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- The Preferred Equity Playbook for Acquisitions Part 1
The Preferred Equity Playbook for Acquisitions Part 1
Three money terms that drive 90% of the economics
Shaun Tiwari
October 23, 2025 • Estimated Reading Time: 7 minutes
If you're raising equity for an SBA acquisition, you've probably heard investors mention "preferred return" or "liquidation preference" and nodded along while frantically Googling under the table.
Here's what nobody tells you: these aren't just fancy finance terms. They're the actual mechanics that determine when you start making money and how much you keep when you sell.
PACT agreement templates were built specifically for search funds because traditional equity documents are 80+ pages of Silicon Valley legalese. Today, we're breaking down the three money terms that drive 90% of the economics.
What Is PACT?
PACT is a standardized operating agreement for entrepreneurship-through-acquisition deals. Think Y Combinator's SAFE notes, but for buying main street businesses.
The structure:
Delaware LLC with two classes of units
Preferred Units → investors (put up cash)
Common Units → operator (that's you)
Bridges the 10-20% equity gap in SBA deals
Why it matters: Standardization cuts legal costs and speeds up deals. Both sides work from the same playbook instead of negotiating 80 pages of boilerplate.
1. Preferred Return: The Clock That Never Stops
An annual rate (typically 10-15%) that accrues and compounds monthly on invested capital. No payment schedule. No invoice. It just keeps growing until you pay it off.
How it works:
Investor puts in $500K at 12% preferred return
Monthly accrual: 1% (12% ÷ 12 months)
After Year 1 with no payments: $500K → $563K
After Year 2 with no payments: $563K → $631K
The payment priority: Every distribution dollar goes to:
Accrued return first
Then original capital
Only then does your common equity see anything
Why this matters: The math creates pressure to pay investors before your SBA loan. Your SBA loan is 8-9%, doesn't compound, and has prepayment penalties. Preferred equity is 12-15%, compounds monthly, and has no prepayment penalty.
On a $500K investment at 12%:
3-year payback = ~$200K in total return
7-year payback = ~$420K+ in total return
That's a $220K difference based purely on timing.
Your negotiation leverage: The preferred return rate is highly negotiable. Fight for 10-12% if you can. A 12% vs 15% rate on $500K over 5 years = $75K+ difference in what you ultimately pay.
2. Liquidation Preference: Who Gets Paid First
The pecking order when money comes out (distributions, sale, or liquidation).
The waterfall:
First: Investors get back capital contributions
Second: Investors get all accrued preferred return
Third: Common equity participates (finally, you)
Real scenario #1 - Annual distributions: Your business generates $200K in distributable cash
Investors still owed: $500K capital + $80K return = $580K total
Result: Investor receives: $200K
You receive: $0
Real scenario #2 - Business sale: You sell for $2M after 3 years
Investors owed: $500K capital + $150K return = $650K total
Result: Investor gets: $650K off the top
Remaining $1.35M: Split based on ownership %
The reality check: You could run a profitable business for years and never see a distribution check. This is why operators obsess over payback velocity. It's the difference between building wealth and just having a job.
3. Equity Step-Up: Where You Actually Make Your Money
Once investors are fully paid back, their preferred units convert to common units at a stepped-up value (typically 2-3x their original investment).
This is your reward mechanism and the most important term you'll negotiate.
The math:
Investor puts in $500K at 2x step-up
You pay them back completely
Company now worth $5M
With 2x step-up: Investor treated as $1M stake = 20% ownership
You retain: 80% ownership
Without step-up: Investor = 10% ownership
You = 90% ownership
That 10-point difference on a $5M exit = $500K in your pocket.
Why this term exists:
Incentivizes fast payback (conversion triggers your upside)
Rewards you for building value, not just repaying capital
Ensures you keep meaningful ownership post-payback
Creates alignment on value creation
The negotiation:
1.5x step-up = you keep more equity, harder to raise money
3x step-up = easier fundraising, costs you ownership
Sweet spot: 2-2.5x
Model this carefully. A 2x vs 3x step-up on $500K might mean owning 65% vs 50% of a $10M business. That's $1.5M to you.
The Full Journey: A Real Example
Year 0: Investor puts in $500K at 12% return, 2x step-up
Years 1-4: Business generates $150K/year distributable cash
→ All $600K goes to investor
→ By Year 4: $500K capital + ~$100K return paid back
→ You: Taking salary, zero distributions
Year 5: Investor fully paid. Conversion happens.
→ Investor: 20% ownership (2x step-up)
→ You: 80% ownership
→ $150K distribution: $30K to investor, $120K to you
Year 7: Sell business for $8M
→ Investor gets: $1.6M (20%)
→ You get: $6.4M (80%)
Everyone wins, but only if you understood the structure going in.
Your Action Plan
These three terms drive 90% of the economics. Here's what to do now:
Build a spreadsheet modeling different scenarios
Run the math at 3, 5, and 7-year payback timelines
Test exit valuations: $3M, $5M, $10M
See how rate and step-up changes affect your take-home
Find investors who've used PACT before (speeds everything)
Don't accept terms you don't understand. Push back during negotiation. The step-up multiple especially is negotiable and has massive long-term impact.
Next week: The control terms. What decisions require investor approval? What do you control completely? How does the put right work? Understanding the money is step one. Understanding who runs the business is step two.
The best operators don't just understand these terms. They design their entire business strategy around them.
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