MM M&A 024: Minority Stakes – Read the Fine Print

Middle Market Mergers and Acquisitions by Colonnade Advisors

This episode is an excellent continuation of our discussion in E023 about the pros and cons of partnering with a financial sponsor.

When a company is considering an M&A transaction, there’s a range of alternatives. On one side of the spectrum, there’s selling 100% of the company and exiting. On the other side of the spectrum is no transaction at all (“stay the course”).

In the middle are the options to sell various amounts of a company’s equity.

When considering raising capital, more often, we see our clients sell a majority stake, in which an investor buys more than 50% of the equity in the company. In some cases, we see a minority stake investment, which is less than 50% of the economics.

Today’s episode dives in deep on minority investments, and Colonnade Advisor’s Managing Directors Gina Cocking and Jeff Guylay explore:

• Reasons companies take on minority investments
• Different types of minority investors and what they are seeking
• How minority investments are valued
• What rights come with minority investments
• The biggest challenges associated with a minority stakes investment
• Advice for companies exploring minority stake investments

Reasons companies take on minority investments (1:56)

Gina: The most common reason we see is to buy out a minority partner. Another reason is to increase the equity capital in the business so it can raise debt and finance growth. Often, there’s a thin layer of equity in founder-owned companies because they’ve been distributing their own capital. They now want to make an acquisition, for instance. To make that acquisition, they will need more capital in the business. They need equity to then raise debt.

We hear business owners say, “I want to diversify my investments. Or, I would like to fund my kids’ education, weddings, etc.” Minority investments can be raised to give owners of businesses some liquidity.

Jeff: In our last podcast (E023), we talked about the value that financial sponsors bring to a founder-owned or an entrepreneurial-run company in terms of strategic benefits to the growth of the business. Sometimes we hear our clients say: “I don’t need a lot of growth capital” or “I don’t need a lot of liquidity” or “I don’t need to buy anybody out. But this might be the right time, given what’s going on in my industry, at this particular point in time, to bring on somebody who can help me out. I might need help in the capital markets. I might need help with a growth plan. I might need help with acquisitions.”

These strategic issues are important and sometimes supersede the economics of the transaction.

Different types of minority investors and what they are seeking (4:58)

Gina: I tend to put the investors into three buckets: venture capital firms, strategic investors, and private equity firms and family offices.

Venture capital funds frequently make minority investments in companies. VCs are more focused on companies that are pre-profit and in the early stages with a lot of growth ahead. When you take an investment from a venture capital firm, you’re not getting liquidity. Dollars are not going into your pocket.

Jeff: Venture capitalists are focused on putting capital into the business to help you grow.

A strategic investor is interested in investing in a company to lock in a long-term relationship. If one of your vendors has an investment in you, you’re probably not going to move away from that vendor. So that’s where you can get strategic money. Strategic investors will also invest in companies to watch new technologies as they grow. They are then at the forefront and in a position to make an acquisition later of that company.

Jeff: Strategic partners bring not just capital but relationships. They’re investing in you because there’s a good business case, and they’re going to help you grow.

Gina: The third bucket is private equity firms and family offices. Some PE firms will make minority investments. We often see private equity firms making minority investments because they really like the company and they want to get their foot in the door. The company’s not ready to sell yet, and the investor wants to be the first capital there. They partner with the company, sit at the board level, and help with strategic decisions. When the company’s ready to sell, they’re a trusted partner and the first one in line.

How minority investments are valued (10:03)

Gina: There is typically a minority discount. A minority position is less liquid. A minority shareholder will have different rights than a majority shareholder. We see valuations of minority investments typically at a 10% to 15% discount to a complete sale.

For example: A $100 million company, no debt, so $100 million equity value. If a minority investor wants to come in and buy 40% of the company, they may do so for $30 million. So they’re buying at a discount.

Jeff: Conversely, when an investor or buyer is looking to buy a significant majority stake, or 100% of the company, they’re going to pay a premium to the valuation. They’re going to pay a 10%, 20%, or 30% premium for control of the business.

Gina: When we work with private companies, they often assume a minority investor invests in common stock. When we talk to the investors, it’s more often as preferred stock or even debt with warrants. If the capital stack can accommodate the debt, they’ll do debt with warrants. That way, they’re de-risking their investment, because they’re higher in the liquidity preference. Debt will be paid back before equity if a company goes into bankruptcy.

