Search Funds: How to Structure an LOI
As we continue to help more and more search funds with diligence and acquiring a small business, we often get the same question along the lines of 'how do I structure an LOI' as well as 'how do I structure an accretive acquisition without the seller walking away'. We recently helped a searcher work through negotiating an LOI with a stingy seller where headline valuation was very important. The seller had a $17 million enterprise value stuck in their head and were not willing to budge. The searcher had initially planned on a $15 million enterprise value to achieve a mid-30% IRR and they were worried the increase in purchase price would impact their returns.
Given SOFR has dramatically increased over the past 24+ months and interest expense has essentially doubled for most small businesses, we wanted to provide searchers (both traditional and self-funded) some tips on how to negotiate a favorable LOI without the seller walking away.
Leverage - given interest rates have risen materially we recommend underleveraging your acquisition upfront. This doesn't mean leverage is bad and you can't layer it in throughout the investment period, but we find having ample cushion upfront will help you sleep at night. Rather than utilizing 3.0-4.0x of leverage like a traditional private equity fund, put 2.0x leverage on the business at closing. After the business has performed and delevered during the first 12 months of ownership you now have optionality which is important given current macroeconomic concerns. The searcher may then decide to do a dividend recap, distribute excess cash to shareholders, and layer on incremental debt. The searcher can also use this excess liquidity to fund a near-term tuck-in acquisition rather than calling equity from investors.
Seller Notes - While interest rates have increased which means the price of seller notes has also gone up, they are a great way to mitigate traditional bank debt at closing. Seller notes provide a little 'skin in the game' from the current owner and typically do not have traditional covenants that a senior debt, unitranche or mezzanine debt provider will require. Again, this flexible structure will help you to sleep at night. Most seller notes are priced at 8-13% interest rate and PIK throughout the investment period, costing the business no cash upfront, but will be paid out at exit. While this slightly eats into the equity returns, it is more beneficial to pay dollars in the future vs. dollars today.
Seller Rollover - Many sellers are more than willing to help a searcher transition into the business for a period of 6-18 months and want to see their business continue to grow and build upon its brand post-closing. Seller rollover is a great way to create strong alignment of interest with the current owner (ideally 20-30%) to ensure the business does not fall off a cliff post-closing. It helps create certainty heading into closing that you are on the same team as the seller and they truly want to see the business succeed going forward.
Earnouts - Many sellers will often try to pitch you that next year is a 'big year' for the company to get you excited about the acquisition. Rather than fight with the seller over uncertainty, structure an earnout for the company's performance over the next 12-24 months. We always recommend earnouts that are based on gross profit or EBITDA rather than revenue. Revenue earnouts can misalign the seller to 'stuff' new business into next year, delay or speed up contracts, and sign contracts at poor / reduced gross profit margins just to meet an earnout payment. They may counter-argue that they cannot control EBITDA if the searcher plans to add new hires and increase SG&A spending which will impact the bottomline so typically we recommend gross profit earnouts. You can also structure earnouts on a sliding scale or cliff to highly incentivize a seller to achieve a minimum threshold.
Going back to our initial question - how do you properly negotiate an LOI to mitigate giving up returns while not forcing the seller to walk away from the sale? The seller wants a $17 million headline valuation and you didn't anticipate going above a $15 million valuation. Above we lay out three scenarios that all achieve nearly the exact same net IRR despite having a different enterprise value. The initial offer of $15 million achieves a 3.5x net MOIC and a 33.4% net IRR. Scenario #2 increases the enterprise value by $1.0 million but reduces cash at closing by $1.0 million and shifts $2.0 million into the earnout. While the net MOIC comes down given the heightened purchase price, net IRR does not change. Scenario #3 looks at a $17 million enterprise value with only $4.5 million cash at closing, a $5.5 million seller note, and a $7.0 million earnout. Despite the increased purchase price, net IRR once again does not change. The more you pay for a business the lower MOIC you'll achieve (all else being equal), however, seller notes and earnouts are a great way to provide incremental upside to the seller without sacrificing IRR. We modeled earnouts to be paid out via a split of debt and equity (enhances returns) as well as paid out in two years (vs. cash today), both of which help to drive IRR.
Reach out to our RiverStone Reporting team today if you are seeking help with structuring a favorable LOI with a business owner.