The Preferred Equity Playbook for Acquisitions Part 2

The Split: What You Control vs. What Needs Approval

PACT agreements divide the world cleanly into two categories.

What you control completely (no approval needed):

• Day-to-day operations and vendor selection (within budget)

• Hiring/firing non-executive employees

• Pricing, marketing, and sales strategy

• Customer and supplier relationships

• Product development and operational improvements

• Banking relationships and cash management (within debt limits)

What requires "Investor Majority" approval: Everything on the Major Decisions list (see below).

You're running the business, not managing a committee. The veto list exists to prevent disasters, not second-guess every operating decision.

Major Decisions: The Investor Veto List

These actions require written approval from an "Investor Majority" (typically 50%+ of preferred equity, excluding any preferred held by you).

Business Structure Decisions

• Future Acquisitions Any new business acquisition or "tuck-in" deal requires approval.

Why it exists: Investors funded one deal, not a blank check for add-ons. This prevents you from overleveraging or chasing shiny objects.

• Additional Debt Beyond Thresholds Usually set at a specific dollar amount (like $50K) or percentage of EBITDA.

The exceptions:

• Your SBA loan is pre-approved

• You CAN refinance the SBA loan with personal funds (with approval)

Why it exists: Prevents creating obligations that hurt investor recovery.

• Issuing New Equity Can't dilute existing shareholders without approval. Includes options, warrants, or equity plans.

Special provision: Lead investors get pre-emptive rights (first shot at maintaining their ownership %).

Why it exists: Protects everyone from surprise dilution.

Money and Compensation Decisions

• Executive Compensation Changes Your salary is set in the initial budget. Any increases, bonuses, or equity awards need approval.

This includes:

• Hiring/firing key executives

• Changing CEO or CFO compensation

• Any compensation to you beyond your base salary

Why it exists: Prevents paying yourself excessively while investors wait for payback.

• Budget Deviations Over 5% You submit an annual budget 45 days before the fiscal year. Can't exceed it by more than 5% per line item without approval.

The reality: Most investors are reasonable about legitimate business needs. This prevents runaway spending, not smart investments.

• Distributions Before Payback Cannot take distributions before preferred obligations are satisfied.

Exceptions:

• Tax distributions (so members can pay taxes on pass-through income)

• Required debt payments to lenders

Why it exists: This is the whole point of preferred equity.

Strategic Decisions

• Selling the Business Cannot sell without investor majority approval.

Important caveat: If the offer is arm's length at fair market value, investors can't unreasonably withhold consent.

Why it exists: Prevents fire-sale exits, ensures fair process.

• Material Leases or Facility Changes New office, warehouse, or major lease agreements need approval (unless in approved budget).

Why it exists: Leases are long-term obligations that can outlast you.

• Related-Party Transactions Hiring your spouse, renting from your LLC, selling to your brother? Must be arm's length AND approved.

Pro tip: Just don't do these. The scrutiny isn't worth it.

What This Means in Practice

You're making 95% of business decisions without asking anyone. The 5% that require approval are big, risky, or self-interested moves that could blow up the business.

Most experienced operators appreciate these guardrails after they've been in the seat for a while.

The Put Right: The Investor's Exit Option

After the SBA loan is fully paid off, investors can force the company to buy back their shares at fair market value. This is unilateral. They decide when and if to use it.

How It Works

Triggering the put:

• Investor sends written "Put Notice" to company

• Can be for all shares or just a portion

• Only available after SBA debt is completely clear

• Why the SBA restriction: Protects lender's first lien position

The valuation process:

Step 1: Company hires independent valuation firm (company pays)

Step 2: If investor disagrees, they hire second firm (investor pays)

Step 3: If still disagreement, third firm hired jointly (costs split 50/50)

Step 4: Final value = average of 3 appraisals (excluding outliers >10% from middle)

Payment terms:

Company must pay fair market value

If insufficient cash: Company issues promissory note

• 3-year amortization

• Interest: Prime Rate + 2% (currently ~10%)

• Secured by shares being repurchased

Why This Exists

From investor perspective: Provides liquidity even if no buyer emerges. Lets them exit if the business plateaus or relationship sours.

From operator perspective: Forces you to think about enterprise value, not just cash flow. Can create surprise capital needs if triggered.

The Strategic Reality

Many operators, once they reach this point, proactively seek a buyer or recapitalization. If you're going to face a valuation exercise anyway, might as well control the timing and potentially create a better outcome through competitive process.

Model this scenario: If your business is in year 6, SBA is paid off, and investors exercise the put at a $3M valuation, can you afford the buyout? If not, you need to be thinking about exits earlier.

Other Critical Control Provisions

Information Rights: Your Reporting Requirements

Quarterly Financials (within 45 days) Unaudited balance sheet, P&L, cash flow statement

Annual Audited Statements (within 120 days) Full audited financials with footnotes (or at minimum "reviewed" by reputable firm)

Tax Reporting (by March 15) K-1s for all members plus supporting documentation

Lead Investor Special Rights

• 5-day notice access to all books and records

• Right to meet with management

• Access to all board materials simultaneously

• Cannot be waived without lead investor consent

Why this matters: These rights are how investors monitor their investment. Treat this as relationship management, not administrative burden.

Key Person Life Insurance

The company must maintain life insurance covering:

• Full SBA loan balance

• All outstanding preferred obligations (capital + accrued return)

How it works:

• Company owns policy and pays premiums

• Upon your death: Proceeds pay SBA first, then investors

• Investors named as collateral assignee

• Cannot cancel, borrow against, or change beneficiary without approval

Why this exists: If you die tomorrow with $1M in SBA debt and $500K in investor obligations, your family isn't stuck with the mess and investors aren't holding an empty bag.

Annual Budget Process

Timeline:

• Submit proposed budget 45 days before fiscal year

• Must include: P&L projections, capex, cash flow, financing needs

• Requires investor majority approval

If not approved: Operate on prior year's budget (adjusted for inflation and contractual obligations) until new budget approved.

Pro tip: Treat budget approval as strategic planning, not administrative task. Get investors aligned on your vision and you'll have smoother sailing when execution requires tough calls.

The Bottom Line: Partnership, Not Prison

These control terms aren't about investors micromanaging you. They're about preventing the mistakes that kill businesses:

• Overleveraging

• Related-party conflicts

• Uncontrolled spending

• Premature exits

Your mental model:

• You run the business day-to-day (95% of decisions)

• Investors veto big, risky, or self-interested moves (5% of decisions)

• The put right ensures investors aren't trapped forever

Most operators find that investors who've done 10+ search deals have seen every mistake. Their approval process actually makes you sharper.

Your Action Plan

• Review the Major Decisions list with your attorney

• Understand which items are standard vs. negotiable

• Model the put right scenario at different valuations

• Set up systems for quarterly reporting from day one

• Build relationships with investors before you need approvals

Don't view these as restrictions. View them as the guardrails that let you drive fast without going off the cliff.

The operators who succeed don't fight these terms. They use them to build better, more disciplined businesses.

Tell a Friend

If you received this newsletter from a friend, don't miss out on future insights. Subscribe now at thefinancingflow.net to receive weekly issues directly to your inbox.

To your financing success!