Private growth companies have ups and downs – only rocket ships tend to go straight up.  Therefore, it can be difficult for an investor holding a minority stake in a private company to know whether a challenging time for the business represents only a temporary rough patch, or  whether the company’s road to long-term success has become much steeper. This post reviews various problems that arise in business to help minority investors evaluate the impact the company is facing. In most cases, the best approach when a problem arises is for the investor to wait and see if the company mounts an effective response to address the situation. But if the company’s response seems to be digging a deeper hole, seeking a prompt exit from the business may be the investor’s wisest path.

Initial Question – Does the Potential Exist for a Partner Exit?

The first step for a minority investor in evaluating whether it is time to seek an exit from a business is to determine whether this exit right exists in the company’s governance documents or in any agreements that the investor entered into with the other owners of the business. If a minority investor does not have a buy-sell agreement in place that requires either the majority owner or the company to repurchase the investor’s ownership interest in the business, the investor may simply lack the ability to exit the business when desired. We have posted before about the importance of securing a buy-sell agreement or other partner exit plan at the time the investment is made. When an investor has reached the decision to exit the business, the existence of the buy-sell agreement is essential to secure a timely departure on reasonable financial terms.  

For those minority investors who have the right to trigger an exit from the business, the remaining portion of this post reviews a number of problems that can arise during the growth phase of the business, which may cause the investor to decide to exercise that right.

Departure of One or More Company Founders

It is not uncommon for one or more company founders to depart during the company’s growth phase. Some entrepreneurs are simply much better at conceiving of a new, profitable idea than executing on it in a business setting. The peaceful departure of a founder who is not equipped to facilitate the growth of the business could be a positive for the company. This is particularly true when the departing founder retains a stake in the business and remains fully supportive of the business and the remaining or new management team.

In a more dysfunctional scenario, however, a company founder may be ousted due to financial struggles, removed by larger investors, or remain a negative external influence. In this situation, it may seem like the best course is to abandon ship when the founder is removed. But caution is advised, because the larger investor will not want to see its investment in the company squandered. As a result, this large investor may bring in a more experienced management group, oversee a better growth plan for the business, and turn the company around. Thus, before seeking an immediate exit when one of the company’s founders departs under hostile circumstances, the investor may want to allow the dust to settle a bit to see whether the company’s next phase is more promising after new leadership has been installed. 

Entry of New, Larger Competitor in the Marketplace

The early success of the company may attract other competitors to the marketplace, and if so, and some of them may be larger and better funded. Taking on an established competitor can be a very daunting task for a growth company. But once again, jettisoning the investment in the company at the first sign of more seasoned competition entering the marketplace is not advised.  The growth company is smaller and likely to be more nimble, more connected to the customers and vendors, and may be preferred over the larger company. This is another situation where patience is required to see whether the company can withstand and continue to succeed in response to the challenges that are posed by the larger competitor. 

It is not unusual for the larger competitor to realize at some point that it is better to join forces with the growth company than to continue to divide the market. If this happens, and the larger company seeks to purchase its smaller competitor, this would be regarded as a strategic acquisition. This transaction would bring top dollar for the private company and provide the investors with handsome returns. Of course, this will only happen if the growth company is able to continue thriving in response to the competition posed by the larger competitor. 

Government Delays in Issuing Certifications, Approvals or Patents

For companies doing business in regulated industries or that rely on patents to protect their intellectual property, delays by the government in permitting new drug trials, giving FDA approvals or issuing patents can be harmful, if not devastating to the business. But liquidating a private company investment once the news of the delay is received is likely not the best option.  At that point, the company’s value will be at a low point, and an exit at this stage is destined to result in a significant loss. Thus, the investor must decide whether to exit at this low point or to stay the course in hopes that the company can survive the delay, secure a belated approval from the government or await the issuance of a new patent to boost the company’s value.

Assessing Litigation Risk

Another frequent business risk is litigation that embroils the company, and lawsuits can threaten the company both internally and from third parties. By way of example, the founders of the company can become involved in fights over control, the company could be hit with lawsuits by competitors, or the company could become subject to some type of cyberattack resulting in litigation by customers. Each of these lawsuits presents different types of problems to assess, which may be difficult because the investor likely will not have access to all of the facts that are necessary to thoroughly evaluate the risk that the litigation poses to the company. 

