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Fast-growing private companies are exciting to observe as outsiders, but on the inside the company founder has the challenge of securing enough capital to fuel the rapid growth of the business. The company’s continuous need for capital places the founder in the position of having to manage the company’s operations while at the same time engaging in perpetual fundraising efforts. And as new investors come on board, the founder will face significant pressure to cede control and also to reduce the founder’s ownership interest in the company because the equity that the new investors are acquiring in the business have to come from somewhere – namely, out of the founder’s hard-earned ownership interest. 

This is the founder’s dilemma: how to grow the business in way that does not require the founder to say goodbye to control of the “baby” the founder has birthed and grown? This post reviews a game plan that is designed to help founders thread this needle successfully in growing their businesses. At a minimum, founders should take proactive steps that prevent them from being kicked to the curb by new investors who seek to leave them with little to show for their efforts.

How Fast to Go – Haste May Not Be the Founder’s Friend

The pace at which the company grows is one of the founder’s most vexing challenges. On one hand, growing the company quickly creates energy and excitement, which brings momentum that will help keep the company ahead of its competitors. On the other hand, a fast growth rate is what generates the need for the founder to secure more capital than the business can produce on its own. But when the founder secures new investors to provide this additional capital, not only will it dilute the founder’s ownership stake, but the new investors may also seek to remove or substantially limit the founder’s control over the business at some point, including by terminating the founder’s status as both an officer and employee.

To avoid conflicts with investors, the founder may want to consider growing the business at a slower rate. If the founder adopts a more moderate rate of growth for the business, this may enable the company to cover the cost of its expansion from its own earnings or from third-party debt financings rather than from equity investments. The loans that the founder obtains will have to be paid back, of course, but banks and other lenders may be better business partners than new investors because lenders do not tell the company founder how to run the company or seek to remove the founder from the business. The cost of capital is frequently a determining factor when a found decides between debt and equity financing, in addition to whether or not the company then satisfies a lender’s credit requirements.

In short, founders need to weigh the pros and cons of a rapid growth strategy. Both approaches carry some amount of risk, because growing the company at a slow pace may cause it to fall behind other competitors in the marketplace. But if a slow growth approach does not harm the company’s business prospects, this approach may avoid the need for the founder to obtain new investors and new capital, and this will, in turn, allow the founder to maintain control over the company throughout its growth cycle. 

Don’t Get Bitten by the Helping Hand – Maintaining Control Is Key

The founder’s ability to secure new investments can seem like a godsend at the time, but the new investors may turn out to be wolves in sheep’s clothing. Investors who provide growth capital do so with the clear expectation of securing a very substantial return on their investment.  Therefore, if the company does not perform as expected, or fails to generate returns as quickly as desired, the investors may turn on the founder. In their minds, this is just the nature of business, and they will exercise their power to replace the founder with a president/CEO they consider more capable of delivering the financial results they are seeking. 

There is no free lunch for founders, and sophisticated investors will not provide capital to purchase an interest in a private company without securing the rights to exercise some measure of control over the business. But the founder, to the extent it is possible in the negotiations with new investors, should limit the terms demanded by these investors to avoid what amounts to immediately turning over the keys to the castle. The devil is in the details, but the following are some critical parameters:

  • Veto Rights – The founder’s ownership percentage in the company will likely be reduced as new investors purchase interests in the company, but the founder should retain voting rights that prevent certain key actions without the founder’s approval. This may require the company to agree that unanimous consent is required for certain actions, which gives the founder a veto right to approve/reject these actions. Some examples of the types of veto rights the founder should seek to obtain may include the right to approve the sale of the business, material changes being made to the company’s governance document, the issuance of new shares/units, removing a director or manager, or expanding the size of the board.
  • Board Seats – Regardless of the ownership percentage held by the founder in the company, the founder should be permitted to serve on the board or as a manager of the business. In addition, the founder may insist on being able to appoint at least one other board member or manager to serve on the board regardless of the amount of equity that is held by the founder in the company. This may not place the founder in control, but it will give the founder another, hopefully persuasive, voice at the table involved in the decision-making process by the board.
  • Governance – When new investors join the company, the founder may want to require that the business operate with a greater degree of formality. For example, the founder may want to require that board meetings be held regularly/frequently to ensure that everyone is on the same page as to how the business is performing. In addition, the founder may want to preclude the board from taking actions by less than unanimous written consent. This will require all decisions by the board to take place at actual meetings or by unanimous written consent rather than behind the scenes without the opportunity for the founder to participate.

