The Power of the Minority: Why minority investment in your company can be bad

In its best form, a minority investment can be great for a company. It can provide critical growth capital. It can bring in another sophisticated advisor to improve business operations, open new sales opportunities, and assist in recruiting key management. But there other possibilities that entrepreneurs should understand before they accept the money.

Typically a minority investment will come from an angel investor, a financial investor such as venture capitalist, or a strategic investor like a corporate partner. Each one will have different motivations for making their investment and will play their role as shareholder differently. Understanding their motivations will help founders ensure they get the value they are looking for.

Most minority investments are in the form of preferred stock. Preferred shareholders have rights and preferences not shared by common stockholders. The rights and preferences recognize the value of the capital and protect the investor as a minority shareholder. These differences between preferred and common shares impact both economics and control.

First, there are economic benefits that minority investors will try to obtain. For example, preferred stock may be interest bearing, which means the company will accrue interest based on the amount the investment. There may be a preferred return as well, which would kick in when the company is sold or merged. In this case, the preferred shareholders would get their money back first (either at par or at some multiple) before the common shareholders get any money.

Second, preferred shareholders may also exert control that exceeds their percentage ownership. For example, they may have greater representation on the board or have rights that require their approval for certain corporate actions, such as budgeting (the key way a company allocates its resources to its business activities) or a sale of the company.

The rights and preferences of preferred shareholders, even a minority position, can have profoundly negative impacts on common shareholders. This is seen most clearly in an acquisition or merger.

Preferred shareholders may get tired of staying the course and use their control provisions to force a sale of the company in order to get a return of their investment. This is more often seen with financial investors like VCs. Whether the sale is forced or not, the economic preferences must be satisfied before other shareholders get any sale proceeds. This diminishes the consideration available to common equity owners, which gets increasing onerous as transaction size decreases. Minority preferred shareholders may try to force a sale at a price that makes them whole, and is attractive to buyers, but leaves nothing for others.

If the minority investor is a strategic investor, they may not want an acquisition to happen at any price because they value the business benefits of the close relationship. Even if they are willing to sell, they may not want the company sold to certain acquirers. Since they made their investment for strategic business reasons, it is no surprise that the logical buyers may include their direct competitors. Minority shareholders have dissenters rights in many states, which may enable them to slow down or even derail an acquisition.

So if youre tempted to take a minority investment, understand that they can be a two-edged sword and seek professional advice to help reduce your risk.

Posted by , Chairman Emeritus on 15 April 2011
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