Loading summary
Transcript16 lines
- [00:02]
A
Welcome to the Path to Exit, a podcast to help software and Internet founders understand the process to raise capital or sell their business.
- [00:20]
B
Hello and welcome everyone. I'm Mike Lyon, Founder and managing director at VistaPoint Advisors, and this is the Path to Exit. This show is dedicated to helping founders of software and Internet businesses understand what it takes to raise capital or sell their business and how to do it well. My guest today is Scott Austin, managing director of VistaPoint Advisors. In this episode, we'll discuss minority transactions and common pitfalls. With these transactions, we'll talk about how to avoid the pitfalls and maximize the upside for a minority deal. Please enjoy my conversation with Scott. Scott, first of all, get us started. What is a minority transaction and why would a founder choose to do that over like a majority transaction or a full sale?
- [00:56]
C
Yeah, very often when we speak with founders, it's a pretty binary answer when we talk to them about a transaction where they either want to pursue a minority deal or they have a heavy preference towards a majority or control type transaction. Oftentimes when founders are looking at minority deals, it's really over the concept of maintaining control of their business. So from a high level, a minority transaction is when you sell less than 50% of your business. A majority transaction is when you sell more than 50% of the business and therefore give up proverbial control of the company moving forward. So in a minority deal, oftentimes what founders are thinking is that, hey, if I can sell less than a 50% stake in my company, one, I maintain more of the upside of the business as I grow it over the next three, four or five years and look for that second bite of the apple. And then also in terms of the day to day decision makings of the business, you are able to control the direction of the company. More so than if an investment Group owns say 70 or 80% of your company and was playing a little more puppet control. So oftentimes there comes a time in a company's life cycle where they want to pursue a transaction and our experience is that it comes down to founders that are hyper focused on control and those that are, I'd say, willing to give up control to investors that might have more experience on scaling a company from 10 to 50 million in ARR and then therefore want to work with experts and are open to giving up more ownership of their business where they think that their rollover can be valued a lot more with more experience at the table.
- [02:21]
B
Absolutely. And I think another thought process founders go through when they're choosing that minority deal is Scott mentioned the control element. So with a minority deal, in theory, you're in control of your business as opposed to a majority and a full sale where you're clearly giving up control. You might still have some control, but you're giving up control at the board level, but also just this concept of upside. So in a minority deal, you're getting the least amount of liquidity, you're owning the most amount of go forward equity. So if you think the business is going to be a rocket ship for the next five years, that can be a good trade. We tend to see founders thinking about it, as Scott said, from a control and upside perspective. And it's a really important rubric founders use. The challenge with the minority deal, though is I like to call it the most dangerous deal on the table. It is much more complex. And the basic reason why it's complex is in the majority, in the full sale, it's really clear what's happening. You're getting a lot of liquidity, but you're giving up most of the control and a lot of the upside. In the minority deal, what investors have done is they're trying to kind of take more in terms of control and upside because they are a minority holder. So if they can get more, there's a lot of value to them, and that's what makes it dangerous. And they basically invented all these security structures and terms to deal with a minority deal. That means, frankly, you have to pay a lot more attention on a minority deal than the other types of transactions. So, Scott, maybe talk a little bit about a couple of the features that make a minority deal dangerous.
- [03:42]
C
As you can imagine in a majority deal, just to hit on that quickly, you generally see Perry pursue transactions where the founders own the same security as the private equity firm or financial buyer that's acquiring the majority stake in the business. And there's less games to be played there. Given the ownership structure in a minority type transaction. A lot of times what growth equity and private equity firms want to do is get effectively outsized interest compared to their actual economic ownership in the business. What that can often look like is different economic structures or different board level seats that might look different than the 40% of the business that they own. So what we generally see in minority type deals is preferred stock. Those are generally either convertible preferred or participating preferred. These are kind of the two most common. Convertible preferred is what we would kind of dictate as the market option for a company. So in that scenario, you have a convertible note on the business and then once it gets to the value of the enterprise value of the asset it converts to common stock. And then you participate in the upside from there. So for an example, if you raise 25 million at a hundred million valuation and you sell for greater than a hundred million, the investor converts their shares and gets the percent stake in the return. Now if the company underperforms and sells less than that 100 million enterprise value, you're aligned here because the investor gets their 25 million back. So they have that downside protection. And that's generally a pretty conservative structure that fits well for both founders to get that cash or get that liquidity injection, but also for the investors to be able to potentially participate in the upside. But in the event of a not optimal sale, they do have some protection. The trickier structures are with participating preferred structures. So with that the founders would get their 25 million back, but then anything over that, they also get their percentage share of the consideration. So let's just say in the prior event that I mentioned where you're raising 25 million at 100 million valuation, if it sold for 75 million in a non optimal transaction, the investor would get 25 million plus their 25% ownership of the remaining 50 million consideration. So it really ends up looking like they own 35 or 40% of the business versus the 25% equity check that they initially wrote. However, obviously in a better 200 million exit, they would get their 25 million back plus 25% of the 175 million. So rather than it just converting where everyone effectively has the same upside, their upside tends to look different. And it's not that peri pursue security that we mentioned before. The next I'd say trickier structure that you'll often see is with liquidity preferences. If there's let's say a 2 or 3 times liquidity preference on that initial 25 million check. In a 2 times they would get the first 50 million out plus their percentage ownership. In a 3 times liquidation preference, they'd get the first 75 million out, then participate in the remaining upside. So you can very quickly see that where a lot of times when you look at a transaction, say common Stock, you own 25%, you get 25% of the outcome. That's not always the case. And investors really tried to hide this. I'd say disjoint between what the founders are expecting for an outcome and what they're getting for an outcome with these very complicated structures within a transaction.
