/>iAs private companies grow, they need to secure capital to support their efforts to provide more (and/or better) products and services to their clients. The need for emerging companies to obtain growth capital often leads the majority owner to consider accepting an investment in the business by a private equity (PE) firm. In this post, we share a cautionary note: Business owners need to be wary in their dealings with PE firms. If the majority owner does not thoroughly vet the PE firm, the owner may soon discover after the investment that the PE firm is imposing and carrying out a new set of business objectives, which may conflict with the majority owner’s vision for the business.
Determining Whether Business Goals Align
A potential tension exists between company owners and PE firms because their goals may diverge. While the majority owner/operator is typically focused on growing the company to achieve significant appreciation in value over a lengthy timeline of 10 years or longer, PE firms more often focus on achieving a tighter window for return on investment (ROI) to provide robust returns to their investors, usually within five to seven years. The key takeaway here is that the majority owner should determine at the outset whether common ground can be reached with the PE firm on both the goals of the investment and the firm’s stated timetable for achieving those goals.
If the majority owner and the PE firm are not aligned, the PE firm may require the business to adopt timelines that accelerate the ROI, but that fundamentally alter the culture and character of the business. As just a few examples, PE firms may require the company to adopt aggressive cost-cutting measures, to expand rapidly into new markets, and to implement other operational changes with the goal of achieving short-term profitability rather than the long-term growth model the majority owner was building. The owner may value investments in the company’s culture, employee development, or in setting the stage for customer relationships, but the PE firm may view these items as inefficiencies that must be jettisoned to meet the PE firm’s financial performance targets.
For a majority owner to avoid a situation where the PE firm takes the company in an unexpected and undesired direction after investing, the owner needs to investigate the track record and method of operation of the PE firm. Specifically, the owner needs to dig in to find out how the PE firm managed previous investments in other portfolio companies to determine whether the PE firm’s approach aligns with the owner’s vision. The majority owner should be asking these questions: (i) Did the PE firm work in concert with the company’s existing management; (ii) did the PE firm exert its power to redirect the company’s operations in unexpected ways; and (iii) did the PE firm essentially treat the company as a turnaround situation to rebrand and remodel its approach or did the PE firm enhance the company’s performance without rewriting the entire script?
Getting answers to these questions will require the majority owner to obtain specific references from the PE firm to current and former clients and the right to speak freely with them about their experiences with the PE firm. In addition, the owner should ask whether the PE firm has been involved in litigation with any former clients, and if so, it is advisable to understand what transpired regarding that dispute, i.e., what claims were made by the former client against the PE firm. Finally, the owner should ask detailed questions about what the former clients experienced in their business dealings with the PE firm, as noted above, in regard to operational changes, new timetables, and exercise of control. This type of due diligence will yield key insights about what the majority owner can expect if the courtship turns into an actual investment in the company by the PE firm.
Majority Owner Contract Protections – Preserving Control and Exit Rights
Many PE firms will not agree to make a non-controlling investment in a private company and will require the majority owner to accept being diluted to a position of holding less than a 50% ownership stake in the company. The PE firm will insist on becoming the company’s majority owner, thereby securing the right to direct and control the business. But even if the majority owner accepts the required dilution and becomes a minority partner in the business, the owner should still insist on preserving some important rights in the investment agreement discussed below.
First, the majority owner should attempt to retain veto power over fundamental decisions that would dramatically alter the nature of the business. These are “protected decisions” that would require the PE firm to obtain the majority owner’s consent and may include the following: the sale of the company or key assets; large increases in the amount of the debt carried by the company; the addition of new investors in the business that dilute the ownership percentages of existing owners; expansion of the board/managers; large changes to executive compensation; or major operational changes such as opening an office in another state, shutting down an office or territory, or adding a stock option plan for executives. Unless the majority owner retains these veto rights, the PE firm can make whatever changes it may desire to the company without any constraints or restrictions.
Second, if the PE firm drives a hard bargain, the majority owner may permit the PE firm to override the owner’s veto and/or remove the owner from management. But if the PE firm elects to exercise these rights, the majority owner needs to secure a “put right” that the owner can trigger to demand that the PE firm purchase some or all of the majority owner’s interest in the company at that time based on a pre-determined valuation process or valuation formula. Thus, the PE firm will have the right to overrule the majority owner or even oust the owner from the company, but not without giving the owner the right to obtain a buyout at the time of exit. In short, this “put right” ensures that if the PE firm engages in actions that conflict with the majority owner’s voting rights or ownership in the company, the owner can monetize the value of its interest in the business at that point.
When to Walk Away – Red Flags Showing That Love Is Not in Bloom
The majority owner needs to approach a potential PE investment with the mindset of being willing to walk away if the PE firm’s financial goals for the investment are unrealistic, if the firm is rigid in its approach to the business, or if there are red flags that crop up during the due diligence process. Not every PE firm will be a good, collaborative partner, and for the majority owner, waiting to grow the business until the right partner comes along is a far better alternative than bringing into the fold an unyielding partner that exercises complete control over the company in a manner that defeats the majority owner’s own vision.
Some red flags may include PE firms (i) that insist the company can meet aggressive growth and revenue projections well above industry norms; (ii) that demand the company meet unrealistic timelines; or (iii) that reduce capital expenditures and insist on making sharp spending cuts and requiring immediate and substantial employee layoffs, which are not tailored to minimize the impact on the company’s culture. A final red flag is a PE firm that declines to explain how setbacks will be handled if the company misses a deadline, fails to meet a revenue projection, or has other problems. If the PE firm cannot engage in a problem-solving exercise before issues arise that is a major concern, because challenges are inevitable and business partners need to be able to work together in an effective manner to meet and overcome them.
Conclusion
Successful private companies need capital as fuel to power their growth. But majority owners need to engage in the process of securing capital from PE firms with care if they want to avoid becoming roadkill the PE firm churns through without slowing down. This requires a majority owner to assess whether the PE firm’s goals, approach to the business, and timetable closely align with the owner’s long-term vision.
At the outset, the majority owner needs to develop a clear, specific statement of the owner’s own goals, to conduct detailed due diligence on the PE firm’s track record, and to adopt contract terms that protect the owner’s ongoing rights to ensure that the company will continue to operate in a manner that aligns with the owner’s vision. The majority owner must also maintain discipline, if necessary, to end discussions with PE firms when that alignment does not exist or when the PE firm insists on contract terms that give the firm the right to kick the owner to the curb with no recourse after investing. Sometimes the right response for the majority owner to the PE firm is to “Just Say No.”