The provisions discussed above will provide the founder with protections when new investors join the business. These are subject to negotiation with the investors, and investors may not choose to go forward in making the investment if they determine that the rights that they are obtaining are too limited. That may be a good thing, however, because new investors who show no deference to or confidence in the founder at the outset may be signaling that the founder will be on a short leash and subject to quick replacement.

When Forced to Say Goodbye, Make Sure It Counts (in Dollars and Cents)

The final critical issue the founder needs to address when new investors come into the company is the status of the founder’s continued ownership in the business. Investors may insist on being granted the right to remove the founder as CEO/president as a condition of making the investment. The founder may agree to accept this condition to secure the investment, but if the investors do exercise this right at some point in the future, the founder needs to ensure that the termination takes place in a way that enables the founder to realize at least some portion of the value that the founder has created in the business.

Specifically, the worst case scenario for a founder is to be removed from the company without receiving any payment and then be left on the sidelines hoping for some future liquidity event that pays the founder something for his or her ownership interest in the business. This dire situation can be avoided, however, if the founder insists on securing an employment agreement or requiring the company to adopt binding provisions that protect the founder’s interest when the new investors make their investment. Here are some specific protections for founders to consider:

  • Termination – The founder can insist that his or her removal can only take place on a showing of cause, i.e., improper conduct. Alternatively, if the founder does agree to be removed by new investors without cause, that type of removal should trigger the payment of a substantial severance payment to the founder. The founder may agree to serve in a consulting role after termination, but these terms will need to be spelled out, including the founder’s new duties and compensation rights.
  • Put Right – In addition to the severance payment, if the founder is removed without cause by the new investors, the founder needs to be permitted to sell some or all of the founder’s otherwise illiquid equity in the company at a price that is determined by a formal process the parties agree to in advance.  
  • Noncompetition Restrictions – The company and the new investors may insist that the founder be subject to a noncompete restriction after termination. This may be acceptable to the founder if the company makes a substantial severance payment to the founder at the time of termination, along with purchasing all the equity held by the founder. But if the severance payment is modest and the founder does not receive a full buyout of all equity, the founder will want to narrow the scope of the noncompete restriction as much as possible to permit the founder to pursue other, possibly competing, opportunities after the termination takes effect. 

Conclusion

Company founders seem to be faced with a no-win choice: They need to bring in new investors to provide funds that fuel the rapid growth of their business, but securing this influx of capital puts them in a danger zone. The founder may have to cede control over the business to the new investors who later decide to remove the founder from the business when they become displeased by the company’s performance. There is a win-win structure available here, however, that strikes a balance between the new investors’ goals and the founder’s objective of staying active in the business or in providing for an exit on favorable terms.

This game plan for the funder has a number of components, but the goal is to permit the founder to retain some measure of continued control over major decisions by the company. To secure the new investment, the founder may need to grant investors with the ultimate right to terminate the founder’s employment in the future. But the founder should negotiate to include a provision providing that, if this right is exercised, the founder will receive a severance payment and obtain a buyout upon exit of the founder’s interest in the company (at least in part). The takeaway is that the founder who secures additional capital is doing right by the business, but the founder also needs to look out for No. 1. When new investors are brought into the company, the founder needs to insist on including terms that, in the event of the founder’s ouster, provide a reasonable return for the blood, sweat and tears the founder has devoted to the business.

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Private company investing is inherently risky, but these risks can be mitigated if investors take proactive steps before making this type of investment. This due diligence action plan for potential investors includes the following specific steps: (1) identifying whether key factors are present in the businesses that mark it for success, (2) evaluating the current and future capital structure of the investment, and (3) securing a contractual exit strategy to provide an off-ramp if things do not go as planned. The failure rate of private companies is high but investing in early-stage companies continues to flourish because the financial rewards can be so great. In this high-risk/high-reward scenario, an investor who adopts the approach discussed in this post can improve the prospects for success, while also reducing the risks of this investment.      

