Closing
What Can I Do When There Is an Equity Gap?
An equity gap arises when the amount of equity capital you have available falls short of the equity required to close a deal. This can be a common challenge for search fund operators or entrepreneurs looking to acquire a business. Fortunately, there are several strategies to bridge this gap without derailing the acquisition process. Below are some of the most effective approaches for closing an equity gap, along with best practices for each.
1. Seller Financing: A Flexible Option
Seller financing is one of the most common and flexible solutions for addressing an equity gap. In this arrangement, the seller agrees to accept a portion of the purchase price in the form of deferred payments, effectively loaning you part of the capital needed to close the deal.
Why It Works: Seller financing reduces the amount of upfront equity you need by spreading out payments over time, typically with interest. It’s also a sign that the seller has confidence in the future success of the business.
How to Structure It:
Negotiate a reasonable interest rate (often 5-10%) and repayment schedule.
Set clear terms for the length of the loan, typically 3-5 years.
Use seller financing as a way to bridge the gap but keep in mind the seller will likely want personal guarantees and first rights on assets if the business struggles.
Best Practices:
Ensure the business has strong cash flows to meet the repayment terms.
Structure the payments to align with the seasonality or cyclicality of the business to avoid liquidity issues.
Use seller financing to build a relationship of trust with the seller, which can be especially useful during the transition period.
2. Earnouts: Tying Payments to Future Performance
An earnout is another strategy to address an equity gap by linking a portion of the purchase price to the future performance of the business. In an earnout, you agree to pay the seller additional compensation if the business hits certain financial milestones after the acquisition.
Why It Works: Earnouts reduce the upfront capital needed, as part of the payment is deferred and conditional on future performance. It also shares the risk between you and the seller, since the seller only gets the additional payment if the business performs well.
How to Structure It:
Define the metrics clearly—earnouts are often tied to revenue, EBITDA, or net profit targets.
Agree on a timeframe (usually 1-3 years) for achieving the milestones.
Cap the total earnout amount to avoid overcommitting based on future performance.
Best Practices:
Ensure the performance metrics are achievable and within your control as the new owner.
Be transparent with the seller about your post-acquisition strategy and how you intend to meet the earnout conditions.
Draft clear legal agreements outlining how performance will be measured to avoid disputes later.
3. Attract Additional Investors: Fill the Gap with New Capital
If the equity gap is too large to fill with seller financing or earnouts, you may need to bring in additional investors. These investors could be institutional investors, family offices, angel investors, or even existing search fund investors who are willing to contribute more capital.
Why It Works: Bringing in additional investors spreads the risk and increases your available capital, enabling you to close the deal while keeping a manageable level of leverage.
How to Structure It:
Offer equity in the business in exchange for the additional capital. Be mindful of how much equity you're willing to dilute to bring in new investors.
Approach investors who understand the search fund model and are aligned with your vision for growing the business.
Set clear terms on decision-making and governance if bringing in new equity partners to avoid conflicts down the road.
Best Practices:
Target investors who bring strategic value beyond just capital—whether through industry expertise, networks, or operational experience.
Offer an attractive return structure (e.g., preferred equity with a reasonable dividend or return multiple) to entice investors to bridge the equity gap.
Ensure transparency with your existing investors, especially if you’re bringing in new partners who could impact decision-making.
4. Mezzanine Financing: A Hybrid Approach
Mezzanine financing is a hybrid of debt and equity, where a lender provides capital in exchange for subordinated debt that can convert into equity if certain conditions aren’t met (e.g., if the company doesn’t meet repayment terms). It typically carries a higher interest rate but offers greater flexibility than traditional debt financing.
Why It Works: Mezzanine financing can bridge the equity gap by giving you access to additional capital without diluting your equity stake as much as bringing in new investors would.
How to Structure It:
Negotiate the interest rate, which is usually higher than senior debt (10-15%).
Set terms for potential equity conversion, which is typically triggered by failure to meet loan payments.
Define clear exit strategies for mezzanine lenders, as they may require repayment from future cash flows or a portion of the eventual sale of the company.
Best Practices:
Only consider mezzanine financing if the business has strong, predictable cash flows, as the interest payments can be high.
Work with reputable mezzanine lenders who have experience in the lower middle market and understand the nuances of smaller business acquisitions.
Use mezzanine financing as a temporary solution, with the goal of refinancing or repaying the loan once the business stabilizes.
5. Equity Rollovers: Partnering with the Seller
An equity rollover is when the seller agrees to reinvest part of the sale proceeds back into the business by taking an equity stake in the new ownership structure. This reduces the upfront capital you need while also keeping the seller invested in the company’s future success.
Why It Works: Sellers who believe in the long-term prospects of their business may be willing to roll over part of their equity in exchange for continued involvement or a share in future growth.
How to Structure It:
Agree on the percentage of equity the seller will retain and their role in the business post-acquisition (if any).
Align expectations for future payouts, such as dividends or exit opportunities, if the company is sold again.
Best Practices:
Use equity rollovers as a way to incentivize the seller to remain engaged during the transition period.
Be clear about decision-making rights—while the seller retains equity, they may not have voting rights, depending on how the deal is structured.
Make sure the seller’s retained equity aligns with your long-term goals. For example, you don’t want the seller to have too much control over the future direction of the business.
6. Partner with a Private Equity Firm or Family Office
If the equity gap is substantial, you may consider partnering with a private equity firm or family office. These institutional investors often have a long-term investment horizon and can provide both the capital and strategic support needed to close the deal.
Why It Works: Private equity firms and family offices bring both capital and expertise, which can enhance the value of the business post-acquisition. They are often open to partnering with search fund operators who have operational expertise but need additional capital to close larger deals.
How to Structure It:
Negotiate the ownership split and the level of control each party will have. Ensure the terms align with your vision for the business.
Offer the private equity firm or family office a preferred equity stake, where they receive a priority return on investment before other shareholders.
Best Practices:
Look for a private equity firm or family office that specializes in the business’s industry, as they can provide more than just capital—they bring strategic value.
Be transparent about your long-term plans for the business, as private equity partners often seek exit strategies (e.g., selling the company or taking it public) within a specific timeframe.
Ensure that the partnership allows for operational autonomy so that you maintain control over the day-to-day management of the business.
7. Government Grants and Subsidies
Depending on the industry and location, government grants or subsidies may be available to support acquisitions, especially if they create jobs, contribute to economic development, or promote innovation.
Why It Works: These grants can help close the equity gap without diluting your equity or taking on debt. They are particularly relevant for industries like renewable energy, manufacturing, or healthcare.
Best Practices:
Research available grants and subsidies in your region, industry, or for specific business types.
Ensure you meet the eligibility criteria and be prepared for a potentially long application process.
Partner with a grant consultant or specialist to help identify opportunities and streamline the application.
Conclusion
When faced with an equity gap, there are several strategies you can employ to bridge the difference and successfully close the deal. Seller financing, earnouts, mezzanine financing, and equity rollovers offer flexible ways to reduce upfront equity needs, while bringing in additional investors or partnering with private equity or family offices can provide the capital needed for larger deals. The key is to structure the solution in a way that aligns with both your financial goals and the seller’s expectations, while ensuring the business remains profitable and scalable post-acquisition. With careful planning and negotiation, you can successfully navigate the equity gap and close the deal on favorable terms.