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— A VPA Perspective

Transaction Options: Minority vs. Majority vs. Full Sale

Summary
  • The pros and cons of each deal type: minority deals, majority deals, and full sales
  • Why you should include all deal types regardless of preference

As the time approaches to engage with potential buyers of your business, you will face an important question: How much of your business do you want to sell?

The percentage of your company that you sell will depend entirely on your goals for the company and personal finances following the transaction. These goals include:

  • Roles. How involved in the company do you want to be following the sale? What role do you want the buyer to fill?
  • Liquidity. How much of your ownership do you want to cash out on? How much equity would you like in the company going forward?
  • Decision-making power. How much influence do you want to have on the future of the company?
  • Risk. How much risk are you willing to take on following the transaction?

Your answers to the above questions should give you a strong indicator of which type of transaction you prefer: a minority deal, majority deal, or full sale. Regardless of your preference going into the deal, having options is paramount to yielding the best outcome of the transaction.

Don’t Rule Out Any Selling Options from the Beginning

Founders and their investment bankers often approach the sales process from the starting point of a preferred transaction type, building the buyer landscape around that preference. This approach contains several flaws, including:

Lack of options. What happens if you exclusively pursue a minority deal and 6 months down the road you realize you’d rather sell the entire business? That’s 6 months you can’t get back and you essentially have to start over. 30% of the time, our clients change their mind on the type of transaction they want.

Lack of leverage. When you build your buyer/investor universe around a single transaction type, you lose out on the opportunity to negotiate out the weaknesses of one type of deal using the strengths of another type of deal.

Lack of competition. Valuations in the lower-middle market (sub $500M in valuation) are relatively subjective. The more transaction types you consider (which means more buyers/investors in your process), the better you’ll have full market transparency on price and terms.

Lack of experience. As a founder, you may have never sold a business before, so you have a limited idea of how working with a partner will be, such as the level of control you’ll be able to exercise or your role post transaction.

Rather than starting from the platform of a single transaction type, have your investment banker build a buyer/investor list around all transaction types. Doing so will take more work on their end, but has little to no downside for you as a client. The end result for you will be a full menu of real-world options to choose from.

With that full menu at your disposal, you’ll be able to evaluate each deal on its own merits, based on the relative strengths and weaknesses of each transaction type, as outlined below.

Minority Deal: Selling Less Than 50% of the Business

Minority deals allow existing shareholders to get some liquidity and/or primary capital while still owning a majority in the business. While this deal structure can solve many goals for a founder by providing liquidity, maximizing post transaction ownership, and adding support to the team, minority deals can present many challenges in regards to terms, post-deal decision making, and equity structure moving forward.

The strengths of a minority deal include:

A bigger say in your role post-transaction, allowing you to work in your desired role going forward.

Stronger control over future decision-making of the business, giving you more power in determining the destiny of the company and your share in it.

A larger percentage of the economics in future liquidity events. Because minority deals allow founders to only sell a small portion of the business now, shareholders are saved from significant dilution and will be able to take part in a greater amount of any future liquidity events. This opportunity holds true whether the transaction is centered around a primary capital round to further grow the business or focused on liquidity for an existing shareholder.

The weaknesses of a minority deal include:

Less liquidity for founders. In a minority deal, since there is only a small portion of the shares up for sale, the amount of liquidity available to founders is substantially reduced. This is further exacerbated if primary capital is being considered in the transaction as the primary capital reduces the available amount of proceeds that would have otherwise gone toward shareholder liquidity.

Minority protections giving private equity firms additional operational and economic rights. In a minority deal, investors focus on protecting their interests. As such, many investors will bake into transactions certain protections that make a minority deal look more like a majority deal from a decision-making and economics standpoint. Some of these protections include:

Liquidation preferences or dividends, which give private equity investors down-side protections and better guarantee a small multiple return on their investment in the event of a future liquidity event, effectively increasing their percent ownership in the business

Board control, in which preferred shareholders (new investors), have more control over specific aspects of strategic board decisions (such as budget, hiring, taking on new investors, etc.), making it harder for existing shareholders with majority control to make decisions

Other terms of potential conflict are: veto rights, anti-dilution protection, and redemption rights

Greater personal risk profile post deal. Because in a minority deal you sell less of the business and thus receive less liquidity, you in turn carry a greater burden of the business’ success moving forward. In many cases, since the vast majority of your personal net worth still resides in the business, you will more likely make conservative decisions for the future of the business to preserve the "value" of your equity. At the same time, the new investor will be more risk-seeking given they require substantial growth to hit growth targets relative to their initial investment. These competing interests can cause friction at a board level.

Partner-fit is paramount to protect against friction at the board level. Given the above potential conflict, having a strong relationship and agreeing on growth strategy early on with the partner at the investment firm becomes crucially important in the success of the business moving forward.

Least likely to get a "strategic" valuation. Due to investors bringing, in most cases, only incremental value to business (i.e. not combining with another entity to get exponential value), minority deals tend to receive the lowest valuation in comparison to majority/full sales transactions (sans exotic security structures). There is also a concept of a “control premium,” which is the value assigned to being able to completely control decision making. Founders would not receive this control premium when selling less than a controlling interest in the company.

Many founders who have been highly involved in business operations are greatly attracted by minority deals. Roughly 30-40% of founders we work with would seriously entertain a minority deal. However, only 10-15% end up closing one. These founders are often turned off by the challenges regarding minority shareholder protections and potential security structures required to get comparable valuations/terms in a majority deal or full sale.