Evaluating the Differentiating Factors: The Secret Sauce of Private Companies

There is no way to state with certainty that an emerging private company will succeed on a long-term basis, and the failure rate for new businesses is quite high. According to the Bureau of Labor Statistics, 40% of companies fail in the first three years, almost 50% within the first five years, more than 65% within 10 years, and only 20% survive beyond 10 years. With these odds seeming stacked against new companies, it is difficult for anyone to know which companies will successfully run the gauntlet and remain in business for a decade or longer. 

Based on my experience working with entrepreneurs in many different fields over the past several decades, however, there are telltale signs that will improve the odds of success. The key factors discussed below are the secret sauce that should be evaluated carefully before investors move forward to provide capital to an emerging growth company. 

1. Quality/experience of management team

The first factor is the experience of the company’s management team and, in particular, whether the company founders are first-time entrepreneurs, or whether they have a track record of success in other businesses. The statistics bear out that company founders who have already had success in starting another business are a better bet to repeat that success in a new company rather than a first-time founder who is tying to start and grow a business for the first time. 

Experienced company founders have learned from their past mistakes. As a result, they are more adaptable to changing market conditions, they are more flexible in their approach to the company’s operations, and they are more focused on getting the company to the next stage of development. In sum, their past experience makes them more nimble, creative and flexible, which creates more avenues for the company to achieve success. Unfortunately, while selecting companies with experienced management improves the odds of investing, this factor alone does not provide a guarantee of success. Founders of new businesses who had success in the past also have a failure rate in starting new companies, particularly when they have moved into industries in which they do not have significant prior experience. The experience factor should therefore be taken into account with the others that are discussed below.

2. Product or service that provides a differentiating factor

The second factor to be considered is whether the company has a distinguishing feature to its product or service that will provide it with a competitive advantage in the marketplace. Doing something new in a way that brings real value to consumers or business buyers is a recipe for success. One good example in the consumer space is Spanx. This new product fit a strong need for women of all shapes and sizes, and it quickly became a phenomenon because, for at least a time, there was nothing else available in the market that fit this same need. 

Another more recent example is Summer Moon Coffee. There are so many coffee shops in Texas (even without including Starbucks locations) that it seems unlikely that a new coffee shop could emerge successfully. Yet, Summer Moon’s addition of a sweet cream to its coffee has generated strong appeal, and it is currently a private company with about 20 locations in Texas. Coffee is a popular, readily available product, but the differentiating sweet cream factor allows Summer Moon to distinguish itself in this active market. Similarly, Black Rifle is another fairly new entrant in the coffee market, and its ethos of being founded by a former Green Beret, hiring veterans to work for the company and appeal to a strong homeland also allows it to distinguish itself for success in this crowded industry. 

3. Growing market need for product or service

A company with a great product or service has a definite chance to be successful, but the odds of long-term success are significantly greater when the market for the product or service is growing rapidly. Therefore, a business that has thoughtfully targeted emerging growth trends is positioned well for success. These growth trends could relate to aging consumers, the movement of large groups of people to Sunbelt states, the desire for healthier foods, or the sharp rise in the price for home insurance. 

All of these trends are significant and present opportunities for new companies, and there are many others that create entirely new markets or, like Summer Moon and Black Rifle, expand existing markets. A company with a business model that ties directly into and that will benefit from these trends presents a better opportunity for investment than a business that has a niche market that is stagnant or, worse, may be declining.  

Determine the Capital Structure of the Investment

The next due diligence factor has multiple components to it. The first aspect requires the investor to study and gain a full appreciation of what is referred to as the capital stack. This will be reflected in a spreadsheet that identifies all of the company’s owners and includes the specific percentage that each owner holds in the business. The investor should also inquire to determine how much the other investors provided in capital to the business, including all of the founders. If the company’s founders have not made any capital contributions, and their ownership interest is based solely on their sweat equity, it is worth exploring the circumstances to make sure that the founders are fully committed to the company. 

