Business owners of private companies invest huge amounts of time and resources in their business, which may include the bulk of their financial capital. For owners who do not want most of their net worth to remain tied up in the business, there are options available that would allow them to take some of their chips off the table without walking away from their business. Some of these options may be attractive to owners who want to secure liquidity in a manner that does not require them to forfeit the right to maintain control over their business.
The Private Equity Option
Private equity (PE) fund raising slowed during 2023, but PE firms raised the staggering sum of more than $550 billion in each of the past two years. Significantly, the total number of deals that PE firms completed in 2023 was 20% higher than 2019, but the total aggregate value of these deals still fell below the pre-pandemic level. Perhaps the key takeaway for business owners is that PE firms are still on the hunt to invest in private companies as PE firms raised more than half a trillion dollars in each of the past two years, which needs to be invested for PE firms to generate a return for their investors.
Although PE investments can be structured in a number of different ways, there are two basic paths the investment will take. The PE firm will buy the whole company or a majority interest that provides the PE firm with control over the business, or it will purchase a minority stake that does not give it complete control over the company. Most PE firms prefer to make investments that provide them with control over the business, but increasingly, PE firms are making minority investments in order to deploy their capital.
From the perspective of the majority owner, selling a minority interest in the company to a PE firm may be attractive because it allows the owner to remain in control of the business. In this scenario, while the PE firm will not secure control over the business, it is likely to have veto power over certain major business decisions that could otherwise be made by the majority owner such as (1) giving the PE firm the right to prevent stock sales that would dilute the PE’s firm’s interest, (2) restricting the owner’s right to take on new debt above a certain level, (3) requiring the PE firm to approve any proposed bonuses to be paid to the owner, and (4) preventing the owner from selling the business without the PE firm’s approval.
The business owner who accepts a PE investment needs to appreciate, however, that the PE firm has become a full-fledged business partner with specific legal rights. Further, the firm will be looking to make an exit from the company in five to seven years, which will generate pressure on the business to improve its financial performance in this time window. The rights of the PE firm are likely to include the veto power discussed above, the ability to participate as managers or directors of the business, and the right to question the owner and others about all significant business decisions presented to the directors or managers.
Picking the right firm for a PE investment is therefore a critically important decision for the majority owner. When the investment works well, the PE firm provides financial support and various types of guidance and industry contacts that will be helpful in growing the business. In sum, the ideal PE firm is one that will be a solid business partner and actively help to enhance the company’s value. The flip side is a PE firm that fails to deliver on its promises, seeks to micromanage the business, and creates problems that hurt the company’s bottom line.
Not all PE investments work well, and majority owners should conduct as much due diligence as possible about potential PE investors to determine if this will be a good fit, including interviewing other companies in which the PE firm invested to discuss their experience. This effort is time and money well spent to avoid, if not eliminate, future conflicts with the PE firm after the investment. When conflicts do arise with the PE firm, it helps to have a written agreement that governs the terms under which a business divorce could take place between the parties.
The Family Office Investment
The family office investment is very similar to the PE investment but will provide the business with a longer time horizon before any exit has to take place. As noted above, PE firms tend to operate on a five- to seven-year time horizon for their investment. If the company is not ready for the PE firm to exit from the business on this timetable, that can create serious conflicts between the majority owner and the PE firm. By contrast, a family office does not have the same pressure to generate a return for outside investors on this specific timetable, and can wait a longer period before seeking an exit to monetize its investment.
The challenge for the majority owner is that there are far more PE firms than there are family offices that are open to making private company investments. As a result, the majority owner may need to focus on securing an investment on favorable terms from a PE firm rather than holding out for a family office investment that may never pan out.
In addition to the previous discussion of PE investments, the majority owner may decide it is best not to shut the door on selling a majority stake in the business to a PE firm. While this transaction would require the owner to transfer control, an investment by the right PE firm may not result in the loss of control that is the chief concern of the majority owner. The PE firm wants to generate a handsome return for its investors, and if it is confident in the majority owner’s leadership, it may leave the owner in control of the business for all practical purposes after the closing. The PE firm may also agree for the majority owner to retain a substantial stake in the business (25% or more) in the belief that the owner’s continued ownership interest will serve as a strong incentive for the owner to continue to grow the business.
The Strategic Buyer Transaction
In this scenario, the majority owner sells the entire company to a buyer that is a larger firm, which wants the business to continue to operate largely in the same manner. Thus, after the transaction closes, the majority owner will continue to operate the business as a division of a larger company or as a subsidiary of a parent company. In either event, the majority owner will largely retain control over the business and will likely receive or be paid a combination of cash and shares of stock in the larger company.
This last option is one that presents the highest risk-reward scenario for the majority owner. The upside potential exists because the owner continues to run the company in a largely uninterrupted fashion and receives both cash and stock in the larger company. This stock may increase significantly in value over time, particularly if the transaction results in strong business synergies between the two companies after the purchase has been completed.
One risk here is loss of control. Specifically, before the sale closes, the buyer may promise not to infringe on the majority owner’s continued control of the business, but after the closing, the buyer may then dictate to the majority owner how the business has to be run. There is also a financial risk as the stock in the larger company may decline due to unforeseen business issues that are wholly unrelated to the conduct of the majority owner or his business. A majority owner who goes down this path must be mindful of these risks, but they can be mitigated to at least some extent if the buyer will negotiate a contract that clearly defines the scope of the majority owner’s control over the business after the sale takes place.
Other Tax-Advantaged Options
Finally, there are other tax-driven options for majority owners to consider, which include Employee Stock Ownership Plans (ESOPs) and exchanging assets for other qualified property as permitted by the Internal Revenue Code. These are complex strategies that will require assistance from specialized tax and legal professionals. These transactions can result in a lower value for the company, however, and the owner will need to decide if the tax savings that may be secured outweigh the lower value for the business that may result when the price is compared to the valuation determined by third-party investments or from the sale to a strategic buyer.
Conclusion
After business owners have shepherded their company to a high value, they may want to secure their financial future, but without engaging in a sale transaction that would require them to leave the business behind. There are a number of avenues available for business owners to attain liquidity in this way, including by bringing in a PE firm or a family office as an investor or selling to a strategic buyer that authorizes the company to continue to operate under the banner of the larger business. These various options should be carefully considered as they provide the potential for the owner to accomplish this financial goal with an acceptable level of risk.
