Money Lost, Money Found - Bringing Back Shareholders Burned by Early Stage Investing

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For all the trillions lost in publicly-traded stocks, overlooked are the billions lost by shareholders of small privately-held companies. These investors enjoyed the double disaster of a declining stock market along with write-offs of significant portions of their private portfolio. Private companies, however, can lure these investors back in the game with some well-considered investor protections that still permit firms to grow and prosper.

1. Provide an Exit Sign Along with the Welcome Mat

Problem: Often, the company gets cash, while shareholders get hope for a future bonanza. Investors too often view their stock as a lottery ticket for a future payoff — with vague notions of a million-dollar moment when the company goes public or is acquired. Companies would benefit from clarifying rules dictating when investors may sell their investment or receive their money back from the company.

Solution: The articles of incorporation or written shareholders’ agreement can give investors the right to demand their investment after a specified time. Investments may include terms that are likely equity stocks, terms like borrowed debt, or a combination of both. Shareholders should incorporate loan covenants and protections in the equity documents. This could include forced dividends akin to interest payments, or a right to sell the shares back to the company akin to a loan repayment. The company could repay the purchase price over a few years via a promissory note. The right to sell the shares back to the company could be triggered by the occurrence of an event of default or upon achieving a milestone. The repayment could be partial or only required of non-management shareholders. While tough love for the company, these investor exit rights give management the benefit of deadlines and targets they would otherwise lack.

2. Empower the Investor

Problem: Investors often write checks, go home and wait for dividends. Aside from the unusually lucky shareholder, small company investing does not work like that. Without written rights to information and management control, investors are as empowered as a medieval serf. Also, without a plan to actively monitor investments, the company loses the discipline and oversight that outside shareholders can provide. Even the best athlete needs a good coach.

Solution: Management should craft corporate documents that describe rules of director oversight, without sacrificing managerial autonomy. The articles of incorporation are like a company’s constitution and are filed with the state. Corporate laws protect investors from arbitrary changes and amendments must be publicly available. In addition, bylaws and private investment contracts provide owners with the following protections, among others: 

• Voting thresholds to approve significant tasks. This could include majority or supermajority approval levels, such as two-thirds of the shareholders. The threshold will depend on the concentration of ownership. In general, investors should ensure that no single manager or lead investor can make all the decisions. On the other hand, the documents should not suffocate corporate management by requiring virtual unanimity.

• List of important decisions requiring approval. These are the significant decisions of the company, such as hiring of senior management, spending significant sums, selling significant assets, making significant acquisitions, or changing the rules governing the company and investors.

3. Manage Expectations – Forging a Foundation for Future Investment

Problem: Shareholders often falsely believe that the first investment in the company will be their last. Like a car requiring gasoline on the road trip, many investors must refuel their portfolio companies every year. If revenues are slow and earnings light, firms commonly look to current shareholders for cash.

Solution: Provide investors protection against the unexpected by giving them some control over the amount of future investment. Alternatively, firms may provide shareholders with “anti-dilution” protection. This usually equates to increasing the shares allotted to an early investor to protect against dilution either in their proportion of ownership, or based on the price per share originally paid.

4. Perception is Reality – Inside Deals that Trigger Investor Anger

Problem: Companies often execute employment and other agreements that reward or protect insiders for initial investments and previously uncompensated time. Firms should avoid approving overly generous agreements. For example, management may execute employment agreements with job protection fit for a sports superstar, but not disclose such an arrangement to the investors. These are especially common for companies that had operated without outside investor oversight.

Solution: Provide new shareholders with a purchase agreement with lengthy representations and warranties, or accommodate due diligence inquiries that require disclosure of all agreements. These agreements could require a review of all inside contracts and arrangements. Firms might empower shareholders to require that windfall deals for the managers be revised to fairly reflect market terms. Future insider agreements should require the approval of outside directors or shareholders.

5. Advertise Realistic Company Values

Problem: Investors often purchase stock based on the creativity and logic of the business idea, not the measure of the value of the entire business. The private company is usually small and the business concept untested — why else would an entrepreneur launch a new venture? As a result, traditional valuation methods fail. Comparables in the public market — are you kidding? Net present value of a stream of earnings — what earnings? Liquidation value of the assets — ever try selling used clothes?

Solution: Investors are left with methods that resemble valuing a home. Companies can assist by identifying similarly sized, similarly situated firms. How did the investors value this comparable company? How much did a larger company pay to acquire the company? If there is no comparable firm or idea — then management should be prepared to radically discount the value of the investment.
In addition, agree upon a fair sharing of the business. Once the parties establish a value, simply assign a percentage of the company based on the amount invested. This might vary slightly if the investors negotiate rich dividends and other protections. However, often investors mistakenly believe that their purchase of thousands or millions of shares represents a significant stake. In fact, these seemingly large numbers might actually amount to a very modest proportion of many millions more issued to other purchasers. If a company needs their help or financial assistance again, the one-sided deal will come back to haunt the company.

