Keeping Management Motivated Post-Exit

takenotes08's picture
Rank: Neanderthal | 3,296

Hey all,

I was able to acquire a small managed service business a few months ago ~1M Revenue, 300k EBITDA almost all recurring revenue. I am looking to acquire another one in a different area ~3h flight away from where I am living now.

The deal is ~2M Revenue and ~500K EBITDA, with about 60% being recurring and 40% being project based revenue. The two owners are late 30s, early 40s and are interested in selling 100% of their business and staying on board for a few years after as employees to help transition the ownership. They want to transition out of the business as they have other ventures and I think are just bored of this industry.

Im thinking of structuring the transaction as follow:

$1.7M purchase price: $1M cash at close (senior debt), 300K after 2nd year, 200K after 3rd year and 200K worth of preferred shares in my topco, convertible into common shares at a valuation of 3-4M when at exit. The idea of the shares in topco is to make sure they still have some kind of skin in the game and to also get them to help me with some intros to other owners in the same industry/area + be references for next deals.

My question is, how do you keep the sellers motivated to keep closing and performing contract-based revenue? The recurring part, im not too worried about as they have long standing relationships with the clients and its simple not to lose the clients unless you fuck up very badly.

Would it make sense to have some kind of revenue share/bonus or commission for contract-based revenue closed while they stay on board? (Owners would like to stay onboard at least 3years and keep their current salaries of ~150K each, which is already priced into EBITDA so its fine)

Also, the LOI hasn't been presented yet so any insight on transaction structure would also be appreciated.

Thanks bros,

Comments (43)

Apr 8, 2019

Why not an earn out?

e.g. following your structure:

Year 0: 1m at closing

Year 1: 300k * Budget Achievement (%)
...

So that depending on their performance the actual valuation could move between 1.0 and 1.7m.

You can also replicate this as a management incentive rather than a purchase price earn out to link it better to their managerial role rather than a shareholder role (just to protect you in the unlikely case they break a non-compete or a gross negligence type of clause).

PS - Budget Achievement formula can get as complex as you want, I'd suggest a mix of FY EBITDA and FYE Net Debt to reflect Equity Value and take out a lot of loopholes (increasing unprofitable sales, boosting gross margin via additional marketing expenses, boosting EBITDA capitalizing costs, etc) while keeping it relatively simple.

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Apr 8, 2019
Sprezz:

Why not an earn out?

e.g. following your structure:

Year 0: 1m at closing

Year 1: 300k * Budget Achievement (%)
...

So that depending on their performance the actual valuation could move between 1.0 and 1.7m.

You can also replicate this as a management incentive rather than a purchase price earn out to link it better to their managerial role rather than a shareholder role (just to protect you in the unlikely case they break a non-compete or a gross negligence type of clause).

PS - Budget Achievement formula can get as complex as you want, I'd suggest a mix of FY EBITDA and FYE Net Debt to reflect Equity Value and take out a lot of loopholes (increasing unprofitable sales, boosting gross margin via additional marketing expenses, boosting EBITDA capitalizing costs, etc) while keeping it relatively simple.

Yeah this makes perfect sense. I think we will try and opt for something like this vs pure seller note. Especially since not all their revenue is recurring.

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Apr 8, 2019

Structure an options package ratcheted by level of return to the GP:

15% at a 25% IRR
20% at a 30% IRR

Something like that. Then, to support your argument, build a proceeds summary at each level of return to the management team. They get more excited about $$'s than percentage points.

Charge a management fee to cushion your downside a little bit (maybe 5-10% of entry earnings) and negotiate for a preferred equity structure with a 8-10% pref. coupon (basically give yourself a hurdle before management realizes their rollover).

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Apr 8, 2019
Elite_Bulge:

Structure an options package ratcheted by level of return to the GP:

15% at a 25% IRR
20% at a 30% IRR

Something like that. Then, to support your argument, build a proceeds summary at each level of return to the management team. They get more excited about $$'s than percentage points.

Charge a management fee to cushion your downside a little bit (maybe 5-10% of entry earnings) and negotiate for a preferred equity structure with a 8-10% pref. coupon (basically give yourself a hurdle before management realizes their rollover).

Hey, thanks for the response.

