How can you structure the equity portion of an LBO?

1 Equity sources

When planning an LBO, the first step is to identify the sources of equity. Depending on the size and complexity of the deal, you may have a variety of options, such as your own funds or those of your investment firm, co-investors, management, and mezzanine or preferred equity. Each source has its own benefits and drawbacks, such as cost, availability, alignment of interests, and exit strategy. It's important to evaluate each option thoroughly and select the optimal mix for your deal.

2 Equity valuation

The second step is to determine the value of the equity portion of your LBO. This is usually done by applying a multiple to the company's earnings before interest, taxes, depreciation, and amortization (EBITDA). The multiple reflects the expected growth, profitability, and risk of the company, as well as the market conditions and comparable transactions. The higher the multiple, the higher the equity value, and vice versa.

However, the multiple is not the only factor that affects the equity value. You also need to consider the amount and structure of the debt that you use to finance the deal, as well as the expected cash flows and exit value of the company. These factors will determine the internal rate of return (IRR) and the cash-on-cash (COC) multiple of your equity investment, which are the main measures of your LBO performance.

3 Equity allocation

The third step in an LBO is to allocate the equity portion among the various stakeholders. This is done by creating a capitalization table, which displays the ownership and rights of each equity holder. The capitalization table should reflect the relative contributions, risks, and rewards of each party, as well as the alignment of incentives and goals. To achieve this, there are several key elements that need to be taken into consideration, such as the type and class of equity (common, preferred, or convertible), the number and price of shares, liquidation preference and participation rights, vesting and dilution provisions, and governance and control rights (such as voting rights, board representation, veto power, drag-alongs, or tag-alongs). Allocating equity can be a complex process since it affects the returns and risks of each party. Thus, a balance needs to be struck between attracting and retaining the best partners while preserving one's own interests and value.

4 Equity optimization

Optimizing the equity portion of your LBO is the fourth step to enhance your returns and reduce your risks. Strategies such as leveraging the tax benefits of debt, reducing the cost of capital, improving operational and financial performance, creating value through synergies, acquisitions, or divestitures, and exiting the investment at the right time and price can help you do so. However, each strategy has its own benefits and challenges that require careful planning and execution. Therefore, it is important to monitor the performance and value of your equity investment throughout the LBO process, so that you can adjust your strategy accordingly.

5 Equity challenges

The final step in an LBO is to anticipate and overcome potential challenges and pitfalls related to the equity portion. These can include finding the right target, partner, and lender; raising enough equity capital; managing debt burden and covenant compliance; dealing with conflicts of interest among different equity holders; and mitigating legal, regulatory, and reputational risks. All of these issues can affect the success and sustainability of your LBO, so it is important to conduct thorough due diligence, build strong relationships, and implement best practices to avoid or resolve them. By following these steps, you can create an attractive equity structure that maximizes returns and minimizes risks.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?