Business owners looking for minority investors are much more in control, before and after the sale.

March 01, 2016

If a business owner you advise is considering strategic alternatives for his or her business, taking on a minority investor may be an option worth considering. The big questions for the business owner are likely to be: “How much control of the business will I retain once I sign this deal?” and “Is it worth it given the amount of proceeds I’m likely to receive?”

For decades, the answer would have been “Not as much control as I’d hoped, relative to how little I received” because the vast majority of private equity (“PE”) firms would insist on “control-like” clauses and/or deeply discounted valuations.

Traditionally, business owners have viewed minority investments as a bit of a trick bag. Its name implies that the majority shareholder would be, in theory, the controlling party. Yet many owners have discovered the opposite — the fine print in an agreement allowed the minority stakeholder to effectively run the business.

Today, the tables have turned due to post-recession market trends. Investors are now embracing the idea of true non-control minority stakes because there is so much competition for investments in successful private companies. In addition, valuations in many industries are at historic highs.

As a result, business owners looking for minority investors are much more in control — before and after the sale.

If you advise business owners, this article will help you understand how these compelling new dynamics might fit into their transition plans.

More Deals, Higher Valuations

The reason investors and owners are now closing so many non-control minority deals is because a flood of new money into the market has created an imbalance between potential investors and attractive private business opportunities.

This increased demand has its roots in the hundreds of billions of dollars parked in 401(k)s, pension funds, insurance annuities and similar vehicles.

When investment houses like Fidelity, CalPERS, Northwestern Mutual and their peers receive such funds, they primarily look to re-invest them in the following asset classes:

  • Public equity and/or debt markets
  • Real estate, foreign exchange, commodities
  • Private equity (companies either in venture/growth stage or mature businesses)

PE investments typically are categorized as “alternative” investments and provide a means for fund managers to diversify beyond traditional publicly-traded securities in hopes of generating higher returns. Fund managers typically allocate just 2% to 5% of their total assets under management to alternative investments, but over time, as the aggregate amount of capital under management has grown, so has the total number of dollars earmarked for PE.

As more capital has been committed to PE, two things have happened:

  1. PE firms have come under increasing pressure to deliver the returns demanded by their own investors; and

  2. Competition for available private company investment opportunities has intensified. There are nowhere near enough M&A investments available to satisfy this entire need, which has kept a lot of money on the sidelines.

As a result, there’s a buildup of cash that’s ready to invest. Commonly referred to as “dry powder,” this buildup currently is estimated to exceed $500 billion (see Figure 1).

The imbalance between potential investors and available investments also has pushed valuations for mid-market businesses to higher levels. In the last two years, valuation multiples have reached — or exceeded — pre-recession levels in most industries (see Figure 2).

For PE investors who need a place to invest their money, minority investment is often a preferred alternative to paying an exorbitant valuation to buy a company outright.

This confluence of events has put the owner of a successful business in an enviable position, with many potential suitors who are willing to get creative so they can close a deal.

When a Minority Investment Makes Sense

Owners typically contemplate bringing on an investor because they are:

  • Considering transitioning from the business; or
  • In need of an infusion of cash to buy new equipment, expand their business, or help it survive during challenging conditions; or
  • Diversifying their net worth and/or seeking to realize some of their monetary gain.

Once a minority investment deal is complete, the business owner may discover the potential to build a partnership with the new investor, working together to add value to the company with little uncertainty about who is in control.

That was the case with an emergency air transport company that took on a minority investor in New Heritage Capital. It was important for the company to let its employees, suppliers and major customers — hospitals — know that the founder-owner was still calling the shots.

“It’s an active partnership,” said Michael O’Brien, Vice President at New Heritage Capital in Boston, which has partnered with founder- and family-owned businesses since the 1990s on investments in which owners do not cede majority control.

A sale of a non-control minority stake can:

  • Provide liquidity and enable shareholders to diversify their personal net worth
  • Allow majority shareholders to maintain control over much of the company’s major decisions; sometimes this is possible even if the owner cashes out for more than 50% of the company’s value
  • Often generate more proceeds than via a leveraged recapitalization
  • Preserve the company’s culture and provide stability during the transition, and possibly allow increased investment in the business thanks to the added capital (to the extent proceeds are reinvested in the business)
  • Bring in a shareholder with valuable industry expertise and contacts
  • Manage potentially divergent financial planning objectives of multiple shareholders

Even if the goals of the owner and the investor partner eventually diverge, the owner still can come out ahead. For example, if the owner sells 40% of the business at current historically high valuation levels, those proceeds will still be in the majority owner’s pocket even if the business goes in a negative direction down the road.

Planning Is Crucial

Owners need to understand the many financial, operational and legal considerations that must be addressed well in advance of taking on a minority investor, many of which can dramatically affect the value of the business and the ease of the transition.

Here are some of the possible “staging” actions that can make the business more attractive to potential investors and maximize the economics for the owner:

  • Evaluate management strengths and structure, and fill any critical gaps (or identify action plan)
  • Conduct financial audits
  • Quantify customer / supplier concentration and pursue strategies to diversify revenue / procurement
  • Define key operating metrics and implement systems to regularly track them
  • Analyze material contracts to surface unexpected covenants and required consents, and pursue ways to mitigate uncertainty
  • Clean up the balance sheet (i.e., related-party arrangements; bad debts; obsolete / slow-moving inventory; etc.)
  • Identify and evaluate outstanding litigation and other potential contingent claims, and pursue strategies to resolve or mitigate their uncertainty

A Financial Advisor’s Essential Role

A trusted financial advisor can help an owner and the owner’s current advisory team with planning and preparation before reaching out to potential investors.

A financial advisor will:

  • Help owners determine which investment alternative is best for them
  • Bring expertise about market terms for various alternatives
  • Develop a roadmap for the transition and an action plan
  • Assist owners in crafting the company’s “story,” casting the opportunity in the clearest light, and anticipating potential questions
  • Solicit suitors and compare / contrast them
  • Facilitate the due diligence process
  • Lead or assist with negotiating an optimal outcome

It’s important to select an advisor who understands and honors an owner’s needs because many financial advisors have a deal-first mentality. Most are transaction-driven and tend to polarize the options, ignoring the possibility of an alternative minority sale or other more nuanced solution, potentially to the owner’s detriment. They may focus on the most routine, “one-size-fits-all” alternatives, especially those which can be consummated the quickest and/or most easily for the advisor.

The right financial advisor will be smart about the business, the industry in which it operates, its capital structure, what alternatives are available in the marketplace and their prevailing market pricing, thereby ensuring the recommended transaction solution is based solely on the owner’s requirements and is in their best interest.

Ultimately, a financial advisor’s success is based on orchestrating a structured process in which the owner can select the best partner based on agreed-upon criteria. When that happens, the owner won’t have any surprises once the deal is consummated.

Stout’s focus is on empowering the owner and taking the long view. The ideal scenario for all involved is when we’re consulted early in the process — the point at which you start thinking about a transition but before any action has started.

Our approach is better for businesses and owners because we’re willing to be involved all along the way. As we discussed in this report, there are many preparatory steps that need to take place many months, or even years, ahead of time. We want to help with that planning and transition.

R. Ed Nichols