The Hidden Pitfalls of a Minority Deal When Selling Your Company
- Why founders' expectations of minority deals are often wrong
- How investors use protective provisions to assume greater economic and decision-making control
When founders look to raise capital and/or sell a portion of their business to de-risk their personal wealth, many will lean towards carrying out a minority deal.
A minority deal is when founders sell a non-controlling stake (less than 50%) of a company to investors.
In pursuing a minority deal and maintaining majority equity ownership, founders are usually trying to:
- Maintain control of the business
- Take advantage of current growth and future upside in their equity ownership
What many founders don’t realize is that minority deals are one of the most dangerous deal structures a founder could consider.
The Dangers of a Minority Deal
Founders often paint a simple picture of the minority deal: "If I own more and I retain control of the business, that’s good for me as a founder." As a result, they rule out other transaction options (like a majority deal or full sale) altogether.
But owning more of the business isn’t necessarily good. Minority deals are dangerous because they result in limited personal liquidity. When a founder has too much of their wealth tied up in a single business, then an unforeseen downturn could take the founder’s wealth with it.
In addition, the scope of minority deals (and the level of control for founders in each) is significantly broader than most founders realize. There are at least 15 contract terms specific to minority deals that range from highly seller-friendly to highly investor-friendly. These terms can significantly impact founder control and exit economics post deal, independent of equity ownership.
At the most basic level, the "I own more and I’m in control" story is flawed. Equity ownership on the cap table is not the only determinant of control and economic rewards upon exit. If founders aren’t aware of the different structures of a transaction, they may unknowingly give up control or effective ownership of the company.
How Founders Unknowingly Give Away Economic Rewards to Investors
Even if you’re able to secure a great valuation for your business, if the structure of the transaction is too investor-friendly, you may be giving up a greater percentage of the economics than your cap table would indicate.
Two primary ways founders unknowingly give away economic rewards to founders are through security structure and liquidation preferences.
Security structure refers to the nature of the shares sold to investors.
Investor shares are almost always issued as preferred stock, meaning that these shareholders are paid first in a liquidation event. But these preferred shares can take many forms, such as:
- Convertible preferred
- Participating preferred
- Capped participating preferred
- Uncapped participating preferred
- Convertible preferred with dividends
- Participating preferred with caps and liquidation preferences
- And more
Each form has different features that determine who gets how much in the final sale of the business. The below example will expose how differences in structure can have a strong effect on outcomes.
Example: Convertible Preferred vs. Participating Preferred
Consider two security structures (among many) for preferred shareholders: convertible preferred vs. participating preferred securities.
A convertible preferred security enables investors, upon a liquidation event, to either:
- Convert their preferred stock to common stock and receive their consideration from the liquidation in proportion to their equity ownership
- Receive back their initial investment amount at their predefined liquidation preference (more on this later)
For example, consider a scenario where an investor purchases $25M of a company valued at $100M.
In the event the company later sells for >$100M, the investor would convert their preferred stock into common stock and cash in on their 25% stake for a positive return.
But if the company sells for <$100M, then the investor’s 25% share would be less than the original $25M investment, in which case they would opt to receive their initial $25M in return.
Even though investors have downside protection in this case, a convertible preferred structure is considered relatively founder-friendly as the goals of both investors and founders are aligned to grow the business.
A participating preferred security, on the other hand, is highly investor-friendly. Participating preferred securities entitle the shareholder to receive back their initial investment and then their consideration from the liquidation in proportion to their equity ownership.
For example, considering the same investment details from above ($25M investment for 25% ownership), if the company went through some hard times and sold at $75M and the investor held participating preferred securities, the investor would get back:
- Their initial $25M investment
- 25% of the remaining $50M, or $12.5M
In total, the investor would get back $37.5M upon liquidation—50% of the total transaction, despite only owning 25% of the company.
If that same $100M company instead sold for $200M, the investor would get back:
- Their initial $25M investment
- 25% of the remaining $175M, or $43.75M
In this case, the 25% ownership in a participating preferred would equate to roughly 35% of the economic rewards.
Looking at the numbers, you likely now can see why security structure is just as important (if not more) than the valuation itself. Unfortunately, contracts will never demonstrate the effects of security structure, only declare the security type.