Majority Deal: Selling More Than 50% of the Business

In a majority deal, the company receives a large portion of liquidity or capital to grow the business but, since existing shareholders are losing their controlling interest, the decision-making ability largely lies with the new investors. In many ways, their strengths and weaknesses are the reverse of a minority deal.

The strengths of a majority deal include:

Substantial amount of liquidity for founders. Given there are more shares available to be purchased, there will be more liquidity allocated to existing shareholders even if primary capital is contemplated.

Decreased go-forward risk profile. Because founders’ personal financial risk is less associated with business performance moving forward in a majority deal, they can feel more comfortable making aggressive business decisions to forward the business.

An opportunity to capture upside in the future of the business. Because the founder still owns part of the company, they can take part in a subsequent transaction (sometimes called a "second bite of the apple") following business growth.

The weaknesses of a majority deal include:

Less control over future decision-making in the business. Since you are relinquishing controlling interest, founders and existing shareholders will need to be comfortable with not being the sole decision maker.

Less control over your role post transaction. The founder’s level of control greatly depends on the type of investor the founder brings on, but regardless of that, existing management teams and founders will likely see their roles change to varying degrees post transaction. That said, in most cases, firms want to keep management teams firmly intact and motivated—a primary reason why many firms are adamant about founders not completely selling their equity and instead rolling some equity forward. These firms focus more on being supportive from a board level and augment the management team where gaps are present.

Partner fit remains important, though less so than in a minority deal because the new investor will have the primary say in directing the future of the business.

A smaller percentage of the rewards in future liquidity events go to founders due to less post-deal equity ownership.

A low likelihood of getting a "strategic" valuation. Similar to a minority deal, most of the value brought by an investor in a majority deal is incremental vs. exponential. Still, founders tend to experience greater valuations than they would in minority deals due to the control premium, though not always.

Because of the recent increase in the quantity and financial power of investors in the lower middle market, there has been a significant influx in the competition for these deals. Due to this increased competition, in conjunction with 1) low interest rates for debt financing, and 2) the necessity for these firms to deploy capital, valuations have increased substantially for majority transactions.

As a result, we have seen founders lean more towards majority transactions due to the benefits far outweighing the weaknesses. Historically, roughly 30% of our clients ended up choosing a majority deal. That number continues to grow as the valuation gap between strategic and financial buyers shrinks and more founders place value in some equity ownership post deal.

Full Sale: Selling 100% of the Business

Full sale transactions to strategics hold the greatest potential for the highest valuation but can take significantly more time and precision to accomplish.

The strengths of a full sale include:

Complete liquidity for the founder. In a full sale, you cash out on your entire share in the company, maximizing the amount of proceeds that go to founders.

A higher likelihood of getting a "strategic" valuation. Strategic buyers tend to offer higher valuations (a 20-30% premium over financial buyers). Because strategic buyers have an existing captive customer base, extensive operational resources, and larger budgeting capabilities, they can value businesses significantly higher than pure financial investors as they can grow the acquiring target substantially faster and more efficiently.

Little to no risk of future business performance. Because you liquidate your entire share in the business in a full sale transaction, the value of your personal assets are no longer tied to business performance, reducing personal risk.

The weaknesses of a majority deal include:

Little to no future economic benefit, because you no longer have any investment in the business.

In some cases, despite selling the business to a strategic acquirer in a "full sale" transaction, the deal could contain some provisions for earnouts and acquiring party equity, in which case the sale wouldn’t technically be a 100% deal, at least not initially. The challenge with these types of outcomes is that you lose a significant amount of control over how you will successfully achieve your goal. As such, our opinion of these types of compensation is that they should be valued lower than full cash offers and viewed as “bonuses,” not guarantees.

No control over the future vision of the business, because you no longer have any decision-making power.

Very small likelihood to have a role in the organization long-term after the transaction, because the business will be absorbed into the operations of a larger whole. In addition, founders typically have little interest in being an employee of a larger entity. Our suggestion would be to plan for a 6-18 month transition period before you leave the organization all together.

Negotiating Out Weaknesses Across Transaction Types

Each transaction type has different strengths and weaknesses. When you consider them all together, you’re more likely to find ways to negotiate around some of the challenging aspects of certain deals. For example, if you’re trying to muscle favorable terms into a deal, strip unfavorable terms from a contract, or increase the valuation bid, doing so is much easier when you have other deals on the table to compare against.

We strongly recommend founders look at all transaction types at once to maximize not only outcomes but also optionality. You never know what is best for the business moving forward until you have the full set of facts—making a decision this significant, based on assumptions, is short-sighted.

Handling a Transaction Is Time Consuming. Hire a Banker.

The idea of casting a wide net and negotiating with numerous buyers and investors—all while running your business—likely sounds impossible. One of the greatest risks to your business/process is a drop in performance because you’re spending too much time overseeing the transaction. Hiring an investment banker to handle the transaction is prudent, as doing so will help you achieve a better outcome as well as allow you to focus on your business.

Investment bankers who specialize in sell-side transactions can do the legwork—negotiating terms while understanding what drives value for all types of parties, and enabling you to stay focused in your corner while they work in theirs. They’ll use their expertise to yield the best outcome for you, the founder who has already poured so much into the business.

Modified on Jun 19, 2020