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Attracting Equity Investors in Today's Government Contracting Landscape

Introduction:

• Government contracting remains a hotspot for investors seeking stable returns in uncertain times.

• Understanding investor interests can help you go after larger deals.

• Securities like participating preferred equity and convertible participating preferred equity offer strategic advantages.

Making up a scenario that illustrates the point

In 2024, Skinny Mike owned Anacostia Brooms and Dustpans (NOTE: THIS IS A FAKE COMPANY FOR ILLUSTRATION PURPOSES ONLY), a small facility management company in Washington, D.C. His business specialized in maintaining government buildings, providing steady cash flows from long-term contracts. What Mike lacked in brains he made up from with hustle and set his sights on acquiring a much larger company to expand his operations.

Mike found the perfect acquisition target: a facility management company in Columbia, MD with $16 million in revenue and $3 million in EBITDA. Mike negotiated an acquisition price of $10 million and planned to partially finance the deal through an SBA loan.

The SBA Dilemma

Good news! The SBA was ready to back Mike’s loan, but they had a rule: Mike needed to come up with 10% of the purchase price as equity. For a $10 million acquisition, that meant Mike needed $1 million—money he didn’t have. To make matters more complicated, if an investor took more than a 20% stake, the SBA would require that investor to also provide a personal guarantee—a condition Mike wanted to avoid.

Why Would Investors Seriously Consider Putting Money Into Skinny Mike’s Deal

In a general sense, investors like government contracting businesses because of their lower risk profile compared to other industries. The stability of government contracts, often insulated from economic fluctuations, ensures a predictable cash flow. This reliability not only reduces investment risk but also facilitates easier financing.

Furthermore, the minimal capital expenditure requirements in many government contracting businesses, particularly those in services, allow PE firms to grow the business without burdening the balance sheet. This contrasts with more capital-intensive sectors where constant reinvestment is necessary.

The Power of Convertible Participating Preferred Equity

Skinny Mike learned that he can get investors into his deal by using a security called convertible participating preferred equity. It’s a neat tool that satisfies the SBA requirements and adequately satisfies investor requirements. Here’s how it works:

1. Initial Investment: Investors contributed the $1 million needed for the equity portion of the acquisition. In return, they received preferred shares in the company, ensuring they would be paid back first from profits, without initially taking a large ownership stake that would trigger the personal guarantee requirement.

2. Repayment Phase: Mike used the cash flow from the expanded business to repay the investors their $1 million investment. During this time, the investors did not have more than a 20% ownership stake, allowing Mike to avoid additional personal guarantees.

3. Conversion and Step-Up: After the repayment was complete, the investors had the option to convert their preferred shares into common equity. Due to the business’s increased value post-acquisition, the investors’ stake would step up, but remain within a level that preserved Mike's control and avoided the personal guarantee threshold.

How It Worked for Skinny Mike

Here’s how the acquisition and financing worked out for Mike and his investors:

In this scenario:

• Investors provided the $1 million needed to close the deal, receiving preferred equity with a guaranteed return of capital before any profits were distributed to Mike.

• Mike retained 90% ownership during the repayment phase, ensuring he stayed in control of his business while avoiding additional personal guarantees.

• After the investors’ initial investment was repaid, they converted their shares into common equity, stepping up to a 20% ownership stake without breaching the threshold that would require personal guarantees.

• Upon selling the business for $14 million, both Mike and the investors saw substantial returns, with Mike maintaining an 80% majority stake.

The Takeaway for Ambitious Owners Like of friend Skinny Mike

For business owners like Skinny Mike, convertible participating preferred equity is a powerful tool to secure the necessary capital for big acquisitions without giving up control or forcing onerous personal guarantees onto investors. Investors benefit from the stability of the business’s cash flows and the potential for a significant equity stake after conversion. By using this strategy, owners can confidently pursue growth opportunities, knowing they have structured the deal to protect their financial interests.