Buyers try to align incentives with their sellers in as many ways as possible, and the issuance of TopCo equity (also known as Parent Company Equity or Private Equity) has become the most popular approach to achieve that alignment. At Ackerman Group, nearly 75 percent of the transactions we facilitate include some form of TopCo equity.
What is TopCo equity?
TopCo equity provides the seller with ownership in the buyer’s parent company. It’s different from a joint venture where the seller retains ownership in their individual hospital. With TopCo equity, practice owners obtain ownership in the veterinary entity that buys their hospital and, technically, a small ownership stake in every hospital that this buyer owns.
TopCo equity is an imperfect mechanism to align incentives because the performance of the seller and their hospital is (usually) a small piece of the buyer’s total performance. Economists call this risk a potential for a ‘free rider’ – the seller may not have to work hard but can still have strong returns on the investment based on how other hospitals perform.
Why is TopCo equity so popular?
TopCo equity is common in today’s market for several reasons:
- TopCo equity reduces the amount of cash a buyer needs to provide to a seller and with interest rates high now, it allows buyer’s to reduce their interest costs and cash outlay.
- It’s simpler than a joint venture. Joint ventures include more legal documents to close, and post-closing requires more collaboration and communication than what’s required of TopCo equity.
- TopCo equity provides some incentives (although imperfect) for the seller to work hard and support the initiatives of the buyer.
- TopCo equity is generally obtained in a tax-free contribution of existing practice assets, so no taxes are due on that portion of the sale. It may be the only pre-tax investment possible in most transactions; so to some degree, part of your investment dollars are actually tax dollars otherwise due on a sale.
TopCo equity is popular because it’s proven to be a very good investment for those who received it back in 2016 to 2020 –when practice valuations were lower and still rising. As valuations of individual hospitals and buyers steadily increased until late 2021, TopCo equity’s value followed suit.
Is TopCo equity a good investment today?
Sellers in 2021 received unprecedentedly high valuations and generally received some TopCo equity at the time of sale. With buyer valuations declining since early 2022, it will be interesting to see if TopCo equity issued in 2021 proves to have strong returns. However, the practice valuation most veterinary practice owners’ received in 2021 were very high, so even if the returns on the TopCo equity are not what they have been historically, those sellers will still have done well. In 2022-2023, valuations of hospitals and buyers have softened, which means the valuation and returns on TopCo equity will likely become more uneven in the near term.
TopCo equity may come in the form of different share classes with different economics and priority of payment at a sale. Some equity may include preferred stock. If that’s the case, it will have a coupon attached with priority on distributions at the buyer’s recapitalization but either lesser or no participation in the common share equity returns. The main takeaway is this: each potential buyer has their own unique capital structure, and understanding the priority of payments is important to understanding your upside (and downside risk).
It’s imperative to understand the details of your TopCo equity to determine if it’s a good investment, especially as valuations soften in 2022-2023. Some buyers moved the valuation multiples for their TopCo equity up to 23-25x EBITDA during late 2021 and early 2022. Other buyers were more conservative and did not move the valuation of their TopCo over 20 or 21x EBITDA. With valuations declining in 2022-2023, practice owners who were issued TopCo equity at a high EBITDA multiple will need to see their buyer continue to grow, otherwise, their TopCo equity could sell at a discount.
I’m considering TopCo equity. What questions should I be asking?
There are questions you can ask to properly evaluate a buyer’s TopCo equity offering relative to other interested buyers’. Those key questions include:
- What EBITDA multiple was used to value the TopCo equity?
- How is the EBITDA calculated and what are the adjustments to actual EBITDA?
- How frequently do you revalue the equity?
- What are the specific economics around a seller’s equity relative to other shareholders?
- When is the likely maturity date? Does that holding period align with my duration at the practice and my investment objectives post-sale?
These are just a few of the questions that an experienced advisor will ask your potential buyers before explaining to you the benefits or risks of their answers. With the veterinary practice sales market softening, being well-versed in the nuances of potential deals and their risks is all the more important to maximizing the value of your practice sale. At Ackerman Group, we’ve facilitated over 200 transactions — we know the economic cycles that impact the value of the TopCo equity, and we are well-positioned to guide you through the decision-making process.
Want to make the most out of selling your veterinary practice? Trust the experts at Ackerman Group. To learn more about what we do, or to receive guidance tailored to the sale of your practice, contact us to get started.