Second, and importantly, the investor needs to determine how future capital contributions to the business will be structured. If the investor is making an initial or early-stage contribution, it is likely that the company will require additional rounds of financing. As a result, the investor needs to be concerned that future rounds of financing will substantially dilute the investor’s share of the business. This can be handled in a variety of ways, i.e.,the investor can agree to make additional contributions infuture rounds of financing to maintain its  original percentage ownership, or the investor can insist that its percentage of this business will remain static even if it does not make additional capital contributions. The investor’s concern regarding future dilution can be handled through the purchase of preferred shares that provide it with priority rights that will not be impacted by future financings or it can insist on including an anti-dilution provision in the investment documents to maintain its ownership percentage.  

Secure an Exit Strategy (A Put Right)

The last element of the investor’s due diligence strategy needs to be securing an agreed exit path, which will be in the form of a put right. This is a contract that permits the investor to trigger a redemption/purchase that requires the company to buy the investor’s interest in the business. We have written extensively in the past about buy-sell agreements, and this agreement will need to address: (1) when the put right can be triggered, (2) how the value of the investor’s interest will be determined, (3) how the payment for the investor’s interest will be structured, and (4) what collateral, if any, will be provided by the company to protect the investor in the event of a default in payment. 

Conclusion

The risks of private company investing cannot be extinguished, but they can by reduced when investors take proactive steps to conduct specific types of due diligence before making the investment. When the investor confirms the business has legitimate distinguishing factors that differentiate it in the marketplace, when the company has a capital structure in place that protects the investor as additional capital is raised, and when the investor secures a put right that provides a contractual path to an exit, these steps will definitively lessen the investor’s financial exposure in making this high-risk investment.

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Conflicts between co-owners in private companies are common, but the vast majority are worked out through dialogue and negotiation. When these internal conflicts cannot be resolved, however, minority investors may file suit against the company’s majority owner. Anecdotally, these investor claims seem to be on the rise, including claims that the majority owner breached fiduciary duties owed to the company. This post therefore reviews strategies for majority owners to consider when they are required to defend investor lawsuits.  

Seek Early Settlement of Litigation

Litigation between private company co-owners is not for the faint hearted. Minority investors tend to be passionate about their claims against the business owners, which means the litigation is likely to be protracted and expensive, as well as disruptive to the business. For these reasons, the majority owner is wise to make diligent efforts to resolve the lawsuit at the outset if there is a reasonable path to settlement that avoids a drawn-out legal battle. A prompt settlement will save the majority owner a vast amount of time, dramatically reduce the legal expense that is involved in litigation and avoid a public legal battle that could be harmful to the business.

Achieving a settlement with a disgruntled minority partner makes a lot of sense, but it can be difficult to achieve as investor claims often have an emotional component. Further, investor lawsuits are typically filed only after settlement negotiations between the parties have not been successful. Given this background, the following are several approaches for the majority owner to consider, which may not have been pursued before the lawsuit was filed.

  • Mediation – A mediation may not seem productive based on the parties’ impasse in their negotiations before the suit was filed, but this session will require the parties to focus on a potential settlement with assistance from an experienced business mediator. Even if the mediation is not successful, it may provide a settlement framework that can lead to a later resolution. In addition, the mediation may provide information that will be helpful in the majority in the litigation before any discovery takes place in the lawsuit.
  • Arbitration – A mandatory arbitration provision may not be included in the LLC company agreement, the bylaws, or shareholder agreement, but the parties can agree voluntarily for their disputes to be resolved through arbitration, which would expedite the outcome in a matter of months rather than after years of litigation. For example, when the primary dispute between the parties concerns the company’s value and the amount to be paid for the purchase of the investor’s interest in the business, the parties may agree to have the value question resolved by a single arbitrator or an arbitration panel.
  • Structured Buyout – The impasse that led to the lawsuit being filed may be broken by a settlement in which the minority investor receives a substantial payment for most of the investor’s ownership stake in the business. The settlement will also provide the investor with a carried interest in the company (by contract not ownership equity) that results in a future payment based on the company’s future performance. This type of settlement may work if the investor is looking for short-term liquidity that will monetize a portion of its investment. Further, to provide the investor with some protection regarding the future payment, this amount can be structured with a floor and a ceiling, i.e., the investor receives a guarantee the future payment will be for at least a certain set amount. 
  • Company Sale – Finally, in some circumstances it may be advisable for the majority owner to sell the business rather than engage in a legal war of attrition with the minority investor. A sale of the company on favorable terms that provides for a cash out of all owners is also likely to result in the resolution of the lawsuit.