In this situation, some important questions for the investor to consider before seeking to exit the business are: (1) Is the litigation an existential threat, i.e., are the claims severe enough that they threaten to bring about the company’s demise or does it present a challenge that can likely be managed by the company’s leaders; (2) does the company have insurance that applies to the claim and the legal defense costs (claims that are covered by insurance pose far less risk for the company); and (3) is the company functioning on a business as usual basis while the litigation is ongoing, or is the litigation such a large distraction that is having a direct, negative impact on the company’s performance? Securing the answers to these questions will help the investor to decide whether the company can ride out the storm of the litigation or whether getting out before the litigation concludes is the right option, which would be before things become even more dire for the business.

Conclusion

Growth companies are successful not because they have no problems, but because they have learned to overcome their challenges. Investors in these companies also need to decide whether their company and its management team are built to last, or whether the company lacks the resources or the leadership skills necessary to survive over the long haul. If the company is responding effectively to the types of problems discussed in this post, it may be best to stay the course, but if the company is struggling to overcome them, the investor may need to exit and find a better opportunity in which to invest. Many investors refer to the “eye test,” as in don’t deny what your eyes are seeing when the bloom has come off the rose. 

The public markets were down last year, and private company values also took a hit. So, is now a good time for a new investment in a private company? The best answer is it depends.  There is never a bad time to invest in a great company, and when the value of a terrific business is lower in a tough business cycle, it is a superb investment opportunity. Before making a new private company investment, however, it is wise to consider if there are red flags, because the risks involved in private company investing are notable. According to LendingTree, 18.4% of private companies based in the U.S. fail within just one year, 49.7% go out of business in five years and by year 10, 65.5% have failed. This post reviews some of the red flags that should be carefully assessed before making a new private equity investment.

Lack of Transparency in Financial Reporting

The first red flag may be the condition of the company’s financial books and records. If the company’s financial reports don’t clearly set forth how well the company is performing, and a potential investor cannot discern whether the company is flourishing or floundering, that is a major concern. The basic questions to ask include:  (1) Are the profits or losses of the company clearly stated in its financial reports; (2) does the company work with a reputable outside accounting firm or does it handle all of its finances and taxes internally; and (3) does the company have a strong CFO or controller who presents the financial condition of the company in plain terms?

If the answers to any of the foregoing questions is no, that is a red flag. If the company’s financial reports are muddled, if the company has no oversight from outside, experienced CPAs, and if there is no one at the company with a strong grip on its finances, it is not reasonable for an investor to expect that these troubling issues will suddenly improve after the investment is made.

Declining or Inconsistent Profit Margins

When the financial reports are clear but they reflect that the company’s profits are not stable, that is as serious a concern as having poor financial reporting. Ideally, investors want to see profits rapidly increasing, or at least trending upwards. Startup companies often take time to become highly profitable, however, and that will require the investor to review the company pro forma to understand the critical factors that will lead to profitability. For example, the company may project it will become profitable when certain key hurdles are reached, such as securing a contract with a major client, achieving a certain level of visits/traffic to the company’s website, obtaining a patent on its key product or securing a license agreement on an existing patent.

The investor will need to decide whether to make a riskier investment before the hurdle has been achieved, or to wait until the milestone is reached before coming on board. That delay, however, may make the investment more costly or unavailable. Once the hurdle has been cleared to profitability, the company may no longer need the investment, or the price of investing may have increased substantially as the company’s value increased. This is a classic risk/reward scenario that the investor will need to carefully evaluate, with input from company management to determine whether the hurdles are legitimately within reach before the investment is made.

Rapid Employee Turnover

When employee turnover is high, this is an important red flag. It suggests that there are a host of problems at the company, including leadership problems, lack of strong company culture and an inability to scale the business over time. Determining the reasons for the turnover require more due diligence to be conducted to determine what types of employees are leaving (are they actual employees or contractors), why they are departing, how quickly they can be replaced and whether the problems that caused them to leave can be fixed.   

High Client Concentration

If the company’s success is pinned to just a small number of clients, that is yet another red flag to consider. If the loss of a single customer would send the company into a tailspin, that makes the investment more high risk. Follow-up questions would therefore include (1) whether the company’s major clients are subject to long-term agreements or whether they have the ability to opt out of the agreement at any time; (2) what is the likelihood that the company can diversify its client base over time; and (3) what contingency plans does the company have, if any, in the event that it were to lose one of its largest clients?     

Relative Access to Capital

The goal of investing in private companies is to secure a robust return, which is based on the future growth of the business. For the business to grow requires it to have access to capital, and a critical question, therefore, is whether the company has the ability to access the capital that it will need to fund its growth curve. This capital could be in the form of borrowing, such as a line of credit, from existing investors who have committed to fund the company’s growth, or from an expected round of additional investors. This additional investment will then have a dilutive impact on the investor’s ownership. The investor needs to consider whether future dilution is a risk worth accepting or whether it should seek anti-dilution protection.

