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Entrepreneurs are incredibly devoted to the success of their business, but even a thriving company may be severely impacted by a high conflict marital divorce. When a couple decides to part ways, the ripple effects can extend beyond their personal lives and potentially jeopardize the business they worked so hard to build. Although the couple may have irreconcilable conflicts that require a divorce to take place, preserving the value of their business should be a mutual goal. While their marriage may not be salvageable, both spouses share an interest in maintaining the success (and the high value) of their company as they go through their divorce. 

The Cost of Business Disruption in Divorce Actions

When divorce proceedings become contentious, the business in which the marital estate has an ownership interest may experience negative effects as a spillover from the conflicts that take place during the divorce process. The potential adverse consequences to the business may include all of the following:

  • Decreased productivity due to owner distraction
  • Uncertainty and reduced morale among employees
  • Loss of clients and loss of new business opportunities
  • Substantially larger legal and professional fees
  • Possible forced sale or liquidation of the business

These adverse factors can significantly reduce the business’ value, which can negatively impact the financial outcome for both spouses in their divorce. The elephant in the room here may be a cynical view that is held by the spouse who is seeking to acquire the interest held by the other spouse in the business in the divorce settlement. That spouse may believe that having the business crater during the divorce will allow the interest to be purchased for a below-market value and then the business will snap back to its true value once the divorce becomes final.

This self-serving view does not square with reality, however, for the following reasons. First, if the spouses do not shield the business from the conflicts inherent in the divorce, the negative effects are likely to be long-lasting with employees, customers and others, some of whom may depart or decline to do business with the company after the divorce. Second, the company’s competitors will see the business as weakened by the divorce and exploit this time of weakness. If the company loses market position during the divorce, this loss may not be readily regained once the divorce has been completed. Finally, a spouse who presents the company as having a steep loss in value to secure a lowball purchase price in the divorce may be opening the door to other negative outcomes, i.e., unintended consequences. These could include a lender declaring an event of default based on the company’s poor financial condition, the divorce court awarding the business to the other spouse, dealing with a hostile takeover attempt launched by the other spouse either alone or with employees and/or other investors, or the business being required to liquidate as problems cited by the spouse seeking a low-ball purchase price spin out of control.

The takeaway here is that a spouse seeking to purchase the interest in the business held by the other spouse is better off purchasing that interest by structuring the payment based on the company’s true fair market value. This avoids creating the potential for long-term damage to the business. In addition to the factors noted above, the divorce also likely impacts third parties, as well as the spouses themselves. Forbes reports that of companies that have more than 500 employees, almost 87% of them are privately held. Of companies this size, many, if not most of them, have multiple owners. When a divorce has potential negative consequences for other partners in the business, the stakes become even higher, because the other partners do not want their business dragged into a marital dispute. This multi-faceted ownership structure adds another layer of urgency in securing a prompt and amicable resolution of the business issues in the couple’s divorce.

Charting a Path to a Win-Win Outcome

While the risks to the business are significant in any high-net-worth divorce, there are steps the divorcing couple can take to achieve a positive outcome for their business for their mutual benefit. This type of win-win resolution is possible when the spouses seek to achieve a divorce that preserves the value of the business by taking the approach outlined below.

  1. Prioritize Business Continuity: By maintaining the value of the business as their goal, this allows both parties to maximize their outcome. This requires the parties to keep the business running smoothly during the divorce, including by keeping matters related to the divorce as private as possible. While the spouses likely have serious issues with the other spouse that led to the divorce, these marital conflicts should not be shared with others who are active in the business, because it may disrupt the business. The message from the couple needs to be that they share a common desire to see the business continue to thrive during and after their divorce.
  2. Obtain Valuation Result Without Trial: While it would be ideal for the couple to retain just one neutral business valuation expert to determine the company’s fair market value, that is not likely in the real world. Invariably, each spouse will want to retain their own valuation expert, but if they allow a dispute over the value of the business to become a battle of the experts that goes all the way to trial, that will prolong the divorce at great expense and also provide financial information about the business to competitors during the divorce proceeding. To avoid this unwelcome outcome, the couple can consider other options. They could agree to allow their valuation experts to decide on a third expert to value the business and then average the amount of all three valuation reports, or they could allow the court to appoint a third valuation expert who considers the other two reports and issues a final, confidential valuation report to which they both agreed to be bound.
  3. Consider Creative Buyout Structure: To avoid a valuation fight that requires a full buyout upon settlement of the interest of one spouse, the couple could agree that one spouse will become the majority or the sole owner of the business, but the other spouse will retain either a minority equity interest or continued contract rights in the business that provide for the departing spouse to receive additional financial returns over time. This could involve the spouse who sells the interest in the business to receive:
    • An initial down payment
    • Additional installments paid over time
    • A profit or revenue-sharing arrangement, which is a form of earn out based on the future performance of the company
    • An option to sell the minority stake in the future – a put right that requires the majority owner to buy this minority stake when the option is exercised
  1. Protect Other Stakeholders: If there are other business partners in the company, they can be involved appropriately in discussions about the company’s future, but in a private manner that ensures continued confidentiality. This buy-in of other partners who will support the creative buyout structure of a spouse’s interest in the business could be crucial for the company’s continued success.
  2. Plan for Tax Implications: Work with tax professionals to structure the settlement in a way that minimizes tax burdens for both parties.
  3. Maintain Open Communication: Strive for transparency and regular communication throughout the process. This can help prevent misunderstandings and build trust.
  4. Focus on Long-Term Value: Rather than seeking short-term gains, the spouses should consider the long-term potential of the business and structure a purchase that provides for a fair return over a time that extends beyond the divorce. A thriving business after the divorce can provide ongoing benefits to both parties.
  5. Seek Experienced Legal Counsel: Finally, engage attorneys who are experienced in high-net-worth divorces involving the division of complex business assets. This type of expertise and creative problem-solving can be invaluable in achieving a win-win resolution. Now is not the time to retain counsel to handle their first rodeo.

The goal of these strategies is to achieve a divorce settlement that is less contentious, more prompt, and more cost-effective, which will preserve the value of the business for the benefit of both spouses. Taking a  collaborative approach in the divorce proceeding not only protects the assets for both spouses, but it can also reduce the emotional and financial toll of the divorce process.

Conclusion

A high-net-worth divorce that involves the transfer of business assets in a settlement is a complex exercise, but it does not have to destroy the company’s value. If the couple can focus on securing a realistic valuation of the business, explore creative buyout options for the purchase/transfer of the interest owned by one spouse in the company, and prioritize the continued profitability of the business, they can achieve an outcome that is a true win-win. This approach will preserve the value of their hard-earned assets, and also set the stage for the continued success of the business.  The continued vitality of the business may be important if the divorce settlement provides for both spouses to receive financial returns based on the company’s future performance.

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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.