What Is an Equity Purchase in a Business?

An equity purchase in a business represents the acquisition of ownership interests in an existing company. This transaction structure allows a buyer to gain control or a stake in the business entity itself, encompassing its existing assets, liabilities, and historical performance.

Understanding What an Equity Purchase Is

An equity purchase involves the direct acquisition of ownership interests in a business entity, rather than just its individual assets. The buyer assumes ownership of the entire company, including all its assets, contracts, and liabilities, both known and unknown. The existing legal entity of the business continues to operate without interruption, only its ownership changes hands.

This method of acquisition contrasts sharply with an asset purchase, where a buyer selectively acquires specific assets and assumes only the liabilities explicitly agreed upon. The comprehensive transfer of the entire entity can simplify the transaction process, as it avoids the need to individually transfer titles for numerous assets or reassign contracts. However, it also places a greater emphasis on thorough due diligence to uncover any hidden risks or undisclosed liabilities that could impact the business post-acquisition.

An equity purchase is often efficient because the existing business structure, including its employee relationships and operational licenses, typically remains intact, facilitating a smoother transition of operations. For sellers, an equity purchase can be advantageous because all business liabilities are transferred to the buyer, which can simplify their exit from the business.

Forms of Equity Subject to Purchase

Equity in a business generally refers to ownership in a company, and this ownership can take various forms depending on the legal structure of the entity. The most common types of equity interests subject to purchase include common stock, preferred stock, membership units, and partnership interests.

Common stock, or common shares, represents the most basic form of equity ownership in a corporation. Holders of common stock typically possess voting rights on significant company matters, such as electing board members or approving mergers. While they are entitled to receive dividends if declared by the company’s board, these payments are not guaranteed and are distributed after preferred shareholders receive theirs.

Preferred stock, or preferred shares, is another form of corporate equity, often issued to investors. Unlike common stock, preferred stock usually does not carry voting rights but offers other benefits, such as a fixed dividend payment that takes precedence over common stock dividends. In the event of liquidation, preferred shareholders also have a higher claim on the company’s assets compared to common shareholders.

For businesses structured as Limited Liability Companies (LLCs), ownership is typically represented by membership units or interests. These units define the owner’s share of profits, losses, and control within the LLC, similar to how stock functions in a corporation. In partnerships, ownership is held through partnership interests, which delineate each partner’s capital contributions, profit-sharing ratios, and management authority as outlined in the partnership agreement.

Steps in an Equity Purchase

Completing an equity purchase involves a structured sequence of steps, moving from initial interest to the final transfer of ownership. The journey typically begins with identifying a suitable target business that aligns with the buyer’s strategic objectives and investment criteria. This initial phase involves market research and sometimes direct outreach to businesses that may not be formally listed for sale.

Once a potential target is identified, the next step involves initial negotiations and the submission of a Letter of Intent (LOI). The LOI is a non-binding document that outlines the preliminary terms of the proposed acquisition, including the purchase price, payment structure, and key conditions. Negotiating the LOI can take several weeks, typically ranging from two to eight weeks, as both parties work to establish a foundational agreement.

Following the signing of the LOI, a comprehensive due diligence period commences. This phase allows the buyer to thoroughly investigate the target company’s financial, legal, operational, and commercial aspects. Due diligence typically lasts between 45 to 180 days, but can extend to six to nine months for more complex deals.

During this period, the buyer’s team, often including legal, accounting, and financial professionals, will review financial statements, contracts, intellectual property, employee records, and any potential litigation or liabilities. The purpose is to validate the information provided by the seller, identify any hidden risks, and confirm the business’s overall health and value. If significant issues are uncovered, the buyer may renegotiate terms or withdraw from the deal without penalty.

After successful due diligence, the parties proceed to draft and negotiate the definitive purchase agreement, often called a Stock Purchase Agreement or Equity Purchase Agreement. This legally binding document details all the terms and conditions of the transaction, including representations and warranties from the seller, indemnification clauses, closing conditions, and post-closing adjustments. This negotiation phase can take two to four weeks, or even longer, as legal teams meticulously craft the agreement. The purchase agreement addresses how liabilities will be handled post-acquisition, often including indemnification provisions where the seller agrees to compensate the buyer for certain pre-existing liabilities that may arise after the sale.

The final step is the closing of the transaction. At closing, the buyer transfers the agreed-upon purchase price, and the seller transfers the ownership interests (shares, membership units) to the buyer. This involves signing all necessary legal documents, transferring funds, and completing any regulatory filings or third-party consents required for the change of ownership. The entire process, from initial search to closing, can range from six months to over a year, with many factors influencing the timeline.

Valuation and Financing in Equity Purchases

Determining the value of a business and securing the necessary funding are two important financial aspects of an equity purchase. The valuation process aims to establish a fair price for the equity interests being acquired, while financing involves arranging the capital to complete the transaction. These elements are often intertwined, as the valuation can influence the financing terms available.

Valuation in an equity purchase typically employs several methodologies to arrive at a reasonable price. One common approach is using multiples of earnings, such as Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) multiples. This method calculates a company’s value by multiplying its EBITDA by a specific factor, or multiple, derived from comparable transactions in the same industry or market. For private companies, a typical EBITDA multiple can range from 4x to 8x, though this can vary based on industry, company size, growth prospects, profitability, and risk. For instance, a stable business with consistent cash flow might trade at a lower multiple, while a high-growth company could command a higher one.

Another widely used valuation technique is the Discounted Cash Flow (DCF) method, which estimates a business’s value based on its projected future cash flows, discounted back to their present value. This approach considers the time value of money and the inherent risks associated with future earnings.

Financing an equity purchase can involve a combination of sources, tailored to the buyer’s financial capacity and the deal’s structure. Cash, either from personal savings or existing business capital, often forms a portion of the purchase price, particularly for smaller acquisitions. Debt financing is another prevalent method, typically obtained through bank loans or other financial institutions. Business acquisition loans are structured as term loans, repaid with interest over a set period. Lenders often require a down payment, which can range from 10% to 30% of the total loan amount for SBA loans.

Seller financing, also known as owner financing or seller carryback, is a flexible funding option where the seller provides a loan to the buyer for a portion of the purchase price. This arrangement involves the buyer making installment payments directly to the seller, often with interest, over an agreed-upon term. Seller financing can bridge the gap between the buyer’s available cash, traditional bank financing, and the total purchase price. This method can be attractive to buyers who might not qualify for full bank financing and aligns the seller’s interest with the ongoing success of the business.