/>iWe have been enjoying a nice spring in Dallas – moderate temperatures, not too much rain and mostly sunny skies. In the investing world, these conditions signal that the time is ripe for a private company investment. But just as gardeners inspect the soil, check on the sunlight, and consider the available water sources before planting, investors need to be careful that their spring enthusiasm does not blind them to warning signs regarding a private company investment. This post considers key aspects of a target company’s ownership and management to determine if red flags are present, which suggest that the investment is high risk and may be better to avoid.
Red Flag No. 1: Decision-Making Paralysis
Decision-making can be a red flag if the company’s leadership makes decisions in a haphazard way. Lack of decision-making creates conflicts or indecisiveness that can lead to missed opportunities and the failure to deploy the company’s capital and resources effectively. This is a problem for any business striving for robust growth, but a flawed decision-making structure is not always easy to discern by a potential investor during due diligence.
Sussing out the effectiveness of the company’s decision-making (or problems in this area) takes effort and the willingness to ask good questions. To get to the heart of this issue, investors should (1) request a list of the top strategic decisions that the company’s management has made over the past three to five years, (2) meet with current investors, and (3) also meet with current managers or board members. These meetings will be critical to discuss how the decisions were made, how long it took for decisions to be made, and how the company’s management dealt with challenges when some of their decisions did not work out as planned.
A well-managed company should be able to demonstrate how its management makes effective decisions, and indeed, a company that cannot explain how its decision-making process works productively is showing evidence of a red flag.
Red Flag No. 2: Investors Treated as Mushrooms
Minority investors appreciate they will not be running the show and that they will take a back seat to the company’s majority owners, who control the business. But substantial investors expect to be able to express their views to management about the company’s major decisions, to be kept informed about developments that impact the business, and to avoid surprises in the form of negative results regarding the company’s performance. Stated more simply, it is a red flag if a sizable number of the company’s current investors feel they are marginalized and unappreciated by the company’s management.
To evaluate the transparency of company management and the opportunities for minority investors to participate to some extent in decision-making, investors need to consider engaging in at least two different approaches. First, investors need to review the company’s governance documents to determine the extent to which (i) the company is required to conduct meetings on a consistent basis with investors, (ii) the company regularly issues management reports to investors regarding the company’s financial performance and operations, and (iii) the company holds votes on important measures. Potential investors will want to confirm that the required meetings are held, that the management reports are issued, and votes are held. If the company fails to conduct regular meetings with investors, lacks a consistent reporting system, and operates without any formal structure, the absence of good “corporate hygiene” poses a serious concern.
The second track for investors is to consider the experience of the company’s current investors. If they are disgruntled at how they are being treated, it will be hard for them to mask their frustration with how management conducts business. It is also a red flag if the company refuses to permit a potential investor from meeting/speaking with current investors or designates just one owner as the sole person for investors to speak with during the due diligence process. If the company tries to “hide the ball” regarding the views held by current investors, this lack of transparency is a notable red flag.
Red Flag No 3: Distracted/Conflicted Management
Majority owners who manage the business and have their fingers in many pies can also pose a significant concern. The ideal private company investment is one where the ownership (and managers) maintains a laser focus on guiding the business to success. By contrast, when the members of management split their time between different companies and/or engage in deals with other companies in which they also own an interest, this may create a serious problem for the business. When managers have dual responsibilities or their loyalties are divided among a number of different companies, this situation can result in distraction for the target company’s operations, as well as conflicts of interest that make investment less desirable.
The potential dual or divided loyalty question can be challenging for investors to evaluate because current management typically does not volunteer this information, and managers may be blind to the problem. The investor needs to seek disclosure of financial information from the company that details outside business activities by the company owners and managers, including related party transactions. Specifically, the investor will want to understand what role the target company’s managers have in other businesses and what level of ownership they have in other affiliated companies. More generally, the investor should assess how focused the management team is on the business in which the investor is considering an investment.
Evaluating this issue will require pointed discussions with current management about their bandwidth, the existence of divided loyalties, and potential conflicts with other companies. The bottom line is that managers who have their fingers in multiple pies can create unwelcome distractions for the business and also become subject to direct conflicts of interest that will be a drag on the company’s performance.
Red Flag No. 4: Uncertain Partner Exit Rights
We have covered in other posts the importance for investors to secure an exit right in the form of a buy-sell agreement at the time of their investment. This is a “put right” that authorizes minority partners to trigger a buyout of their interest requiring a purchase by the company or the majority owner. The specific process for valuing the minority interest will be set forth in the agreement as well, after the minority partner triggers the buyout.
Before investing, the potential investor therefore needs to carefully scrutinize the terms of the buy-sell agreement, whether it is contained in the company’s governance documents or set forth in a separate owners agreement. Some buy-sell agreements are so poorly drafted they cause the buyout process to become protracted or, worse, they are so complicated the buyout right almost becomes illusory. The investor should seek the following in the buy-sell agreement: (1) a clear statement as to when and how the investor can trigger the buyout, (2) the elimination of all discounts that reduce the value of the minority interest based on lack of marketability or lack of control, (3) a requirement for valuation disputes to be subject to a prompt arbitration hearing that avoids a lengthy, expensive court battle, and (4) the obligation for the company to reimburse the investor’s legal fees if the investor prevails in the valuation dispute.
The buyout right protects the minority investor when conflicts arise with management, and it ensures that the investor will not be required to continue indefinitely holding an illiquid interest in the company. This exit right is therefore critical for the minority investor to obtain at the time the investment is made. A company that refuses to provide this exit right is presenting a red flag right from the outset. There is a caveat here, however, that involves timing. It is not uncommon for a company to provide a buyout right to the minority investor, but to preclude the investor from exercising that right for some period of time after investing. A buyout right that the investor cannot trigger for two to three years is much less of a red flag as the company is seeking to avoid the duty to return funds to the investor in a short time after receiving the invested capital.
Conclusion
Spring sunshine will not make plants grow from infertile soil and in the absence of water, and similarly, a business needs more than a promising product or service to achieve success. The most successful businesses avoid becoming mired in dysfunctional management conflicts that cause companies to languish or fail regardless of the benefits of their products or services. These successful businesses also promote a good, transparent relationship with their investors.
For the potential investor, it is crucial to inspect the garden closely before planting any seeds of capital. Investors should be cautious about investing in companies that lack a clear decision-making process, that do not provide transparency to their investors, and that do not stay focused on the goals of the business. And securing an exit “put right” on the way into the investment is the wisest course regardless of the attractiveness of the garden.
