Independent Sponsor transactions look much more like one-off private equity deals than transactions that take advantage of SBA financing. They require detailed arrangements with capital partners concerning both economics and governance. For acquisition entrepreneurs targeting larger businesses, understanding these deal terms is essential before engaging with potential capital partners.
Distribution Waterfall
The first thing most people search for when reviewing investor documents in an independent sponsor transaction is the distribution waterfall. The waterfall sets forth both the priority and allocation of the distributions that the acquiring entity will make after the acquisition. It is rarely simple.
Step 1: Preferred Return. In addition to their initial invested capital, capital partners receive a negotiated additional percentage (preferred return, “pref,” or hurdle rate) that accrues interest just like a loan until the accrued pref is paid in full. Capital partners can have very different opinions on how quickly the pref should be repaid—some want to be repaid as soon as possible while others want the company to reinvest profits to fuel growth—so it is best for everyone to level set around expectations at the outset. This consideration applies not just to the repayment of the pref but also to other issues such as the exit timeline.
Step 2: Return of Invested Preferred Capital. Again leaning on an analogy to a loan, this is like repaying the loan principal. The difference between this and many loan agreements is that in these waterfall structures the “principal” only starts being paid down once the pref has been paid in full.
Step 3: Common Equity Catchup. The purpose of this is to achieve parity in total distributions. Up to this point in the waterfall, except for tax distributions as required by other parts of the operating agreement, all distributions have been to the preferred equity holders regardless of the equity ownership split if preferred and common were treated as a single class. As the common equity catchup is carried out, the next distributions are made such that the total amount of all distributions made to members becomes pro rata in accordance with the total equity ownership of each member. In practice, this means distributions flow to common equity holders at this step of the waterfall instead of flowing to preferred equity holders as occurred in the first two steps of the waterfall. There can also be performance hurdles based on the investment return for the capital partners before the equity catchup takes effect.
Step 4: Pro Rata Distributions. At this point, distributions occur pro rata based on total ownership percentage treating common and preferred equity as if they were a single class of units. This is usually the most straightforward element of the waterfall. The one potential complication is if the common equity is subject to vesting. If this is the case, then there may be some additional catchup language. The reason for this is that once the common equity vests, then the total distributions to date will no longer be pro rata in accordance with total vested equity ownership. To correct this, subsequent distributions will not be pro rata but will see the common equity holders receive more in order to “catch up” with the distributions they did not receive while their newly vested equity remained unvested. Then once everything is caught up, distributions will revert to being on a pro rata basis again.
Promote and Carried Interest Structure
How much the sponsor receives at the final step of the waterfall is based on a promote or carried interest structure. While institutional PE firms often default to a 20% carried interest, sponsors can sometimes negotiate higher percentages (25-30%) based on their operational expertise and the value they bring to the specific transaction. This carried interest can be structured as a standard promote (a fixed percentage) or as a tiered promote with increasing percentages based on performance thresholds (e.g., 20% until a 2.0x MOIC, 25% until 2.5x MOIC, and 30% thereafter). A sponsor’s carried interest can be structured in a few different ways: it could be a separate class of equity in the operating company; it could be a profits interest in the operating company; or it could be a purely contractual right. These different structures can lead to different outcomes in tax treatment, dilution, and governance rights for the sponsor.
Investor Return Expectations and Promote Structure
Institutional capital partners who fund independent sponsor acquisitions structure deals to achieve their target return thresholds. The economic structure must account for the portfolio approach most capital partners take to investments. Sophisticated investors maintain baseline assumptions about the percentage of investments that will underperform, meet expectations, or significantly outperform (often characterized as singles, doubles, and home runs in investor parlance). To achieve their overall fund returns, capital partners need their successful investments to deliver substantial multiples, typically targeting 2.5-3.0x+ on winners to compensate for inevitably underperforming investments elsewhere in their portfolios.
Management Fee
In addition to the carried interest, sponsors commonly negotiate ongoing management fees that provide continuous cash flow during the hold period. Management fees serve to compensate the sponsor for active management and oversight, provide cash flow stability during the investment period, and create economic alignment as the business grows. Unlike traditional private equity fund management fees, independent sponsor management fees are typically structured as a percentage (or a stairstep of different percentages at different thresholds) of the operating company’s EBITDA and the fees generally increase in line with the actual level of operational involvement by the sponsor. There can be minimum and maximum management fees built into the governing documents and potentially an offset against carried interest if an exit occurs shortly after acquisition.
Sponsor Co-Investment Rights
Most independent sponsor transactions allow the sponsor to invest personal capital alongside their institutional partners. Sponsors typically commit 1-10% of the total equity required and this investment generally participates on the same terms as limited partner capital, receiving the same preferred return and positioned at the same level in the capital stack. Unlike carried interest or management fees, money that the sponsor co-invests into the deal is given the same rights and preferences as capital partners receive.
Board Structure and Control Rights
Control of the day-to-day operations of the company will be in the hands of the executive team. Often this will see the sponsor in the CEO role. This means that the bulk of the control that capital partners are able to exert is through the company’s board of directors/managers. Since the board is their main form of influence, it is most common for the board to be majority controlled by capital partners. Such a structure allows them to maintain some controls over operations such as the amount of debt the company takes on, executive salaries, and lines of business in which the company engages.
Other mechanisms balance control and liquidity considerations. Drag-Along Rights allow majority owners to force minority owners (including the sponsor) to participate in a company sale on the same terms. These provisions ensure that capital partners can achieve liquidity without being blocked by management or holdout investors. Tag-Along Rights protect minority owners by allowing them to participate proportionally in any sale where the sponsor or majority owners are selling their stakes. This ensures that sponsors cannot exit ahead of their capital partners. There are often thresholds for drag and tag rights to apply and they may not spring into existence for a number of years in order to allow the sponsor time to operate the business and build value. There are often also ROFR (Right of First Refusal) provisions requiring that before selling equity to a third party, that equity must first be offered to existing owners on the same terms. This gives the sponsor and existing capital partners the ability to consolidate ownership and maintain control of the cap table.