Before making the investment, the investor needs to understand what specific access to capital is actually available to the company. Many companies with potentially bright futures have been derailed when they were not able to access capital at a critical point. By the time that they obtained the necessary capital, other better-funded competitors in the same space leapt ahead and they were never able to regain their traction. If the company is unwilling to discuss its plans for growth and its ability to access capital in the future, that is another red flag. 

Conclusion

Private company investing comes with an inherent degree of risk because most private companies do not stand the test of time to survive past ten years. An investor, therefore, has to be willing to accept a relatively high degree of risk in pursuing outsize returns, but some of this risk can be reduced if key red flags are noted and the concerns that they present are addressed. If the investor’s due diligence confirms that the company’s financial reporting is sound, that its profits are supportable and trending upward, and that it has the ability to secure the capital necessary to fund its future growth, this may be a risk worth taking.

Following a challenging year for business owners, the time to decompress and celebrate with family and friends this holiday season provided a necessary respite. When business resumes, however, there are important action items for majority owners to consider implementing in the new year. This post reviews several steps business owners can take to position the company for future success by streamlining operations and avoiding internal partner conflict.

Resolution No. 1: The Buy-Sell Agreement/Partner Exit Plan

Ideally, majority owners negotiated and adopted the terms of a buy-sell agreement at the time they brought any minority partners into the business. If that did not happen, this discussion reviews the business issues that majority owners need to address in planning for the potential future exit of minority partners. The take-away here is that even when partners did not enter into a buy-sell agreement when the minority investment was made in the company, co-owners in the business continue to share a mutual business interest in putting this type of agreement in place.

For the majority owner, the Buy-sell agreement provides assurance that he/she will have the right to buy the minority partner’s interest in the company if this partner becomes a problem in the future. Specifically, if the minority partner becomes dysfunctional and/or disruptive to the business, the majority owner can exercise a redemption right that requires the minority partner to transfer his/her interest to the company (or to the majority partner). For the minority partner, if the majority owner takes the business in a wayward direction, the minority partner will want to exercise a buyout right to secure repurchase of his/her interest in the company.

Putting in a buy-sell agreement after the investment has been made often works best if the co-owners adopt a delayed trigger for exercising the buy-out right. Under this option, the majority owner has the right to exercise a redemption right to purchase the minority interest, and the minority partner has the right to demand the purchase of his/her interest. Because the parties agree to a delayed trigger, neither partner will be permitted to exercise the option for a specified number of years after the Agreement is signed. Thus, in perhaps 2 or 3 years, and after the party who is exercising the option provides advance notice (usually at least three months), either the majority owner can exercise the option and redeem the minority partner’s interest or the minority partner can exercise the option and demand a buyout of his/her interest. The partners will also need to reach an agreement on how the the minority interest will be valued when the option is exercised, and the purchase terms, i.e., the buyout term, the interest rate and how collateral will be handled.

It is also crucial for the minority partner to require a “look back provision” to be included in the buy-sell agreement, which will apply if the company is sold within a set period (often six months to a year) after the majority owner has exercised the option to buy the minority partner’s interest. Under this scenario, if the majority owner buys the minority partner’s interest and then sells the company for a higher price within the look back period (six months to a year), the look back provision will require the majority owner to issue a “true up” payment to the minority partner. The purpose of the true up payment is to prevent the majority owner from buying the minority partner’s interest for a low amount and then quickly selling the company for a much higher value. Stated another way, the look back provision protects minority partners from a quick, post-transaction sale by the majority owner that saddles them with a low value.  

Resolution No. 2: Review/Revise the Company’s Governance Document

As the new year begins, the majority owner may realize that a lot of time has passed since he/she last reviewed the terms of the Company’s governance document or requested outside counsel to do so. The company bylaws (for corporations), the company agreement (for LLCs), or the partnership agreement (for limited partnerships) may need serious updating in a number of important respects. The entire agreement should be subject to review, but some of the key provisions that should be re-examined are highlighted below.

