Has the Bloom Come Off the Rose? It May Be Time to Pull the Plug on Your Private Equity Investment
Private growth companies have ups and downs – only rocket ships tend to go straight up. Therefore, it can be difficult for an investor holding a minority stake in a private company to know whether a challenging time for the business represents only a temporary rough patch, or whether the company’s road to long-term success has become much steeper. This post reviews various problems that arise in business to help minority investors evaluate the impact the company is facing. In most cases, the best approach when a problem arises is for the investor to wait and see if the company mounts an effective response to address the situation. But if the company’s response seems to be digging a deeper hole, seeking a prompt exit from the business may be the investor’s wisest path.
Initial Question – Does the Potential Exist for a Partner Exit?
The first step for a minority investor in evaluating whether it is time to seek an exit from a business is to determine whether this exit right exists in the company’s governance documents or in any agreements that the investor entered into with the other owners of the business. If a minority investor does not have a buy-sell agreement in place that requires either the majority owner or the company to repurchase the investor’s ownership interest in the business, the investor may simply lack the ability to exit the business when desired. We have posted before about the importance of securing a buy-sell agreement or other partner exit plan at the time the investment is made. [insert hyperlink to previous post]. When an investor has reached the decision to exit the business, the existence of the buy-sell agreement is essential to secure a timely departure on reasonable financial terms.
For those minority investors who have the right to trigger an exit from the business, the remaining portion of this post reviews a number of problems that can arise during the growth phase of the business, which may cause the investor to decide to exercise that right.
Departure of One or More Company Founders
It is not uncommon for one or more company founders to depart during the company’s growth phase. Some entrepreneurs are simply much better at conceiving of a new, profitable idea than executing on it in a business setting. The peaceful departure of a founder who is not equipped to facilitate the growth of the business could be a positive for the company. This is particularly true when the departing founder retains a stake in the business and remains fully supportive of the business and the remaining or new management team.
In a more dysfunctional scenario, however, a company founder may be ousted due to financial struggles, removed by larger investors, or remain a negative external influence. In this situation, it may seem like the best course is to abandon ship when the founder is removed. But caution is advised, because the larger investor will not want to see its investment in the company squandered. As a result, this large investor may bring in a more experienced management group, oversee a better growth plan for the business, and turn the company around. Thus, before seeking an immediate exit when one of the company’s founders departs under hostile circumstances, the investor may want to allow the dust to settle a bit to see whether the company’s next phase is more promising after new leadership has been installed.
Entry of New, Larger Competitor in the Marketplace
The early success of the company may attract other competitors to the marketplace, and if so, and some of them may be larger and better funded. Taking on an established competitor can be a very daunting task for a growth company. But once again, jettisoning the investment in the company at the first sign of more seasoned competition entering the marketplace is not advised. The growth company is smaller and likely to be more nimble, more connected to the customers and vendors, and may be preferred over the larger company. This is another situation where patience is required to see whether the company can withstand and continue to succeed in response to the challenges that are posed by the larger competitor.
It is not unusual for the larger competitor to realize at some point that it is better to join forces with the growth company than to continue to divide the market. If this happens, and the larger company seeks to purchase its smaller competitor, this would be regarded as a strategic acquisition. This transaction would bring top dollar for the private company and provide the investors with handsome returns. Of course, this will only happen if the growth company is able to continue thriving in response to the competition posed by the larger competitor.
Government Delays in Issuing Certifications, Approvals or Patents
For companies doing business in regulated industries or that rely on patents to protect their intellectual property, delays by the government in permitting new drug trials, giving FDA approvals or issuing patents can be harmful, if not devastating to the business. But liquidating a private company investment once the news of the delay is received is likely not the best option. At that point, the company’s value will be at a low point, and an exit at this stage is destined to result in a significant loss. Thus, the investor must decide whether to exit at this low point or to stay the course in hopes that the company can survive the delay, secure a belated approval from the government or await the issuance of a new patent to boost the company’s value.
Assessing Litigation Risk
Another frequent business risk is litigation that embroils the company, and lawsuits can threaten the company both internally and from third parties. By way of example, the founders of the company can become involved in fights over control, the company could be hit with lawsuits by competitors, or the company could become subject to some type of cyberattack resulting in litigation by customers. Each of these lawsuits presents different types of problems to assess, which may be difficult because the investor likely will not have access to all of the facts that are necessary to thoroughly evaluate the risk that the litigation poses to the company.
In this situation, some important questions for the investor to consider before seeking to exist the business are: (1) Is the litigation an existential threat, i.e., are the claims severe enough that they threaten to bring about the company’s demise or does it present a challenge that can likely be managed by the company’s leaders; (2) does the company have insurance that applies to the claim and the legal defense costs (claims that are covered by insurance pose far less risk for the company); and (3) is the company functioning on a business as usual basis while the litigation is ongoing, or is the litigation such a large distraction that is having a direct, negative impact on the company’s performance? Securing the answers to these questions will help the investor to decide whether the company can ride out the storm of the litigation or whether getting out before the litigation concludes is the right option, which would be before things become even more dire for the business.
Growth companies are successful not because they have no problems, but because they have learned to overcome their challenges. Investors in these companies also need to decide whether their company and its management team are built to last, or whether the company lacks the resources or the leadership skills necessary to survive over the long haul. If the company is responding effectively to the types of problems discussed in this post, it may be best to stay the course, but if the company is struggling to overcome them, the investor may need to exit and find a better opportunity in which to invest. Many investors refer to the “eye test,” as in don’t deny what your eyes are seeing when the bloom has come off the rose.