We sometimes see it as a bait and switch. We’ll see companies that are talking to minority investors. They think they’re talking about common stock. And then, all of a sudden, they get a term sheet that is debt with warrants.

The term that we use in finance is pari passu (equal footing). Are the securities that the investors are coming in with pari passu with the owner’s securities? Are they the same security? When raising capital, the ideal situation for taking on a minority investment is that the equity coming in is pari passu with what the founder/owners of the business have.

Jeff: Pari passu is an important concept. We always try to get our clients to have new money come in pari passu with the existing shareholder’s ownership and investment. With a majority sale or majority investment, that’s more common. With a minority investment, the investor is looking to get additional rights, controls, and protections in any way they can.

What rights come with minority investments (14:21)

Gina: What’s key in minority investing is not just the money.

What’s key is all the other terms. What do the minority shareholders want for the money that they’re investing? They want to vote. They’re going to want a board seat. Minority shareholders always get the right to inspect company records. The company will need to prepare financial statements and present them to minority shareholders. Along those lines, minority shareholders may sometimes require that audits be done.

Jeff: Minority investors will also want anti-dilution protection. The valuations of earlier stage companies are less concrete. As investors look to the next round of financing, an important question they ask is, “What’s going to happen to me as the investor when the next round of money comes in?”

Another area that we will see in minority term sheets is in regard to dividends. The minority shareholders will expect to have pro-rata dividends. Everybody who owns a security gets a dividend when dividends are paid.

What is sometimes unexpected are dividends that are basically tax distributions. The business might be making $10 million a year pre-tax. All of the members of that LLC or an S Corp. have to pay taxes on those earnings. If those earnings are not distributed to the individuals, or the equity holders, it’s called phantom income. For tax purposes, they’ve received income, but they actually never received the cash. Oftentimes, term sheets will have specific criteria around tax distributions.

Gina: Term sheets may also give minority investors approval rights, a supermajority approval right. We see term sheets where the minority investor must approve any merger, acquisition, consolidation, or reorganization of the company.

The investor could also have approval rights in order for the business owner to get a new line of credit or make any material changes in management. For a business owner, that can be pretty difficult to swallow.

Jeff: These potential controls can affect profit sharing plans and equity incentive grants.

Gina: Entering into new lines of business can be restricted for the business owners. The company cannot make a capital expenditure over a certain amount without approval.

The company has to prepare a year-end budget. The budget gets approved by the minority investor and then continually measured.

Jeff: Controlling the exit is the most important element that a financial sponsor seeks. They want to know when the company’s going to be sold, who it’s going to be sold to, what the valuation is, and what the terms will look like.

For an entrepreneur who has been running this business successfully for years, having somebody have a hammer over them, with respect to the exit, can be a real problem.

The biggest challenges associated with a minority stakes investment (25:00)

Jeff: The biggest challenge that we see in minority investments is this balance of ownership versus control.

A minority investor comes in, puts some money in the company, perhaps puts some money in the existing investors’ pockets, and ends up owning less than 50% of the company. The challenge for this minority institutional investor is they’ve got limited partners that they report to. They need to be very comfortable that they have sufficient control elements in the deal structurally. They want to have significant influence on all these topics we talked about, particularly the exit.

Voting, dividends, changes of the business line, etc; these are all important to the minority investor. They want to make sure that they’re in the driver’s seat, even though they have a minority position.

Gina: From the business owner’s perspective, the question is: how much is the capital really worth to you? Is it worth it to give up control of your company, knowing that that investor can force a sale within five years for say, 20% of the economics? Whether or not it’s really in your best interest, they could force a sale. They could prohibit you from doing acquisitions. They could prohibit you from selling the company. Is it worth it for that minority investment?

Advice for companies exploring minority stake investments (29:33)

Partner with a financial advisor who is experienced with these types of transactions and can best protect your interests. Colonnade has developed deep relationships with private equity firms and family offices that make minority investments and can help guide you.

Gina: When it comes to working with investors that are founder friendly when doing a minority investment, three firms that come to mind: McCarthy Capital, Copley Equity, and New Heritage Capital.

All three of these firms respect the rights of the business owner. They’re making the investment not to disguise a majority acquisition, but to do a true minority investment and putting in place structures that work well for the business owner to continue to grow and get the company to the next level.

Jeff: The advice we would give is to focus on those investors that have a successful track record of being good minority partners and work diligently in striking a fair deal. The fairness here is really the balance between economic and voting control.