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Preferred vs. Common Equity 101

Every few weeks I go back through my call notes and look for the question that keeps coming up. Lately two of them travel together, and they show up the moment a buyer decides to raise money from outside the deal.

And right behind it, the one that actually scares investors off:

Deal in Focus: the $4M Trades Business

A buyer acquiring a roughly $4M trades business wanted to raise $300K–$500K from friends and family, hold on to the vast majority of the common equity, and run the business himself. His three questions were the ones I hear every time: does the raise count toward his equity injection, does it help his coverage, and does anyone other than him have to sign a personal guarantee? Watch how the answers play out as we go.

So this issue is the 101 on preferred versus common equity: what each one actually is, where it sits in the capital stack, the SBA rule that quietly turns “preferred” into debt, and the one thing that decides who signs a personal guarantee.

Start with the capital stack

Before the labels, picture the order of who gets paid in an SBA acquisition. The diagram below reads top to bottom; and three things move together as you go down it.

Read it top to bottom and three things move together. Repayment priority is highest at the top and lowest at the bottom. Risk and return run the opposite way. And control sits at the very bottom, with the common equity, the person actually running the business.

Common equity is the owner’s seat

Common equity is you, the buyer-operator. In most of the deals we advise on, the searcher owns the vast majority of the common, almost always the controlling stake. It is the residual claim: you get paid only after every lender and every preferred holder is made whole.

That is the worst seat in a bad outcome and the best seat in a good one. Common holders run the business and make the decisions. They are first to absorb losses if the business underperforms, and they keep all of the value created once everyone senior is paid off. Highest risk, unlimited upside, full control.

Why the buyer almost always holds the vast majority

Note that I said the vast majority, not all of it. Bringing in common-equity investors is perfectly normal, and the buyer rarely ends up owning literally 100%. But the operator almost always keeps the controlling stake, and two forces push in that direction:

• The 20% personal-guarantee line. The SBA requires any owner of 20% or more of the business to sign an unlimited full personal guarantee. Most passive friends-and-family investors have no interest in guaranteeing the loan, so the practical effect is to keep each of them below 20%, which concentrates the common in the operator’s hands. (More on this rule below.)
• The step-up model. Most self-funded buyers price outside equity using a step-up, which awards investors a larger share of the common than their cash alone would buy, compensation for backing the deal and for the leverage they are riding on. The flip side is that the operator keeps the majority. The primer below shows the math.

Preferred equity is debt-like capital

Preferred equity is for the investor who wants a defined return and priority over the owner - but not the keys to the business. It gets paid before common: a preference means the preferred is made whole before common sees a dollar.

The return is a set rate (say a 15% coupon) and it is often structured as PIK, which means it accrues instead of paying cash. There is usually little or no voting, so the investor acts much like a lender. The trade is a capped upside for a safer position.

The two side by side:

The SBA nuance: when “preferred” is really debt

This is where the 101 gets real - and where I see buyers get tripped up. The SBA does not care what you call it on the term sheet. It cares about whether the money behaves like equity or behaves like debt. Straight from the source:

In plain terms: if you promise your investors a buyout or repayment before the SBA loan is gone, the SBA treats that money as debt. It will not count toward your equity injection.

Flip that around and you get the affirmative rule - the one that tells you how investor equity distributions actually have to work for the money to count. The SOP defines eligible equity this way:

What that means for your raise: your investors can absolutely receive distributions - their preferred return, their return of capital, and their stepped-up share of the upside. What they cannot have is a contractual right to be repaid or redeemed before the SBA loan is paid off. Distributions paid out of real cash flow when the business can afford them are fine; a mandatory redemption or a guaranteed buyout on a fixed date is what flips the investment from equity into debt in the SBA’s eyes - and disqualifies it from counting toward the injection.

Standby money can count, but only one flavor of it:

So: full standby, life of the loan, documented on SBA Form 155, and capped at half of the required injection. The other half has to be your cash. And keep real skin in the deal, on a change of ownership the injection is 10% of the purchase price; full-standby paper can cover up to half of that, and you bring the rest.

Banks get uncomfortable when the operator’s own cash drifts toward 5%, so do not engineer yourself down to nothing.

The question that scares investors off: personal guarantees

Does choosing common or preferred change who has to guarantee the loan? Short answer: no. The SBA keys the personal guarantee off ownership percentage of the business, not the label.

The rule: any person who owns 20% or more of the business being financed must provide an unlimited full personal guarantee. The threshold is measured at a beneficial ownership level, the bank looks through any LLCs or holding entities in the cap table and asks who ultimately owns the equity underneath.

Spouses and minor children have their interests combined. And if no single owner crosses the 20% line, at least one owner still has to step up as guarantor. Every loan needs at least one.

What that means when you are raising money

• It is percentages, not dollars. $400K can be 10% or 50% of the business depending on the valuation. The bank looks at the share, not the size of the check.
• Watch both classes. Keep every investor under 20% of the common and under 20% of the preferred. Some SBA bankers look at the preferred split too.
• Control is the red flag. A true full-standby, PIK preferred with no ownership or control can sit outside the cap table. But if it is ownership in the holding company, it counts toward the 20%. And handing an investor control without a guarantee — even by side agreement — can make the deal ineligible.

What lenders need, and when

You do not need every investor’s name on day one. In underwriting, the lender wants the structure: who owns what, how much cash comes from you versus your investors, and the size and basic terms of the raise. The full cap table: with every owner named at every level, is required at closing to pull the SBA loan number, and all owners and guarantors must be U.S. citizens or nationals.

The 60-second version

• Common equity is ownership, control, and upside. That is the operator.
• Preferred equity is a defined return with priority over common. Debt-like, little control.
• Personal guarantees follow ownership percentage. Anyone at 20% or more signs an unlimited full guarantee, no matter the label.
• If you want preferred or mezz money to count as equity, it has to be on full standby for the life of the loan, capped at half the injection, with no promise of an early buyout.
• Keep investors under 20% in both classes, keep real cash in the deal yourself, and lock the structure before you go to underwriting.

Thanks for reading!

If you're working on an acquisition, or are in the pre-LOI phases, you can book a short, informal call here to meet our team and learn how we can help you.

For pre-LOI buyers ready to explore opportunities: Schedule a meet & greet call​

Already have a deal under LOI and need financing help: Schedule an LOI consultation​

Until next time,

Matthias Smith

President, Pioneer Capital Advisory

​www.pioneercapitaladvisory.com​
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Disclaimer: The information in this newsletter is for informational purposes only and should not be considered legal or financial advice. Business buyers are encouraged to consult with their legal counsel and accountant to ensure the proper structuring of their transactions and to fully understand the tax implications of seller financing.

Thanks for reading. Feel free to reply directly to this email with any questions or thoughts.