Whether you own an early-stage or middle market company, it’s critical to attract enough capital to sustain the business and eventually supplement your free cash flow to drive growth. When you’re courting investors, it can be tempting to accept capital in exchange for terms that are less than ideal. While that may seem like a short-term tradeoff, it sets you up for potential problems later.
By anticipating how various capital structures could impact the eventual sale of your company, you can avoid making decisions today that keep you from achieving the best possible outcome when you decide it’s time to exit the business.
Plan Your Optimal Capital Structure with the End in Mind
When you first bring on investors—whether it’s family and friends, or an angel investor providing seed money—planning for your exit from the business may be one of the furthest things from your mind. Even when your company is more mature and you bring on Series A investors, you still might not be thinking about the day you’ll sell the business. Yet, your investors certainly will be looking ahead to the time when the capital they’ve provided will result in a nice payout.
How you structure capital now can have a significant impact when it’s time to sell the business. The more thoughtful and strategic your decisions about structuring capital early on, the fewer problems you will encounter later.
At a minimum, ensuring all shareholders are aligned in their expectations helps avoid competing interests that can prove mentally taxing for a business owner. The right capital structure also prevents smaller shareholders from gaining a disproportional percentage of decision-making power and can help you achieve a better return when you sell the business. Attending to capital structure issues like the following will pave the way for a smoother exit.
Define a Liquidation Event & Liquidation Preferences
Your certificate of incorporation should define what constitutes a deemed liquidation event—a transaction that would trigger the distribution of assets to your shareholders, such as a strategic buyer acquiring the company or a private equity (PE) group taking a full or partial stake in the business.
If you fail to define what constitutes a deemed liquidation event and leave room for interpretation, you could end up with shareholder conflicts. Let’s say you have multiple lines of business, and you sell off one of them. Is that a liquidation event or just an injection of cash into the business? If your shareholders believe it’s a liquidation event, they might expect a dividend or other form of payout.
You should also outline how the proceeds will be distributed when a deemed liquidation event occurs, which is referred to as the liquidation preference or liquidation waterfall. This is the order in which shareholders are paid. Typically, a preferred class of shareholders will receive some portion of the proceeds before other shareholders are paid.
Ideally, you should consider how each class of shareholders will be paid and in what order before you begin to solicit capital. You can set up your preferred liquidation preference upfront, then adjust it as needed based on your shareholders’ expectations.
The issue of liquidation preference can cause problems if you’re in the middle of negotiating a deal and you realize your liquidation waterfall isn’t well defined or hasn’t been clearly communicated. In that case, different shareholders may have different opinions on how they should be paid out. Depending on whether they have veto rights (as explained next), these conflicts could even delay closing the deal.
Be Thoughtful About Shareholders’ Financial Rights
When you take capital from investors, you need to determine whether they will have participating or non-participating rights. This is an important decision that can affect your share of the total payout when you sell the business.
Since both participating and non-participating rights are considered a preferred class of stock, there is already a degree of downside protection for investors in either group. The potential upside of the investment is greater for a participating shareholder vs a non-participating shareholder. Therefore, some institutional investors will push more aggressively for participating rights. The more shareholders with participating rights, the more your own payout will be diluted when you sell.
Establish Protective Provisions
Along with financial rights, different classes of shareholders might have different veto rights when it comes to a transaction or other important event. Since these rights have the potential to hinder your decision making and keep you from moving forward with critical activities, it’s important to establish a degree of protection by limiting veto rights to the extent you can.
For example, shareholders might have the ability to exercise veto rights over increasing debt, adding more shares, amending by-laws, amending the certificate of incorporation, redeeming stock, or creating subsidiaries. The largest investors typically will expect more veto rights.
Keep Your Capital Structure Agile
Proper planning of your capital structure can head off problems, but it’s not a set-it-and-forget-it exercise. Your business is dynamic, so your approach to structuring capital should be, too.
Ongoing shareholder communication can help you spot potential issues and land mines that could hamper an eventual sale. As your business situation evolves and as you take on more investors, be sure to keep your shareholders fully informed.
It’s also helpful to craft an ongoing waterfall scenario model that forecasts the sale timing and business valuation that would be most lucrative for shareholders based on their liquidation preference. Providing the model’s results to shareholders ensures they’re informed of the various possibilities at different points in time.
Form a Team of Trusted Advisors
The best way to avoid capital structure issues is to partner with advisors that have deep experience helping owners obtain the capital they need without giving up too much financial upside or control. In addition to seeking legal counsel and tax advice, you’ll want to team up with an investment banking partner that can help you avoid common pitfalls and think creatively about your capital structure.
Many founders choose The Forbes M+A Group to guide them as they seek capital to fund their extraordinary businesses. Forbes has deep experience helping business owners plan for an eventual M&A exit as they obtain the capital they need to grow and evolve the company. To learn how the right partner can help you achieve the optimal capital structure, contact the investment banking experts at Forbes M+A.