In the first two installments of From Fork to Fund, we covered the basics of private equity (PE) transactions and the preparation steps for executing a sale to PE. In this month’s installment, we will further evaluate the economics of a PE investment, which can often be one of the most complex and misunderstood pieces of a deal.
Evaluating Full Versus Partial Sale
When selling to PE, options exist to sell 100% of the company’s ownership interest to the PE firm or only a portion of the interest may be sold. From an economic standpoint, a full sale is relatively straightforward as the sellers (i.e., current owners) would receive a substantial amount of the sales price as consideration at closing with no further ownership interest. At closing (minus escrows, holdbacks, and earn-outs, all discussed below), the seller can cash out and pay the associated tax liability on the sale.
In a partial sale, either 1) some current owners could exit through the transaction or 2) the current owners could sell a proportionate interest of their ownership to the PE firm. Again, this affords the current owners a way to provide some liquidity as part of the deal as in a full sale but also allows the sellers to participate in the company’s future growth through their retained ownership. Another option similar to a partial sale would be to “roll equity” as part of the transaction. When rolling equity, the current owners could become owners in the PE firm making the acquisition. Rolling equity has two powerful components: 1) The ability to defer tax on a portion of the transaction and 2) The opportunity to have a “second bite at the apple” when the PE firm decides to liquidate its investment.
Escrows, Holdbacks, and Earn-Outs
There is always an inherent risk to a company purchaser, so the buyer will often have escrows or holdbacks as part of the deal. An escrow or holdback is a part of the purchase consideration reserved to pay any unanticipated claims after the closing period that may not have been discovered during due diligence. The amount of escrow or holdback is defined in the closing documents and payable after a period of time (typically 12 to 24 months). As a result, the piece of the purchase price is not payable at closing and is at risk of not being paid. The amount of escrow and holdback is a highly negotiated piece of the deal between the two parties before closing. In addition, tax is not due on the portion of the gain attributable to the escrow or holdback until received.
Another concept of a deal is an earn-out, which is an additional consideration that may be, although not required to be, paid. A buyer may provide options for these payments if the company meets certain performance targets post-acquisition. An earn-out can incentivize the current owners to continue adding value to the company post-sale to drive profitability and cash flow while reaping some of the benefits while not retaining ownership in the company.
Deal Structure
The deal structure of a PE investment is often the most complicated part of the deal. When investing, the PE firm can and often will invest through various means, including:
- Common Units: The least common investment tool, purchasing a common unit typically provides equal profit allocations and cash distribution rights to other company owners. Typically, sellers who retain ownership in the company will be holders of common units with little or no units owned by the PE firm.
- Preferred units: A PE firm will almost always invest via preferred units. Preferred units differ from common units in that they provide for numerous favorable provisions to the PE firm, including but not limited to 1) Priority over common unit holders to distributions, 2) Fixed amounts of return on the capital invested (often called a preferred return), and 3) Priority to income or loss allocations. Through the structure of the preferred units, the PE firm will typically have priority to most economic benefits during its ownership of the company with the remaining benefit going to the common unit holders upon a second sale of the company.
In addition, PE companies will want to or be required to invest in an entity that is taxed as a C Corporation or partnership for income tax purposes. The structuring or re-structuring strategies of a transaction to facilitate this type of purpose could be limitless, and sellers are advised to consider the structuring during the due-diligence phase as the re-structuring could trigger income tax impacts that may require the acceleration of gain or require sellers to recognize ordinary versus capital gain as part of taking on the investment.
Record Keeping and Compliance Costs
As a result of the ensuing deal structure, the company will usually be required to maintain complex equity account computations for both book and income tax purposes. These computations can be very tedious and have significant impacts on implementing the desired economic impact of the PE investment. Companies that take on PE investment should be prepared to have sufficient internal accounting departments or a CPA firm familiar with PE investments to handle these complex record-keeping and reporting requirements.
Evaluating the economics of any PE deal is a significant undertaking and should be evaluated by your broker, legal counsel, and CPA firm during the due diligence phase of the transaction. GBQ has significant experience working with restaurant concepts that have taken on PE investment and can help you evaluate the impacts when structuring a deal.
Next month, we will share real-world insight, highlights, and challenges through the founder of a company that sold a highly successful brand to PE. If you have any questions, please reach out to Ryan Kilpatrick or your GBQ team member.
Article written by:
Ryan Kilpatrick, CPA
Director, Tax & Business Advisory Services
