Equity in Acquisitions: Growth Potential vs. Liquidity Risks
Advisors weigh the benefits and risks of taking equity in acquiring firms.
1Trend of equity rollovers
Financial advisors increasingly opt to roll over a portion of their equity into acquiring firms, often ranging from 25% to 75% of their exit valuation. This trend is driven by the belief that joining a larger firm can accelerate growth or alleviate operational burdens. Additionally, advisors see potential for a second liquidity event at a higher valuation, deferring capital gains taxes until the acquirer exits.
2Growth potential of acquirers
Serial acquirers and aggregators often grow faster than traditional investments, with returns potentially reaching 15%-25% annually. This growth is fueled by rising AUM fees, organic expansion, and subsequent acquisitions. Advisors, familiar with small business risks, may find this growth trajectory appealing compared to reinvesting in publicly traded securities.
3Buyers' motivations
Acquirers encourage advisors to take equity to preserve cash and fund future acquisitions. This alignment of interests ensures that selling advisors remain invested in the buyer's success post-closing. However, sellers often face limitations in assessing the buyer's business valuation, relying on internal formulas that may not reflect fair market value.
4Valuation challenges
Sellers must scrutinize the buyer's valuation methodology, requesting disclosures and external comparables. Even with robust valuations, subsequent acquisitions, management grants, or capital raises can dilute equity. Sellers should monitor financials and negotiate information rights to protect their interests.
5Liquidity risks
Equity received from acquirers often comes with vesting contingencies and transfer restrictions. Even vested shares may lack liquidity due to operating agreements and repurchase rights. Preferred investors typically sit ahead of sellers in distribution waterfalls, reducing the proceeds available to sellers.
6Negotiation limitations
Complex businesses with diverse shareholder bases often cannot alter terms for individual partners. Sellers must proactively conduct due diligence to ensure the acquirer's equity represents a genuine opportunity. Adjusting the valuation of equity shares may be the only negotiable provision.
7Economic consequences
Taking equity in an acquirer introduces separate risks beyond selling the advisory firm. Sellers must weigh the potential for higher returns against the possibility of illiquidity and valuation discrepancies. Clear understanding of the acquirer's equity terms is crucial to mitigate economic consequences.
8Key considerations
Advisors should carefully evaluate the growth potential and liquidity risks of taking equity in acquirers. Proactive due diligence, understanding valuation methodologies, and negotiating favorable terms are essential to ensure fair value and protect long-term interests in the acquisition process.