Reaching agreement with a set of investors represents a pivotal mile-stone for the search entrepreneur, as it is the key to getting started.
Other than regulating the funding and conduct of the search phase (typically up to two years), the Investment Agreement will establish the key economic terms of the future relationship between the two parties once an investment has been made.
Despite their eagerness to get started, however, search fund entrepreneurs need to be disciplined and cool-headed in negotiations with investors, as the agreement reached at this initial stage will determine much of the economic upside that the entrepreneur can hope to reap over the entire investment period.
In contrast to venture capital entrepreneurs, search entrepreneurs will be faced with an upside which is capped. However, with a much lower downside risk, the search entrepreneurs may benefit from a similar and possibly superior risk-adjusted reward position overall.
The amount and structure of the equity package varies significantly. As a guide, search entrepreneurs should target to receive an equity package of 15-30% from a successful investment. An underlying vesting structure for a 30% package may be structured as follows:
- At the start: Immediate 10% vesting upon the conclusion of the sale & purchase agreement.
- During the investment period: Graded 10% vesting over a performance period of four years, composed of four equal portions of 2.5% granted upon each anniversary of purchase, although a cliff vesting at the end of the period is also possible.
- Upon exit: Up to 10% vesting based on the IRR performance hurdles agreed with the investors. Typically, any vesting is subject to reaching a threshold of 20% IRR for the investors, with the full vesting being granted upon investor IRRs reaching 35%. The exact structuring of the exit vesting is of great importance. Straight-line vesting is common, but investors sometimes try to impose a ratchet structure to back-load the search entrepreneur’s vesting to the higher end of the IRR target range.
To best prepare for this negotiation, entrepreneurs need to construct their own spreadsheet models and review a number of different operating scenarios. Legal expertise may be required to address pitfalls in terms of definitions of financial terms and events. For example, the potential impact on the reference IRR of any deferred and contingent exit payments by the new owners needs to be specifically addressed in the agreement. Another area for search entrepreneurs to be aware of are potential clawbacks in case of a breach of covenants or other departures from the conduct agreed with Investors in the running of the investee company.
Inspire Business Law Group, PC assists entrepreneurs with new business formation, guiding owners through issues including choice of entity (e.g. C Corporation, S Corporation, or Limited Liability Company (LLC), choice of jurisdiction (e.g. Delaware or California), documentation, employment issues, intellectual property issues, and initial agreements with customers and partners.
If you require any further information about starting a business, please contact Edward Grenville, Managing Shareholder, Inspire Business Law Group, PC (egrenville@inspirelawgroup.com; +415 279 0779; www.inspirelawgroup.com).
This article is provided for educational and informational purposes only and is not intended to be, and should not be construed as, legal advice.
Written by Benjamin Bartsch.