An ASM subscriber reached out to ask me how to negotiate an equity position when they didn’t have a private equity background. For the purpose of this post, and to make him anonymous, I will refer to him as Emilio.
Emilio was in his late twenties, lacked a private equity background, and for several years had been helping a friend who had access to capital build a single-location car wash business. Collectively, both decided it was time to properly structure their investment in the business. As Emilio described it, he found himself sitting across the table from his partner’s legal counsel, struggling to identify the best path forward. I proposed four steps to help him arrive at an answer.
Note: I have received this question a few times, which is why I decided to record a video on the subject. Surprisingly, and speaking to the popularity of investing in the carwash space, several of these e-mails / phone calls / conversations have covered the same space.
Elevate the Conversation
First of all, if you want to know what kind of investment partner you have, elevate the conversation above the financial models and term sheets. Ask your future partner(s) how they believe the economics should work out under several hypothetical scenarios. But even before developing these scenarios, ask these questions about your partner’s investment objectives:
- Do they plan to sell the company, and if so, over what time horizon?
- Do they intend to make distributions?
- If it is a long-term hold, are they open to a formula that would allow you to sell your shares back to the company at some point?
With this information in hand, you can develop scenarios. Here’s an example: If the partner is making a $10M investment, and the company is sold 5 years later for $15M, how much would you receive? What about exits at $20M and $30M?
If an exit isn’t contemplated, ask for a mechanism that allows you to realize liquidity. One method would be a valuation formula that allows you to sell your shares back to the company.
If the controlling investor intends to make distributions, ask how you would participate in those distributions as cash flow increases.
They will probably want to run the numbers and get back to you, but this will give you an idea of who you are working with. You need to explore the intention of your partner(s), and whether they are aligned with your success as well as their own. You always want to work with people who want to see you succeed if and when they succeed.
Note: I have received this question for both single-location businesses and for business plans that contemplate building new locations or acquiring them. For investments contemplating new build outs or acquisitions, it’s important to also ask if the structure will contain multiple entities. If so, you want to negotiate your participation in the structure that will hold all of the individual investments.
Build A Model
Ask the controlling investor to summarize their offer in a term sheet and use this as a basis to build your own model and forecast your equity value (see distribution waterfall). The numbers may surprise you.
We have plenty of templates and examples available on ASM to help you work through this exercise. There’s also video examples that will walk you through the mechanics with simple illustrations.
In Emilio’s case, he explained that the controlling investor proposed an 8% preferred return on invested capital, and that they were shocked to see how difficult that made it to create equity value over-and-above the preferred return. While that may be appropriate in most private equity transactions, I wasn’t surprised in this instance. That’s a high hurdle to overcome for a single-location car wash that is operating profitably. Which goes to show you that just because the terms proposed are “market” elsewhere, doesn’t mean they should apply in every instance.
And that’s the beauty of having a model you can share. With your model built, take it back to the negotiating table and ask if you have properly captured what has been communicated. Iterate on this process until both sides are in agreement. That’s a private equity negotiation.
Confirm Your Findings
If you like the structure, confirm it. You don’t have to hire counsel right away if you are on a budget, but if you don’t have experience (or even if you do), pay a professional to review the work you have done as well as any documents you have been presented with. Consider it an investment in safeguarding your future. Remind yourself that this could be your career for a 3- to 10-year time horizon.
Diligence Your Partner
Unless you know your partner really, really well, ask for a list of contacts they have done deals with previously and contact them. Learn about their history working with others. In any process, one thing is certain: Something unpredictable will happen. Hopefully it’s positive. But in the event of a negative outcome, a good partner will come back to the table to update your economics, especially if you are adding value to the business.
Equity compensation is an incredible way to build wealth. If this sounds like too much work, take the time to understand the economics. With the right opportunity, the results may surprise you (and even change your life). Also, if equity compensation is offered, don’t put the conversation off. Too frequently I hear people say that “they can figure that part out later.” You may look back later and realize that the opportunity was lost. You get what you negotiate!
Related: Private Equity Stock Options Primer
Related: Incentive Equity Compensation
Learn more about private equity transactions with ASM’s Private Equity Training course. The Private Equity Training course at ASimpleModel.com was developed by industry professionals. The content below goes beyond the LBO model to explain how private equity professionals source, structure and close transactions.