Put Right
If capital partners are unable to force the sale of the company through controlling the board or there are multiple capital partners with different investment horizons, the capital partners may want a put option in the operating agreement. The rationale behind this is that investment funds often have limited lives and must liquidate their positions in order to return capital to their own limited partners. A put right allows this without forcing the outright sale of the company, and offering a put right can help sponsors reassure capital partners who face such constraints. It can also be a useful mechanism to lengthen the sponsor’s holding period on a business if that becomes desirable. And to answer the obvious question, those same capital partners will fight hard against creating an equivalent call right. Capital partners don’t like being forced to cash in on their winning bets too early.
If there is a put right in an operating agreement, it is very mechanical. The right will only become available to capital partners after an agreed-upon number of years and sometimes only if certain performance hurdles have been cleared. The notice requirements and periods will be spelled out, the valuation mechanism will be established, and payment terms akin to a promissory note will be agreed to in the event that the company lacks the free cash to make any required payments at the time the put right is exercised. It is much cleaner to agree to all of these procedures well in advance in order to stave off potential disputes.
Treatment of Tax Distributions
Tax distributions are nearly universal when the acquiring company is taxed as a partnership. These are meant to provide members with sufficient funds to meet the tax obligations that will be imputed to them on their K-1s from the income generated by the company. These distributions are made according to a formula that is laid out in the operating agreement with limited variance from deal to deal. Where there can be disagreements concerns whether such tax distributions should count towards the return of preferred capital for purposes of the waterfall. For holders of common equity/profits interests (e.g. sponsors), it is advantageous for tax distributions to be considered advances on the return of preferred capital. For holders of preferred equity (i.e. capital partners), it isn’t. There can be some very strong opinions on both sides of this issue since it directly impacts financial returns.
Sponsor Vesting
In situations where the sponsor will assume an active role in the acquired company post-acquisition, there are often vesting conditions on some or all of the sponsor’s carried interest (regardless of how such carried interest is structured).
In many deals, a portion of the sponsor’s carried interest will vest at closing as compensation for finding the acquisition target and introducing the opportunity to capital partners. Thereafter, vesting can take a few different forms. Capital partners will probably insist that at least some of the sponsor’s carried interest be subjected to performance-based vesting. The most common metrics for performance-based vesting are internal rate of return (IRR) and multiple of invested capital (MOIC), both measured from the perspective of capital partners. There can also be purely time-based vesting complete with cliffs and vesting schedules. There can also be a mix of different amounts of carried interest being subject to different vesting conditions.
If there is vesting, it is important to consider what happens under various scenarios of the sponsor no longer being affiliated with the operating company. There is often a major discrepancy in the outcome for the sponsor if termination from the company is “for cause,” so the definition of what constitutes “for cause” termination can be of great significance.
Closing Fee
It is common for the sponsor to be awarded a closing fee (also called an acquisition fee or success fee) at the time an acquisition is consummated. This is a reward from all involved for the sponsor’s efforts in sourcing the deal, conducting due diligence, negotiating all of the legal documents, and finally closing on the purchase. Closing fees generally range from 1-3% of the enterprise value of the acquisition with factors like deal size, transaction complexity, and the sponsor’s track record influencing the specific percentage. Sponsors also commonly get reimbursed for deal costs—diligence providers, legal fees, entity formation costs, etc.
There are two options with what the sponsor does with the closing fee (and a third possibility of taking each option with a portion of the closing fee). The first option is to cash the closing fee, or take the money out of the newly established business as a special distribution. The second option is to roll the closing fee, or in other words to reinvest the closing fee into the business in exchange for preferred equity.
Rolling at least some of the closing fee into the deal can be good for a sponsor in showing capital partners that the sponsor has “skin in the game” beyond what exists from personally guaranteeing the debt portion of the capital stack. Capital providers generally expect some meaningful portion of the fee to be reinvested, particularly from first-time sponsors or in deals where the sponsor’s personal capital contribution is otherwise limited.
Post-Close Capital Requirements
Independent sponsor agreements must address how additional capital needs will be handled after the initial acquisition. Whether for add-on acquisitions, working capital shortfalls, or growth initiatives, the terms governing follow-on capital can significantly impact economics for all parties. These provisions can specify whether existing capital partners have rights of first offer on new capital rounds, pro-rata participation rights to maintain ownership percentages (preemptive rights), minimum commitment thresholds for the sponsor in future rounds, and the economics of new capital. There are also commonly dilution provisions that outline what happens if certain partners cannot or choose not to participate in future capital raises. These can include standard dilution mechanics for non-participating capital partners (or less commonly more punitive “pay-to-play” provisions) and protections for the sponsor to maintain certain governance rights even if diluted. There will also be language addressing what happens if a capital partner fails to fund an additional capital call if such additional capital calls are contemplated at the outset.
Conclusion
With larger transactions and more participants on the cap table, deals can become more complicated. Often, the increase in complexity is not linear. These are a few of the most common items that appear in partnership documents for independent sponsor-backed acquisitions. For entrepreneurs pursuing acquisitions in excess of SBA financing limits, it is important to familiarize yourself with these issues before you enter into capital partner conversations. You do not need to be an expert, but you do need to learn the lingo so that you present yourself as a competent dealmaker.
If you need further assistance understanding how purchase price adjustments work or are in the process of negotiating an asset purchase agreement, contact us at info@barlowwilliams.law and we will be happy to discuss your situation.