6. No Financial News is Bad Financial News

Problem: Once the shareholders’ checks have been cashed, they may never again receive detailed financial information on the company operations. Investors are left waiting and wondering whether their investment will ever return.

Solution: Management should provide agreements that require periodic reporting, including the types of financial information required. If necessary, employ third-party accountants to verify the accuracy and veracity of the information.

7. Finding a Home for the Orphan Investor

Problem: If the company has too many shareholders, not a single one holds enough of a stake to care. While this might seem like a summer vacation to unsupervised managers, in fact this deprives them of valuable oversight. Even well-meaning company managers are deprived of the valuable oversight of shareholders with a significant interest. Like the public park that no one cleans, the company becomes a financial afterthought of concern to no one but the management. 

Solution: Corporate documents should dictate that at least two or three investors who have significant holdings also have control. These lead investors can often act on behalf of those with smaller interests. For example, the investors might be grouped into different classes with each guaranteed a representative on the board of directors.

8. Protecting the First Investors

Problem: Shareholders without significant experience investing in private companies often mistakenly believe that the first money in is the first money out. Ironically, often the second or third-round investors receive more protections than the first. Thus, the cruel irony: the most loyal supporters receive the lowest return.

Solution: Companies can protect their early investors by reviewing proposed amendments to corporate documents that benefit later-stage shareholders. For example, later investors might receive their funds first in “liquidation.” Problem is, “liquidation” is usually defined to include the sale of the company. Money from the sale of the company would not be distributed evenly. A ten-percent shareholder would receive ten percent of the proceeds only if the price of the firm exceeded a pre-determined threshold. One group of shareholders may be guaranteed to receive $10 million first, and the others share in the distributions only after the sale proceeds exceed this $10 million threshold. Thus, a ten percent stake in the company could actually yield nothing if the firm sells for $9 million. One investor’s payday is another’s write-off. This imbalance is magnified if one group of shareholders must be paid all their dividends before the others. If possible, investors should receive dividend rates, and payout schedules, comparable with other classes of owners.

9. Create a Board with Genuine Oversight

Problem: Investors often take false comfort when appointed as a director. True, they enjoy the theoretical right to extra information. However, without a contractual veto right, or the ability to vote as a majority of the directors, the position is meaningless. Companies can simply skip meetings or overrule the minority director. Nothing will stop the other directors from simply calling each other, making decisions, and directing management, all without a formal meeting. 
Solution: The bylaws should be drafted to provide a solitary excluded director the right to compel directors meetings. Shareholders’ agreements should require that specific information, including annual business plans, be delivered to substantial shareholders. Directors may also be divided into classes, where an outside group of directors, voting as a class, must approve significant changes.

10. Create Rules about the Rules

Problem: New investors often ignore the procedural provisions of corporate documents — the dullest and densest of the corporate contract. These include procedures to amend the bylaws or the articles of incorporation. A shareholders agreement that appears air-tight may be amended with the consent of merely a majority of shareholders. Company management could provide rules imposing high thresholds for amendment, whether for the articles of incorporation, the bylaws or other shareholders’ agreements. To the recreational investor, these documents may appear “boilerplate” on the first day of the deal. If shareholders neither read nor discuss these provisions with their counsel, however, they can hardly claim to be shocked upon discovering that the rules are written in silly-putty, not stone.

Solution: Companies may provide investors with rights that restrict the company from unilaterally changes corporate procedures. To accomplish this very unexciting exercise of drafting the rules to write the rules, shareholders should either choose a first among equals to review and negotiate the terms, or, alternatively, investors can pool resources to select an advisor to review the deal or represent the new owners when negotiating the deal. 

11. Convertible Notes — the Swiss Army Knife of Investments

Problem: Early-stage investing is like the first brush stroke on a white canvas — no one quite knows where to begin. What is the company worth? What are fair protections for investors? Will the venture ever get its first customer? What will other investors demand? The company is a bitter-sweet cocktail of hope and uncertainty.

Solution: Investors can lend the company the money, with the promise of converting the note into equity once the parties better understand the company’s financial prospects. The promissory note becomes a shareholder right once other shareholders agree to contribute funds. The terms of the converted note will simply mirror that of the future investment. Thus, the original investor need not fret about matching the precise terms of the investment to the market. The parties simply wait and permit the first investor to benefit from the investor’s position as a creditor until the financial future becomes clear. However, investors should carefully negotiate significant terms of the note, such as:

• Who can elect to convert the note — the company or the shareholder?
• Will the note simply convert automatically upon the raising of future equity?
• Is there a minimum future investment before the note converts?
• Will the note contain covenants and interest provisions similar to other promissory notes?

Craig McCrohon specializes in mergers & acquisitions and securities law. For more information, he me may be contacted at 312/840-7006 or

330 North Wabash Avenue, Suite 2100
Chicago, Illinois 60611-3607
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