stockholder agreements.
In a moment, I’ll explain exactly how private equity investors manipulate term sheets to create the value gap perception. But first, let’s look at what motivates investors.
We want to maximise our portfolio returns to increase our carried interest.
Carried interest (carry) is like a performance fee, except it’s calculated on all positive returns. So while the people who run your pension fund may earn 5% on returns above a benchmark, most private equity investors earn 20% on everything. That means,
Private Equity investors are firstly rewarded for protecting their capital.
Keep this concept of protecting capital in mind the next time you pitch your business as “the next Google”, especially if you don’t have revenue. We are more interested in good low-risk businesses, compared to great high-risk businesses. Why?
Firstly, it’s portfolio theory 101.
Secondly, PE funds are big (say $100mm+) and partner numbers are low (say < 5), so we don’t need high returns to get filthy rich. We’ve seen too many funds fold from chasing high-profile deals, so we’re more than happy to gnaw into the low-hanging deal fruit.
While you have very limited sources of potential funding, we have virtually unlimited investment opportunities. If you don’t agree to our terms, there are plenty of other businesses willing to take our money (at least, that’s what we want you to think).
With this in mind, what negotiating chips do you have left?
What we won’t mention is that very few deals represent good, solid, low-risk businesses willing to sell equity at below market rates. This is what we want. This is what presses our buttons.
Founders need to create this perception in order to gain the upper hand.
How? You’ll need to work that out on your own, but in the meantime, let me arm you with the tricks of the investment trade. This is how investors make you sell for less.
You want to sell 50% equity for $14 million, but I only want to pay $10 million. Okay, let’s compromise.
In good faith, and because I’m feeling particularly generous, I’m willing to go to $14 million. But, because I’m new to your business, and don’t know it as intimately as you, I’ll pay $7m now, and $7m in 5 years.
Essentially, I’m agreeing to pay you the full $14 million, but you’re lending me $7m for 5 years. This is called vendor finance. To sweeten the deal, I may even offer to pay you a (very) low rate of interest.
So, what’s the real value of the deal? About $9.8 million based on a 20% discount rate (i.e. my fund’s expected return or opportunity cost for those funds). In the end, I’m paying even less than the original amount and you think you’re getting much more.
Same example as above: you want $14 million for 50%, I want to pay $10 million. Let’s compromise.
In good faith … and because I’m new to your business … I’ll give you $7 million now, but pay the other $7 million (an earn-out) in 2 years, if you hit $10 million EBITDA.
There are two elements here: time value of money and contingent payments. Let’s say the business is currently doing $6 million EBITDA and there’s no debt. You think I’m offering to pay a 4.7x multiple. (14 x 2)/6 = 4.666.
But, if earnings remain at $6 million, I’ve only paid $7 million, which is a 2.3x multiple. If the business grows, but only to $9 million, I’ve still only paid $7 million, which is a 1.6x multiple (7 x 2)/9. But, even if you do hit $10 million in EBITDA, and I have to pay the other $7 million (discounted by 2 years), I’ve effectively only paid a 2.4x multiple (remember the second payment is discount by two years).
I’m paying almost half the amount you think I’m paying.
In addition to the previous concepts (of time value of money and contingent payments), an investor can demand that the company be liable for the earn-out. If you only hold a minority stake, you may miss the significance of this.
Let’s apply this to the example from trick #2.
To meet your $14 million asking price, we will pay $7 million now and the company will pay $7 million contingent upon EBITDA of $10 million next year.
With the right wording, you’ll be surprised how easy it is to miss that the company (not investor) is paying the earn-out.
If the company hits the $10 million EBITDA target, the private equity investor is really only paying $3.5 million of the earn-out because they only own 50% of equity. You’re paying the other $3.5 million. So the investor is paying $7 million + $3.5 million (further discounted for 2 years) for the business which equals a 1.9x multiple.
See this article for more: Earn Out Funding: A Financing Tip for New Players
We investors know that as a business owner, you’re way too optimistic. If you’re not optimistic, then we don’t want to invest in you. We can use this to our advantage.
Your business is growing quickly, which is partly why we’re talking. Let’s imagine your business is doing $1 million EBITDA and you want $5 million for 50% (so, a 10x multiple). You keep telling me you’ll do over $2 million EBITDA next year.
Okay, I’ll meet your number ($5 million), but due to information asymmetry, I want an equity ratchet. To show you’re confident in maintaining earnings, the equity ratchet will reduce your equity by 1% for every $10,000 that your EBITDA is below $2 million for the next year.
I’ve played to your optimism and challenged you to doubt your own numbers. If you say no to the ratchet, it puts your faith in your own business in question. So you agree.
Next year comes around, but after protracted financial crisis, which you weathered quite well, your books (with the help of my financial accounting experts) only show EBITDA of $1.5m. Sure, you’ll likely do $2.5 million next year, but that’s inconsequential.
Guess what, you only owned 50% of your business, and given the ratchet terms, you’ve lost your business. (You did $500k below target, 500/10k = 50, 50 x 1% = 50%.)
You did very well to earn $1.5 million during a crisis, but you never considered losing your business. You also didn’t realise the importance of our definition of EBITDA in the term sheet. Maybe you really did $2.1 million by your old definition, but that doesn’t matter now.
Next year the business does $3 million EBITDA, I now own 100%, so I effectively paid 1.7x instead of 10x.
Don’t fool yourself. Investors are NOT magicians who create unimaginable value in 12 months. They are financial and legal engineers.
This isn’t necessarily a bad thing; it actually comes in handy when you’re dealing with banks, making acquisitions, and securing long-term contracts with large clients. But, creating real long-term organic value isn’t what creates most value in private equity investments. Instead, it’s mostly structuring and debt.
You may think you’re different and would never fall for these tricks. But keep this in mind, I’ve explained these tricks in terms that you’ll clearly understand. You don’t actually think they’ll be explained this way using this wording in term sheets? Even the best lawyers miss our tricks.