Liquidation preferences are a way for investors to protect their upside and they play an important role in determining economic rewards upon liquidation.
Liquidation preferences are often expressed as a multiple ranging from 1x-3x and determine how much an investor gets back from their initial investment upon liquidation.
Going back to our same example, if our above investor had convertible preferred securities with a 2x liquidation preference and the company went down in value, then the investor would be entitled to 2x their initial investment, or $50M.
Liquidation preferences don’t just benefit investors if the business goes sour. Depending on the size of the multiple, investors may exercise their preference and take a greater portion of the economics at liquidation when a company increases in value.
Be careful about structure as a founder
Combined, security structure and liquidation preferences can have a dramatic impact on how economic rewards are doled out to founders and investors upon liquidation.
The greatest challenge with these structures is that purchase agreements between founders and investors don’t outline the economic outcomes mathematically. Instead, the contracts use cryptic legalese whose implications may not be obvious to the average founder.
The above tactics aren’t the only ways an investor might protect their minority interest. See the appendix of this article for 8 other financial terms affecting the allocation of and access to economic rewards.
The best way to avoid falling into the above or similar traps is to hire a professional investment banker who understands the implications of various structures of a transaction.
How Founders Unknowingly Give Away Control to Investors
Another tenet of the minority deal philosophy is that founders don’t want to relinquish too much control to investors.
One issue with this viewpoint is that even investors with minority stakes will influence your business. To some degree or another, investors will sit on your board and participate in decision-making.
In addition, when bringing on an investor, ideally you will be bringing on a partner who you can trust to build your business with you.
That being said, you want to be aware of how much control investors receive—you as a founder are responsible for understanding the terms of your agreement (called protective provisions) so you’re not caught unawares later on.
Understanding protective provisions
Protective provisions give rights to investors with a minority stake. These provisions are an investor’s way to ensure a seat at the table when important business decisions are made, as investors will typically not have control of the company or board.
Most of the rights provided by protective provisions are negative and not affirmative, meaning minority investors will not have the right to make founders do things, but instead the right to prevent founders from doing things.
These rights usually cover business decisions that would effectively change the inherent value and structure of investors’ securities or remove power from the minority shareholder.
Specifically, standard protective provisions give investors the right to veto any action that:
- Alters or changes the rights, preferences or privileges of preferred shareholders
- Increases or decreases the number of shares of both common and preferred stock
- Creates or issues any new class or series of shares (excluding stock options)
- Results in the redemption or repurchase of any shares of existing securities
- Results in the liquidation, dissolution, or winding up of the company
- Results in a merger, reorganization, or change in control of the company
- Sells significant assets of the company
- Changes or waives any provisions in the company’s certificate of incorporation or bylaws
- Results in the acquisition of another company or its assets
- Changes the size of the company’s board of directors
In an investor-friendly contract, the above protective provisions would be standard no matter what.
However, sellers with leverage to negotiate can work on limiting the list of provisions or aspects of a provision to make the terms more founder-friendly.
Avoiding Unforeseen Pitfalls of Selling Your Business
As a founder, you’ve likely never sold a business before, so you can’t be expected to understand all these complicated legal terms and provisions up front.
Your investors, on the other hand, have done deal after deal, and as a result have the experience to know which terms will best protect their interests. You can believe they’re going to do just that.
Your best strategy for protecting your interests, in a minority deal or otherwise, is to get some expertise on your side of the table by hiring an investment banker who understands the terrain.
Below are some other contract terms where an investor might be over-reaching and where you can push back as a founder.
Investor-friendly dividend rights help provide additional downside protection for investors by guaranteeing a return on investment at the dividend rate. These dividends would be paid out at the end of each fiscal year or as otherwise indicated in the investment agreement.
Several features of dividend rights include:
- Cumulative vs. non-cumulative
- Simple vs. compound accrual.
Cumulative vs. non-cumulative. A cumulative dividend does not need to be paid out at the end of each dividend period, but the dividends accumulate to be paid out upon a liquidation event. Cumulative dividends paid at liquidation give investors a larger chunk of the final economics.