Indemnity, Dilution, and Defense of Investor Claims

If the majority owner cannot achieve a prompt settlement of the minority investor’s suit, there are a number of affirmative steps and strategies the owner will want to consider as the case moves forward, which are discussed in the remainder of this post.

Full Indemnity of Majority Owner and Potential Counterclaims

It is not a defense to an investor’s claim, but the benefits of obtaining indemnity should be immediately pursued by the majority owner after the lawsuit is filed. Virtually all company governance documents provide for managers, directors and officers to be indemnified by the business for lawsuits relating to the performance of their duties. The majority owner will be required to make a formal demand for indemnity after which the company is required to pay (reimburse and advance) all of the owner’s legal fees and expenses associated with the lawsuit.  Before the payment or the reimbursement of fees and expenses takes place, the majority owner may be required to provide the company with an “undertaking.” This is a promise by the owner to repay the amounts that are advanced by the company if the owner is ultimately found to have engaged in willful misconduct or gross negligence. This would only take place after a final judgment making this finding against the owner, and after all appeals have been exhausted.

The practical effect of the indemnity provision is that the majority owner’s legal fees and expenses in defending against the minority investor’s claims will be fully paid by the company.  These are likely to be substantial amounts, and include the fees incurred by financial or other experts retained by the majority owner to testify in defense of the claims made by the investor.  By contrast, the investor will be required to pay its own legal fees and expenses, as well as the fees incurred by any expert witnesses who are retained by the investor. 

In addition to securing payment (either advancement or reimbursement) of the legal fees incurred by the majority owner in defense of the lawsuit, the owner may also have grounds to file a counterclaim against the investor seeking full recovery of all legal fees that the owner incurs in the lawsuit. This potential recovery exists if the minority investor has breached any provisions of the company’s governance documents, because Texas law authorizes parties to recover their legal fees upon proof of a defendant’s breach of contact(see Section 38.001, of the Texas Civil Practice and Remedies Code).

Examples of conduct by the minority investor that support a counterclaim for breach include all of the following: (1) if the minority investor has failed to pay the full amount of its capital investment to the company, (2) if the investor improperly disclosed the company’s confidential information to the third parties, or (3) if the investor owes any other amounts to the company that have not been timely repaid. However, before bringing this counterclaim against an investor, the majority owner should evaluate whether asserting the claim would trigger the investor’s right to indemnity by the company under the governance documents. The company’s governance documents should make clear that the indemnity only applies to claims that are filed by third parties. Unfortunately, some governance documents include vague language that may provide the investor with a colorable argument that the company’s first-party claim against the investor is subject to indemnification.

Dilution of Minority Interest

If a buy-sell agreement exists when the minority investor asserts a claim, the majority owner can exercise the right to redeem (purchase) the investor’s interest in the business. In most cases where lawsuits are filed, however, no buy-sell agreement exists, or the minority owner would have already triggered the agreement to require that its ownership interest be purchased by the majority owner. In the absence of a buy-sell agreement, a strategy that may be available for the majority owner to consider exists if the company’s governance document (LLC agreement or bylaws) does not require unanimous consent to amend the governance agreement.

If a simple majority ownership is all that is required to amend the governance document, the majority owner can amend the document to adopt a new buy-sell agreement. This type of amendment is an after-the-fact adoption of a buy-sell agreement, and the majority owner can then apply the terms of the amendment to redeem the ownership interest held by the minority investor. This after-the-fact amendment procedure has not been addressed directly by Texas case law, but the Texas Supreme Court has shown considerable deference to the majority owner’s exercise of powers that are authorized by the company’s governance documents. This deference should include the owner’s power to amend the governance documents in accordance with their terms(see Ritchie v. Rupe, 443 S.W.3d 856 (Tex. 2014)).