When you say 15% at 25% IRR, do you mean they get 15% of the topco equity if we hit 25% IRR with the topco? Seems like a lot of equity when I can just finance the whole transaction with debt and seller financing by using my current co as collateral/equity.

Also, we thought about charging a management fee, but I feel it makes only sense if you are not doing a 100% buyout? We would effectively by charging ourselves a management fee if we own 100% of the business. No?

Also, we thought about the preferred coupon, I think there will be a 5-6% PIK coupon if we do offer them preferred shares in the topco as a way to finance the transaction. However, how does the hurdle mechanism work?

Our idea of the preferred shares is the following:

200K of preferred shares in topco with 6% integrated interest rate and 1x liquidity pref, convertible at $5M equity valuation. Which would yield the following.

Scenario 1: We exit year 4 at 20M equity valuation. They convert at 5M, and get 4X their money.

Scenario 2: We exit year 4 at 4M valuation. They don't convert and get paid 200K(1.06)^4 = 252K, before common share holders (me) get their share of the payout.

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Apr 11, 2019

I think what @Elite_Bulge means about the 15% at a 25% IRR and 20% at a 30% IRR is essentially like traditional carried interest in a PE fund, being they retain 15% of any upside, over a 25% return to the GP.

The fund I work in deals a lot with founder owners looking to sell down up to 100% of their business. We like to keep them in for a minimum of ~10% to keep them motivated and usually throw in a carried interest 'carrot on the stick', exit based incentive as well. In our experience, transaction structures like this have worked really well at aligning selling shareholders / management with the new owner. Even if they don't stay on in a full time management role, the exit incentive is enough (in our experience) to keep them interested at a Board level, and when they have grown the business from nothing to where it was when you purchased it, their existing business relationships, insight to growth opportunities and general forward looking strategy is invaluable.

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Most Helpful
Apr 8, 2019

Awesome topic - can't wait for the responses from real investors. I'll lob in some thoughts in the meantime.

In general, getting people to stay engaged after a meaningful payday is tough, and everyone has their own experiences of what has helped people stay on point through a transition period.

For business owners in the lower middle market, I've found that the "second bite of the apple" motivator is basically worthless if the first payday is large enough. Everyone has a number, and if someone gets their number out of the deal, then it's impossible to get them to give any shits about the next one.

The more capable the management team, and the more heavily the thesis depends on them, the more you want them rewarded for their performance post-transaction on things they control.

Given that, a few comments:

  • Is $1M at close the right number? You know these owners better than any of us, so you know if that's enough to alter their behavior going forward. It sounds like they want to get out and they're not interested, so would they consider a transaction where there's less cash at close and more conditional? I could see cash at close for whatever you decide the contribution value of the recurring revenue is (basically buying the existing machine), and then the remainder being conditional.
  • I wouldn't pay out anything in future years that wasn't explicitly performance-based. I agree with @Sprezz 's comment about having a budget achievement formula, and carrying it out 2-3 years if necessary.
  • The shares in the topco are tricky. They probably won't see those as motivating, since they don't control or have responsibility for the topco - it's just additional consideration in a different form. It can be meaningful consideration, but you have to walk through the valuation game - you get $200k of value, assuming the combination is worth X...but if the combination is really worth Y, then your consideration is worth something different. You also don't want to give up that equity if you don't have to, unless the upcoming consolidation work is dependent on their involvement.
  • I would separate this into two questions: what do you want their involvement to be as owners, and what do you want their involvement to be as employees? If you want them to be out selling and closing contracts like sales employees, then come up with commissions/bonuses like you would any employee. If you want them to run this like owners while you're out making additional tuck-ins, then structure P&L responsibility and equity rewards like you would an owner.

If they're interested in selling 100% of their business, let them. If you need employees for the business you then control 100% of, then that's a new problem. Equity is precious - don't give it away unless you're buying something with it you can't get otherwise.

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Apr 8, 2019
Layne Staley:

Awesome topic - can't wait for the responses from real investors. I'll lob in some thoughts in the meantime.

In general, getting people to stay engaged after a meaningful payday is tough, and everyone has their own experiences of what has helped people stay on point through a transition period.

For business owners in the lower middle market, I've found that the "second bite of the apple" motivator is basically worthless if the first payday is large enough. Everyone has a number, and if someone gets their number out of the deal, then it's impossible to get them to give any shits about the next one.

This is a good point. Really appreciate the advice and thoughts.