- [06:57]
B
And I think one of the things to understand about this is why this Kind of happens in a minority deal, but doesn't happen as much in a majority deal. In theory you could try and do the same things, but it's really a math and a protection issue. So if you're an investor and you own 25% of the business, but you have all these preference structures, you have 100% of the value of the business, right, protecting your 25%, which basically builds you in a ton of downside protection. On a majority deal where let's say the investor owns 90% of the business, if you put these same structures in place, then you'd have 100% protecting 90%. So there's just not as much insurance there, if you will. So this is something that shows up a lot in minority deals. I would say one thing to be on the lookout for. If you're negotiating with an investor and you have a really generic term sheet or loi, and then you give them exclusivity, then this stuff shows up in the investment docs. You want to make sure this is all hammered out in the loi. A lot of times when a founder is doing it, they just get an LOI from an investor and they kind of negotiate off that. But you want to make sure this is affirmatively determined what the security structure is and really ratchet it down. Another point I would just make is investors will sometimes say things like, well, fine, we can put a cap on that participating preferred. Once we get a 3x return, then this all goes away, right? Once we've hit our target return, which sounds good, but the problem with that is it creates this discontinuity around evaluation where they could care less if the value goes up. So imagine a few years later where you're selling the business and you're in this range where it's capped. They just don't really care about improving the valuation that much. And that could come at the cost of you when they're running a process to sell the business. So in general, this lack of alignment is just really bad. First of all, just not being aligned in terms of the outcomes isn't great. But secondarily, as Scott said, they can actually take economics away from you. And sometimes you see some really nasty stuff like there's a liquidation preference, there's a participating preferred with an accruing dividend. You might think you sold 25% of the company. You might find at exit that you sold 40 or 50% of the economics. And that is a nasty surprise. I've seen a lot of first or second time founders just not understand the security that they're selling and they're so focused on the upside of the business, they forget that over a broad swath of outcomes, they've actually materially damaged themselves. And a lot of times they just don't really understand it. So anyway, I think something to really understand on minority dealers. Again, there can be a lot of upside in a minority deal, but you have to make sure you have the right security structure.
- [09:29]
C
We tend to hear a lot from founders. Oh, I saw on TechCrunch, my competitor raised this or they raised that, or we heard it was at a 20 times ARR multiple, et cetera. And in a pure secondary or full buyout or full sale scenario, the multiple is what it is. It's very clean. But I think everything that we just walked through just shows you that a lot of times in these VC type transactions that you might see that are on TechCrunch or other more VC related press releases, often the devil's really in the details and you won't quite see in those press releases about what the liquidation preference bar, if there was a cap or not, and really what type of security it was.
- [10:06]
B
Absolutely. On a minority deal, we hear all the time, well, they raised at this valuation, that valuation on a minority deal is literally meaningless without the other details. If it's an M and a deal, all cash and you know what the valuation is, you know exactly what that means. But on a minority deal, it could have a great headline valuation, but the structure could be awful. We've worked on minority deals where an investor will say to us, you tell us what the valuation is and we'll tell you what the structure is. So I mean, we had a bid once from someone, they gave a really high valuation, but they wanted a guarantee that they were going to get a 5x return before our client within share in any upside, that is a horrible deal. Right. Basically you'd be working for free over a broad range of outcomes. So when you read about a minority valuation, this is particularly prevalent with unicorns, you don't really know what that means unless you have all the details. So just be on the lookout for that. And even if you're getting nervous about some of your competitors raising what seems like a really high valuation, it may be a bit of an illusion because they're just trying to do it for the headline number. And either they don't know or frankly don't care that they're giving away a lot of the upside because they don't think there's that much. Let's talk a Little bit about control provisions. So generally our expectation on any type of deal, minority or majority, is that an investor or a new shareholder coming in would have board representation and control, if you will. That's the same as their economic ownership. So, for example, if they own 40% of the business, they'd own 40% of the board seats. If they own 2/3 of the business, they'd have 2/3 of the board seats. One of the things investors try to do is they'll obviously try to get an outsized board stake, but they'll also put these other things in, known as negative controls, which basically means you have to have their approval for X, Y and Z. Those can be particularly problematic for managing the business. So I would say be on the lookout for those negative controls and just the board control, but know that they're economic ownership and their board control should roughly be the same. Scott, anything you want to add to that?
- [12:01]
C
Yeah, I would just say you don't want to give the board certain controls there. For example, like right of first refusal or drag along rights where they can force a sale of the company without the full board ownership's consent, or at least the management team's consent. And then right of first refusals oftentimes as well, where they might be able to block or match certain acquisition attempts in the business because it doesn't fit what they need for their return, even though it might create economic gain for yourself personally and the other shareholders.