A non-cumulative dividend for preferred stock would not accumulate if the company’s board did not declare dividends for common stock and would be forfeited. Essentially, a non-cumulative dividend ensures preferred shareholders only receive dividends when common shareholders are. For deals Vista Point runs, dividend rights are always cumulative.
Simple vs. compound accrual. For cumulative dividends, they may accrue interest at the dividend rate either on a simple basis or a compound basis on cumulative, unpaid dividends.
As explained in the main article, participation rights give investors the right to participate in the distribution of economic rewards on a pro rata basis above and beyond the rewards from their liquidation preference.
A common feature of participation rights is a cap, which limits the total return a preferred shareholder can earn on top of their liquidation preference. This cap will create a break-even point where the preferred shareholder would convert their preferred shares to common shares.
Redemption rights give preferred shareholders the ability to require the company to repurchase the preferred securities after a predetermined time frame, typically 5 years. These rights give investors a way out of the investment without a liquidation event.
The purchase price of the preferred shares can be determined a variety of ways:
- At fair market value (FMV). In order to sell shares at FMV, the contract would need a protocol to determine FMV through a third-party. Investors often ask FMV not include discounts for lack of marketability or minority share, which can decrease share price by 20-30%.
- At their liquidation preference amount, based on the structure of their securities.
- At a pre-determined or fixed dollar amount. This amount would be outlined in the investment agreement.
Anti-dilution provisions protect investors from losing equity ownership if the target company raises future financing at a lower valuation (known as a "down round").
Consider a scenario where an investor puts $10M towards a company valued at $90M pre-money, purchasing a 10% stake. If that company experiences hardship and later needs to raise new financing at a $50M valuation, then $10M of new financing will own more of the company than the original investor’s $10M (now worth $5M). In this case, their ownership would go from 10% ($10M/$100M) to 8.3% ($5M/$60M). Anti-dilution provisions help protect investors in such a case.
Two categories of anti-dilution provisions are full ratchet and weighted average.
Full ratchet anti-dilution converts the original price of the preferred stock to the conversion price of the new round. For example, if the above investor had full ratchet anti-dilution, their equity ownership gained by their initial $10M investment would be recalculated based on the new conversion price (valuation). Full ratchet anti-dilution can dramatically dilute the value of common stock shareholders, mainly founders.
Weighted average anti-dilution is more founder-friendly, as it effectively reduces the conversion price (compared to full ratchet anti-dilution), which prevents excessive dilution for founders.
Registration rights give minority shareholders the right to convert their preferred shares into common shares and then require the company to appropriately register those shares. Registered shares are available to trade, meaning the investor could force an IPO even with only a minority stake in the company.
An investor-friendly agreement would make registration rights available after a given time period (3-5 years). A founder-friendly agreement would only allow for conversion from preferred to common stock following an IPO.
Right of first offer
The right of first offer is a feature that allows preferred investors to purchase their pro rata share of any new issuance of securities by the target company. While not too much of a problem, the right of first offer creates an obligation to one party when selling a portion of the bueinss, which is never ideal.
An investor-friendly agreement would give an investor the right of first offer with no penalty for electing to not exercise that right.
Founders prefer a pay-to-play arrangement, where if investors don’t exercise their right of first offer, their shares are converted to common stock and they lose the opportunity to participate in future issuances.
Right of first refusal and co-sale
Right of first refusal gives investors the right to match any offer to buy stock that a common shareholder wishes to sell. This right can make selling an asset difficult because buyers don’t like having to defer to another buyer at each bid, particularly when the buyer is putting forth significant resources to evaluate a deal. Investors, however, like this clause because it helps them keep ownership out of the hands of investors they don’t care for.
Watch out for the right of first refusal, as it can be a major deterrent keeping buyers from participating in a process.
Often connected to the right of first refusal, the right of co-sale allows an investor to piggyback on the sale of stock, meaning they can sell their shares at the same price the founder negotiates on. Right of co-sale doesn’t negatively affect founders.
Drag along rights are a feature that allows an investor to force the sale of a business. An investor-friendly contract would include the absolute right to force the sale, while a founder-friendly contract would give no such right.