Want to buy a business, but need some equity to get the deal done? Banks today are less aggressive than they were 12 months ago. So when you are seeking financing to acquire a business, you may find that the equity required to complete the acquisition is more than you have. So as you set out to raise the money you need, your main concern may be that if your investor puts up the majority of the equity, you will end up ceding control to your investor.

So what kind of security should you issue?

Consider issuing preferred stock, a hybrid security that feels a little like debt and a little like equity. The beauty of preferred is that it comes in all color and flavors and can be structured to fit your particular needs. For example, if you require more cash flow to fund the business, you can structure the preferred so that the dividends accrue rather than paid. Or, if you’ve structured a high dividend preferred, you can pay some of the dividend in cash and accrue the rest.

Keep more equity.

The preferred you issue should be less diluting to you (meaning that you will give up less equity) for two primary reasons. First is something called preference. Preference means that the preferred equity holder will receive his money back before the common equity holder. Preference is not just a concept that applies to equity; it also applies to debt financing. A senior bank loan has a preference over a subordinated, or mezzanine note. And, as a bank loan is cheaper than subordinated debt, likewise, preferred equity is cheaper than common equity.

The second reason preferred could be less diluting to you is due to the components of the return to the preferred. The return to the preferred security has two components – dividends and equity kicker. The dividend is expressed as a percentage of the face amount (or principal) of the preferred stock. You can make this dividend whatever you’d like – 8%, 12% or 18%. And, as mentioned above, the dividend can be structured as current pay or accrued. However, since money today is worth more than it is five years down the road, if you accrue the dividend, you will have to give up more equity to achieve the targeted return the investor is seeking. Note also that the dividend provides the preferred investor with a preferred return, meaning that they get a return on their money before the common equity does.

The equity kicker is a claim to some percentage of the common equity of the company. The equity kicker can come in the form of warrants or some type of conversion feature. The equity kicker allows the preferred investor to participate in the increased value of the company after receiving their preferred return.

So for example, say you determine that the return to the preferred equity needs to be 25%. If your preferred dividend is 12%, then 13% of the return needs to come from the equity kicker. Based on your base-case projections and the structure of the preferred, the equity kicker may require 20% of the equity or it may require 60% of the equity. Each situation is different and requires that the deal get modeled to see how the returns behave.

So if you are seeking to raise capital, consider issuing preferred stock to give your investors a little more safety and keep more of the equity for yourself.

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