  • The size of the company’s board or the number of managers may need to be increased to allow for the inclusion of more expertise and knowledge on the board, the length of the terms for board members may need to be shortened or extended, and the schedule and arrangements for the governance meetings may also need to be revised.
  • The company board or managers may need an expanded scope of liability protection. Certain types of fiduciary duties that are imposed on directors, officers or managers can be eliminated or reduced depending on where the company has its principal place of business. For example, governance document can expressly provide governance persons with the right to engage in certain transactions with the company that would otherwise be viewed as subject to a conflict of interest.
  • Similarly, the scope of the indemnity provided to directors, officers or managers may need to be expanded to provide more protection. Related to indemnity protection, the majority owner should meet with the company’s insurance broker to discuss the scope and amount of insurance coverage for officers, directors and managers, and confirm who is subject to coverage under the scope of the existing insurance policy.
  • The process for amending the company’s governance document is often overlooked, but it may become critical if a dispute arises between the co-owners. Once a conflict exists, amending the agreement will be difficult, if not impossible. The majority owner will want the right to amend at least some terms of the governance document based on the ownership of a majority interest in the company rather requiring all amendments to the controlling document to be subject to a unanimous vote of the company owners.
  • The existing governance document is likely to require that disputes between co-owners be subject to litigation. If so, the majority owner may want to transition to a new dispute resolution procedure that requires arbitration of disputes rather than litigation. This is not to suggest that arbitration is always preferable to litigation, but there are attributes of of an arbitration proceeding that may make it more consistent with the majority owner’s business goals. Some of these attributes are noted below:
  • The arbitration provision can include a “fast track” requirement that requires the arbitration to be held on an expedited schedule that is much faster than litigation
    • Arbitration provisions can also limit depositions and the extent of discovery
    • Legal fees incurred in arbitration are usually recoverable by the prevailing party
    • Arbitrations are conducted in private – the filings are not publicly available
    • Arbitrators are experienced lawyers rather than lay people who serve on juries
    • Arbitration results are final – there is no right of appeal

The majority owner will want to discuss the pros and cons of litigation versus arbitration with counsel before making any change to the dispute resolution procedure. The decision will consider a few key factors, including: (i) whether the majority owner expects to be the plaintiff/defendant in litigaiton or claimant/respondent in arbitration. (ii) whether confidentiality is important in resolving the conflict. (iii) whether completing the dispute quickly is important, and (iv) whether the majority owner would prefer the claims/conflict to be decided at trial by a jury rather than by a panel of arbitrators.

Valuation of Company: Start the Process/Set the Standard

The majority owner may want to consider securing an annual company valuation that is provided to all owners of the company. This existence of this annual valuation will be helpful in any future conflict with the minority partner after the buy-sell agreement is triggered. When the company has a track record of issuing annual valuations for years without objection, it will be much harder for minority partners to effectively challenge the amount or the methodology that was used to value the Company. If the partners do agree to rely on on the annual valuation as the benchmark for determining the value of the business once the buy-sell agreement, this should be referenced in the provisions of the Agreement.

Further, if this annual valuation is adopted, it is not necessary for the majority owner (or the company) to incur the expense of retaining an outside business valuation expert to conduct a new valuation each year. Instead, the partners can retain the expert just one time and then have the company’s Board or managers update the various inputs each each year for the next 3 or 4 years. Then, every third or fourth year, they can bring back the valuation expert to conduct a more thorough valuation. Alternatively, the partners can adopt a formula to determine the company’s value each year.

As just one example, they can select a multiple or a percentage of the company’s annual revenues to determine its value. The value could be based on: (A) 1.5 times the revenue of the company or (B) 25% of revenues up to a certain amount and 15% of revenues above that set amount. Thus, this formula could be 25% of revenues up to $50 million and 15% of all revenue above that amount. If the company generated $100 million in revenue, it would have a value of $20 million (25% x $50M = $12.5M + 15% of $50M = $7.5M for a total of $20M). Valuation experts use earnings multiple more often than revenue multiples, but earnings are subject to manipulationand ,therefore, using revenues is a more reliable indicator of value.

Finally, to avoid disputes about valuation, the partners may choose to use three years of data rata rather than a single year when determining the company’s value because a single year could skew the data in one direction or the other. Using three years of financial data should help smooth out the valuation to provide fairness to both sides. This is especially true if the parties are using a December 31 valuation date to determine value and one of the partners triggers the buy-sell agreement in September resulting in a buyout later in the year. The partners can either agree to update the figures when the buyout takes place after June 1 of the calendar year, or they can agree that the December 31 financial figures from the previous year will be used without any updates regardless of when the buyout right is exercised. But the valuation will still encompass data from the previous three years.  

Conclusion

When the toasts are completed and 2023 begins, majority owners would be wise to give thought to action items that will help position the business for success for years to come. These include negotiating and implementing the terms of a buy-sell agreement with all co-owners of the business, reviewing and revising the company’s governance document and putting in place a process for issuing annual company valuations. These are all significant steps to pursue and the goals are to avoid or limit future conflicts between business partners, to streamline the business for efficiency and to adopt good governance practices.