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With Friends Like These…Exercise Caution When Adding New Business Partners
Tuesday, November 5, 2024

Money talks when the majority owners of private companies add new business partners who contribute additional capital. When these investors are high-powered PE firms or high-profile companies, with large balance sheets and impressive portfolio companies, they may seem too good to be true. That may be the case, as well, with high-net-worth individual investors who promise to meet all of the capital needs of the business. 

Majority owners need to be wary, however, as they bring additional partners into the fold — these new investors may seem exciting, but they may believe their money shouldn’t just talk but scream. There is no fail-safe formula for choosing good business partners, but this post identifies potential red flags to help avoid business partners who may create problems in the future, including by seeking to exert control over the business. In all cases, majority owners should secure a redemption right (a business prenup) from their new partners to ensure that if conflicts do arise in the future, the disagreements will not derail the business.

The Due Diligence Process for New Investors

Potential new investors should be subject to a vetting process, which is critical to identify potential red flags. One of the best ways to gain insights about new investors is to speak with others who have firsthand experience with them. This is basic due diligence and a check on the investor’s track record. In the case of PE firms, these will be members of portfolio companies in whom the PE firm invested. Questions may include: Did the firm live up to the promises it made before investing? What was the firm’s approach to management? How did the firm resolve conflicts that arose?

In these interviews of members of portfolio companies, the goal is to determine whether the PE firm was a good partner, was helpful to the growth of the business, played a constructive role in the company’s management, and was collaborative in finding resolutions when conflicts arose. On the downside, red flags will be raised if the reports indicate that the firm sought to dominate the leadership meetings, take control over the business, and showed a lack of respect for and no deference to the company’s existing management. 

The PE firm typically provides a list of references for vetting, but the majority owner should go beyond the listed references and, instead, request that the firm provide a list of all investments it made during the past 10 years. There are likely to be some problem investments included on that list, and the interviews should therefore include people who were members of successful portfolio companies in which the PE firm invested, as well as people who experienced challenges during the period of the PE firm’s investment.

Setting Mutual Expectations

One way to determine if potential new investors will be good long-term partners is to gauge whether their interests are aligned with the majority owner’s vision for the company. In making this assessment, the majority owner will want to focus on these questions to the investor: What is the potential new partner’s investment horizon? What approval rights is the investor is seeking to include over management decisions in the investment documents? Is the investor open to some dilution in connection with potential future rounds of investment?

As just one example where alignment with the investor may not exist, if the majority owner does not expect a liquidity event (sale, merger, IPO) to take place for more than five years, that is likely to be a problem if the investor has a shorter time horizon and desires to monetize its investment in five years or less. Another example is if the investor is insisting that its interest will never be subject to dilution of any amount. This position is likely to make it more difficult for the majority owner to raise additional rounds of financing.

In addition, this approach is a bit formal, but it is generally a good idea to require the investor to describe its expectations in writing to confirm the alignment between the majority owner and the new investor. In fairness, the investor will want to maintain flexibility and retain the right to adapt to changing situations at the company. But, if the investor declines to describe its expected role at the company and to share details of its vision in any written form, that is a red flag. This refusal signals that the investor is saying, in effect, you just have to trust me. In light of this intransigence, the investor’s reluctance to provide any written statement about its role and vision signals that this trust may be misplaced. 

Secure a Business Prenup

Even with the best of intentions, majority owners and investors may find themselves in conflict over the company’s direction at some point in the future. When frank dialogue between the majority owner and investor does not resolve these conflicts, both sides will be glad that they negotiated and adopted a buy-sell agreement (BSA) at the time of the investment. The BSA provides the majority owner with a “call option” that allows the owner to redeem the investor’s interest in the company if the owner decides the investor’s continued involvement in the business has become too disruptive. By the same token, the BSA provides the investor with a “put option” that authorizes the investor to secure a buyout of its ownership interest if the investor becomes dissatisfied with the majority owner’s conduct.

The critical elements of a BSA have been covered in our previous posts, which address how the BSA can be triggered by either party, how the investor’s interest in the company will be valued when the option is triggered, and how the company’s payment for the investor’s interest in the business will be structured. If the parties reach an impasse in their conflict, they should have a clear, prompt method for securing a buyout of the investor’s interest that avoids a protracted, expensive legal battle.

Conclusion

Majority owners of private companies often need additional capital for their business, which they cannot obtain from traditional lending sources. And if the current company owners do not wish to to invest any more capital in the business, the majority owner will need to seek investment from outside sources. At this stage, when majority owners are considering adding new partners who will provide growth capital for the business, the owners need to be cautious or they risk finding out that bringing these new partners on board was a case of the expected cure for the company being worse than the disease.

No one has a crystal ball to know if a new business partner will be a positive, long-term addition to the company. But there are red flags that are likely to surface if the majority owner conducts a thorough vetting process regarding potential new investors, including by interviewing people who have had direct, firsthand experience with the potential investors. Finally, the fail-safe option is for majority owners to obtain a buy-sell agreement from all their new investors. This agreement will provide the owner with a redemption/repurchase right if things do go off the rails with the investors in the future.

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