Rethinking this whole thing and we might just structure it without giving them any equity. We are getting more info about the business and my partner (the operational guy), believes we could just replace them after the transition period (2-3years) with manager a getting paid ~120K to maintain the recurring revenue contracts. We could also get a lead gen agency to help secure a few extra MRR contracts in case there is some churn.

We don't really want to focus on growing the business as we don't see much value in increasing ebitda by 10-25% vs just buying an additional biz and doubling topco ebitda. We just want the business to remain stable and pay down debt.

About the upfront price, the recurring revenue EBITDA is ~220K, so at 1M we are paying slightly above 4x, which is prob overpaying by 0.5-1x, but we are okay with this since it is more important to us to get a deal done and prove the thesis then trying to save 100K.

That being said, I think it could make sense to just structure it where we pay 800K to 1Mish upfront and then have a form of earnout over two years for anything over the recurring revenue EBITDA. Like 0.8X of anything over 220K for the first year, so if they make 500K ebitda we would pay them ~225K at end of next year.

I think we will keep the shares in the topco as a bargaining chip to add some purchase price to the deal if we cant close at 1M upfront + a few 100Ks in earnout over 2years. And if we do go down the equity in topco path, does pref shares convertible into common equity at exit make sense? I feel like LMM owners like pref shares with a fixed value makes more sense to them as their value is kinda locked in + they get upside if we knock it out of the park.

Thanks man

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Apr 11, 2019
takenotes08:
Layne Staley:

Awesome topic - can't wait for the responses from real investors. I'll lob in some thoughts in the meantime.

In general, getting people to stay engaged after a meaningful payday is tough, and everyone has their own experiences of what has helped people stay on point through a transition period.

For business owners in the lower middle market, I've found that the "second bite of the apple" motivator is basically worthless if the first payday is large enough. Everyone has a number, and if someone gets their number out of the deal, then it's impossible to get them to give any shits about the next one.

This is a good point. Really appreciate the advice and thoughts.

Rethinking this whole thing and we might just structure it without giving them any equity. We are getting more info about the business and my partner (the operational guy), believes we could just replace them after the transition period (2-3years) with manager a getting paid ~120K to maintain the recurring revenue contracts. We could also get a lead gen agency to help secure a few extra MRR contracts in case there is some churn.

We don't really want to focus on growing the business as we don't see much value in increasing ebitda by 10-25% vs just buying an additional biz and doubling topco ebitda. We just want the business to remain stable and pay down debt.

About the upfront price, the recurring revenue EBITDA is ~220K, so at 1M we are paying slightly above 4x, which is prob overpaying by 0.5-1x, but we are okay with this since it is more important to us to get a deal done and prove the thesis then trying to save 100K.

That being said, I think it could make sense to just structure it where we pay 800K to 1Mish upfront and then have a form of earnout over two years for anything over the recurring revenue EBITDA. Like 0.8X of anything over 220K for the first year, so if they make 500K ebitda we would pay them ~225K at end of next year.

I think we will keep the shares in the topco as a bargaining chip to add some purchase price to the deal if we cant close at 1M upfront + a few 100Ks in earnout over 2years. And if we do go down the equity in topco path, does pref shares convertible into common equity at exit make sense? I feel like LMM owners like pref shares with a fixed value makes more sense to them as their value is kinda locked in + they get upside if we knock it out of the park.

Thanks man

As a company owner all of this sounds like a garbage deal for the owners, but I don't know the industry, growth rate, comps, margins, etc.

$1M across 2 founders isn't life changing money, but I also don't know the founders. I put more than that into just seeding my company out of my own pocket. If it's a slow growth, low margin industry then maybe this works. I need more excitement than that so I'm probably speaking out of turn.

My company is my 3rd child (have 2 real kids), and someone paying 4x ebitda won't happen, but we are a VC backed situation with very high growth rates. I can't imagine the stress of running a company to walk away with $500k plus maybe some upside. Different strokes...

Apr 8, 2019

I wouldn't do anything more than 1/3 of the total purchase price up front. You can also use a combination of seller note and earn out, earn outs to should be subject to performance and you can see if you can negotiate some type of clawback feature in the note. Definitely give them bonus and commission upside if they're major drivers of the company's sales org. I'll have to say ~1.0x revenue for a recurring revenue business using 100% leverage is pretty amazing. I'd quit my day job if I could pull that off.