Litigation Defenses

In most lawsuits that minority investors file against their majority owners, the investors allege that the owner has breached fiduciary duties owed to the company. Before evaluating any defenses that are available to fiduciary duty claims filed by the investor, majority owners should first examine the company’s governance document to determine whether they include any exculpatory provisions. Some bylaws and LLC company agreements limit the scope of fiduciary duties owed by governing persons. For Texas LLCs, Texas statutes indicate that members may completely eliminate all fiduciary duties owed by managers and officers. 

Specifically, while the Texas Business Organizations Code (TBOC) prohibits the exculpation of corporate officers and directors for breaches of the duty of loyalty (see TBOC § 7.001(c)), it expressly allows exculpation for limited liability companies “to the additional extent permitted under Section 101.401” (emphasis added). But Section 101.401, which applies to LLCs, expressly allows for the restriction of any fiduciary duties, without limitation:

The company agreement of a limited liability company may expand or restrict any duties, including fiduciary duties, and related liabilities that a member, manager, officer, or other person has to the company or to a member or manager of the company (emphasis added).

If the company’s governance documents do not eliminate the fiduciary duties owed by governance persons, majority owners who act as governing persons have statutory defenses to these claims. Under Sections 21.418 and 101.255 of the TBOC, known as the Interested Director Rule, governing persons in corporations and LLCs — under certain conditions — are granted a “safe harbor” immunity when they engage in interested party transactions with the business. This safe harbor applies when:  

  1. The transaction was approved by a majority of disinterested directors with knowledge of material facts;
  2. The transaction was approved by a vote of shareholders with knowledge of material facts; or
  3. The transaction was objectively fair to the corporation when the contract or transaction was authorized, approved or ratified.

The safe harbor statue effectively requires the majority owner (the governing person) to obtain approval for the transaction from disinterested parties. Therefore, if no vote is held by disinterested parties before the transaction takes place, the governing person has the burden to establish that the transaction was fair to the company. When no vote is taken by disinterested parties to approve the transaction, the question of whether it was fair to the company will likely require a trial on this issue, i.e., this question will require a fact finder to determine the issue of fairness, and the court cannot decide the matter on a pre-trial motion. 

In addition to the safe harbor provision, a governing person can also assert the business judgment rule as a defense, which protects officers, directors and managers from claims for breach of their fiduciary duties if the minority investor contends they were negligent, unwise or imprudent. This defense applies when the actions of the governing person were “within the exercise of their discretion and judgment in the development or prosecution of the enterprise in which their interests are involved” (see Sneed v. Webre, 465 S.W.3d 169, 178 (Tex. 2015)). To overcome this defense, the minority owners need to show that the governing person engaged in some type of self-dealing that provided the governing person with a direct personal benefit. 

If the investor alleges in the lawsuit that the majority owner misappropriated a corporate opportunity, the governing person has several factual defenses available. These include the defense that the alleged corporate opportunity was not in the company’s line of business; that the company lacked the funds, personnel or other means necessary to pursue the opportunity; and that the opportunity was not available to the company and could only be pursued by another party. These defenses are fact-intensive, which will require a trial to determine the outcome. To avoid having to prevail at trial in this type of dispute, the majority owner can seek approval from minority partners to confirm that the new opportunity falls outside the company’s line of business, or that it is not available to the company for other reasons.

Conclusion

As private company investors appear to be filing suit more often when disputes arise with the company’s majority owners, there are a number of legal and other strategies for owners to consider when faced with these claims. Based on the substantial expense and distraction of civil litigation, majority owners will benefit if they can work out a prompt resolution of these claims, which may include a structured settlement. When an early settlement is not possible, owners should take the steps necessary to secure indemnification to ensure payment of their legal fees and expenses by the business. Finally, when a reasonable settlement is not achievable with the investor at the outset, the majority owner should evaluate all legal defenses available, as well as potential counterclaims that would allow the owner to take the offensive in the litigation.