- [12:29]
B
One thing that does come up a lot that I think makes founders really nervous is this concept of a redemption right for an investor. So if we briefly and very briefly take the side of the investor on one issue, it would be this redemption right? So minority investor always has a concern, they invest in the business. You decide you want to transition the business to your kids in 30 years and they can't get liquidity. So oftentimes what they'll try and put in there is this thing called a redemption, right? And it reads pretty bad. It reads like, hey, within five years you'll either buy our stake back, back at fair market value, which obviously most companies, if things are going well, couldn't afford to do that, or you'll help us sell the business. What they're really trying to get at here is an exit path for them. So the redemption at fair market value sounds really nebulous. Usually there's a way to negotiate with them so you can make it clear you'll help them get liquidity so that they can get out. If you decide you're just going to manage the business for a long period of time. But I would say this is the one where the legal speak really rattles the founders. And usually there's a good middle of the road here where you can help them get liquidity, but obviously not take on any huge liability. I would say that one surprises founders a lot.
- [13:37]
C
And I would just generally say a lot of this surprises founders a lot. So when we go in and run a process for a client, even if they say 100% want to do a minority raise, we like to run what's called a dual track process. So exploring majority and control deals with minority deals in parallel. And once founders are able to see these side by side and see how much liquidity they're getting up front, what the trade off is there versus what their upside might look at. And especially depending on certain securities that are put in place or negative structures within the minority investment, more times than not, they normally pivot and look at a majority type transaction just because it creates more alignment with you and the investor moving forward, versus some of these more like disjointed securities within a minority deal.
- [14:21]
B
And I think also just working with hundreds of founders, I think founders do find it hard once they see all the input that this investor is going to have, frankly, to trust that situation. So they would either prefer more liquidity or more control. And I think sometimes they're disappointed about the amount of control they would have going forward. So you do see a lot of founders kind of transition to a majority deal. Some of that also just has to do with the valuations you're seeing for SaaS businesses. They're so high that a lot of times more liquidity is more attractive than less. And you still have quite a bit of upside. But I think the decision really comes back to those three core principles, liquidity, upside, and control, and how you're trying to optimize for those.
- [15:00]
C
Also, as a bootstrap business, like a lot of the companies we work with, it's founders that have owned their company for 5, 10, 15 years and they've never had a proverbial boss. But I would just say in general, a lot of times when they do do a transaction, it's the first time that there's board overview and they have that second rung above them. And when you do a minority deal, oftentimes it's a little trickier to transition out of the business, given your ownership stake, versus if an investor owns 70 or 80% of the business and you've rolled 20, 30% of your proceeds moving forward, you Might feel a little safer if you want to make that transition at an earlier time versus rolling so much equity into the uncertainty if you're not going to be a big part of the go forward part of the business after a year or two.
- [15:41]
B
And when you're pursuing a minority deal, I think it makes sense to go broad. One of the benefits of a minority deal for us marketing is the signaling that's involved in a minority deal. So if a founder only wants to sell 20 to 40% of the business, that implies they have a lot of faith in the upside of the business because they want to keep it. Sometimes on a majority deal that's a little bit harder, right, because you're trying to sell 70 or 80% of the business and also signal that you value the upside a lot. So I think going broader in a minority deal makes a lot of sense because it's going to be appealing to a lot of folks given the signaling impact there. But I just think if you uncover the terms of this minority investment in terms of the structure and all the things we talked about in the investment docs inside of exclusivity, you did not use your leverage well. You should have used your leverage to set those parameters much more upfront. Because if you wait till the end, they're just going to go all the way to the investor friendly side of these things. And honestly, in a minority deal, that could tank a deal. On a majority deal it's not that likely. The range of outcomes are much more standard. We still obviously advocate negotiating that up front. But in a minority deal it's even more important. And some firms just have a strategy in mind like they just want this really nasty security structure. We have a firm on a minority deal. We've told them countless times, hey, this does not work for our clients, but they're just really wed to this structure because of how they model their returns. So I think running a competitive process here is even more important and also just making sure you're aligned with the strategy of the business going forward. In today's episode, we talked a lot about founder expectations around minority deals, how they can often be a little misguided. What are some of the pitfalls that you can run into that you may not be aware of and some ways of managing them going forward. But Scott, thanks for joining us on the podcast.
- [17:24]
C
Thanks for having me on. Have a great day.
- [17:27]
A
VistaPoint Advisors is a founder focused investment bank that advises software and Internet founders through M and A and capital raised transactions. We are fully unconflicted investment bank who only works for founders on the sell side, so you know that we're always representing your best interests. Securities offered through VistaPoint Advisors member Finra Sipic this has been provided for informational purposes only. It is not intended to address all circumstances that might arise. Testimonials from past clients may not be representative of the experience of other clients, and there is no guarantee of future performance or success. Clients are not compensated for their comments. If you have any questions questions about the process of selling your business or raising capital, reach out to a member of our team or check out the four Founders section of our site by visiting four Founders Guide.