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Apr 8, 2019
Mephistopheles:

I wouldn't do anything more than 1/3 of the total purchase price up front. You can also use a combination of seller note and earn out, earn outs to should be subject to performance and you can see if you can negotiate some type of clawback feature in the note. Definitely give them bonus and commission upside if they're major drivers of the company's sales org. I'll have to say ~1.0x revenue for a recurring revenue business using 100% leverage is pretty amazing. I'd quit my day job if I could pull that off.

Would be hard to convince a seller to sell his business for only 1/3 of the payout upfront to be honest. Also, we can do 100% leverage since we are buying at a low multiple, typically banks around my area can finance up to 3x Debt/EBITDA no problem, and they dont care if the rest of the transaction is mezz/seller finacning as long as its sub to them. Also, we already have some ebitda from my first acquisition so its an even easier pill to swallow for the bank.

If you are talking to the right banker they dont care about equity for the transaction as long as you are able to respect the Net Debt/EBITA and DSCR ratios, which tends to be easier at low multiples (sub 4x).

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Apr 10, 2019

I've seen 1/3 several times, albeit substantially larger deals at much higher valuations. So point taken.

Apr 8, 2019
Mephistopheles:

I wouldn't do anything more than 1/3 of the total purchase price up front. You can also use a combination of seller note and earn out, earn outs to should be subject to performance and you can see if you can negotiate some type of clawback feature in the note. Definitely give them bonus and commission upside if they're major drivers of the company's sales org. I'll have to say ~1.0x revenue for a recurring revenue business using 100% leverage is pretty amazing. I'd quit my day job if I could pull that off.

LOL

i'm going to stay out of this thread but came here to LOL and give you SB

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Apr 8, 2019
Mephistopheles:

LOL

i'm going to stay out of this thread but came here to LOL and give you SB

i mean i dont think its anything crazy. you just need to be willing to take the time to meet owners, which you typically cant do if you have a full time job. been living like a hobo for past two years looking for a biz to buy. plus it turns out those nice models and CIMs you learn how to do when working in PE facilitates the discussions with the banks

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May 4, 2019

Sorry @takenotes08, I've been facing an unusual volume of work so my activity here's been pretty sparse. I know we've traded a lot of PMs about your efforts on this stuff so it's cool to see some granular details on a live opportunity.

Given my lateness you're probably already past the LOI, but here's how I would've done it.

50% cash at close, 50% cash earn-out paid as a percentage of EBITDA ... with the earn-out duration optimized such that they reach it in three (five if you want to be aggressive against them) years assuming a reasonable annual EBITDA growth figure

So that would be:

  • $850 cash up-front
  • $283 cash at end of Y1 assuming EBITDA growth was 10% or higher
  • $283 cash at end of Y2 (same assumption)
  • $283 cash at end of Y3 (same assumption)

You can include a clause that you guarantee they receive the entire $850 earn-out, but the timing is contingent simply on how EBITDA performs. Any year where EBITDA doesn't hit the target growth rate, they get a different amount (this is usually something like half of the on-target number, so for you here it'd be $125 or something).

This solves a situation where the seller is looking for a 100% exit and is unwilling to accept any portion as a seller roll. It also solves the issue of founders soaking up wage comp without generating any positive impact on the business by creating clear incentive alignment; they can accelerate their payouts by crushing growth targets.

Give them absolutely zero interest in your TopCo. Good God almighty. Always remember that you're in the driver's seat. Deals come along. Never give away something you don't have to. If the seller is being incorrigible on too many different points related to 'skin in the game', that's a pretty clear red flag. If someone wants a 100% sale, an ongoing wage, and you're somehow considering giving them shares in your parent entity, let me tell you emphatically that the scale is really lopsided away from your favor. You'd be too generous.

Congrats on finding what sounds like a cool asset. I hope things keep unfolding positively for you.

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Sep 1, 2019

Hey mate, went through this thread - very inspiring initiative indeed, and like a few commentators it really got me thinking of trying it out in a couple of years. Couldn't help noticing you were in PE before starting this out - do you mind sharing more about your journey , what motivated you to pursue this, etc? Keep it up!

Sep 1, 2019

Also, a quick update on how the deal went would be nice :)

Sep 1, 2019
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