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Cash and Control: Bringing in Private Equity Minority Investors

by Paul Schaye

A lifetime of building a business can be shattered when the union between the business owner and an outside investor goes from a match made in heaven to a relationship formed in hell. Private companies and family-owned businesses that have more than just capital invested are especially concerned with the souring of this relationship. Business owners looking for outside investors question, “Will our business wind up in a chop-shop or will our legacy live on?”

A solution to this quandary is working with minority investors who will exert less control. Minority investors typically control 30-49%. Clearly, smaller transactions are on the upswing. According to Dealogic, private-equity investment deals of less than $100 million jumped to almost $9 billion in 2005, up 66% from $5.4 billion in 2003. In continuing the upward trend, in 2006, deals of less than $100 million totaled nearly $10.5 billion.

The advantage of working with a minority investor is that company owners can cash out part of their equity to attain liquidity and diversification, and get a second bite of the apple on future profits. This is accomplished while keeping control of the business.

Strike While the Iron is Hot

While the owners of any company first have to come to agreement on looking for outside equity and capital, there are a few instances where business conditions are ripe to seek out a minority investor:

  • Strong upside and shareholders want expansion, liquidity and diversification. Owners often do not want to invite a majority investor in just when years of hard work are about to pay off in a big way. A minority investor can provide the cash that allows the owners to realize their dream and stay around to reap more rewards.
  • Changes in marketplace that require capital and expertise. With the globalization of so many industries and the emergence of new markets, now may be the ideal time to expand. Building international relationships takes additional capital and resources, and a minority investor can help you be one of the first in your industry to tap into these opportunities.
  • Strong need for outside business counsel. A time comes when current owners and management acknowledge that their skill sets limit the potential growth of the business. The beauty of minority investors is that while they will have limited control, a company can still use their expert counsel as much or as little as needed.

Get Your “Prenuptial” Agreement in Order

The relationship between a company and its minority investor is more like a marriage, so the process requires special consideration:

  • Allow time for “dating.” When a company considers being acquired, the main objective is to get the most money out of the deal. However, with a minority investor, both parties are “investing” in a long-term relationship. So, before you approach minority investors, think about the optimal profile or ideal characteristics.
  • Ask direct questions. Too often a transaction sours because straightforward questions like the following were not asked beforehand:
• What is your vision and investment strategy, and how does our company fit into it?
• Who are your primary investors?
• What motivates your investment decisions?
• What are your other investments right now?
• Where in your priority list would our company stand?

  • Call references. Bringing investors on as partners is like hiring employees. Ask their references specific questions such as:
  • Were there ever any difficult situations in working together? What was their attitude? Did they rush to judgment or run over to help?
  • If you had trip covenants, how hard did the investors work to enforce them?
  • Were they heavy handed in pushing for management changes?

Avoid the Problems Before They Start

While the details of a transaction vary, there are some general guidelines to help prepare for a positive working relationship:

  • Matching timelines. Investment capital is something a company leases, not owns. Investors typically want their investment back within five to seven years with an internal rate of return of about 15-20% a year.
  • Living with covenants. The agreement will include triggers for the investor to take more control in the event the company does not meet agreed-upon expectations. Take the time to talk through some possible scenarios to see how those can be arbitrated rather that dictated.
  • Personnel changes. If, during the evaluation process, it becomes clear that certain personnel changes must take place after the transaction, address the issue upfront and determine how much time should pass before there are major shifts in management.

Today, investors have a lot of capital and are looking for companies. Many are willing to take a smaller piece of companies they pursue. However, at the end of the day, the question is not about the money, but how the investor works to build a mutually beneficial relationship.

With minority investors, owners can get an additional payout. It is very attractive for owners to have the ability to take cash off the table now with the incentive that they could take more out later.

The benefit of gaining cash and maintaining control can be realized with minority investors. Company owners who spent their lifetime building their businesses can achieve greater profits to better preserve their legacies.