Diluting your ownership stake this way may solve the immediate problem, but it can have unforeseen consequences when the business eventually is sold.
Stockholders’ personal circumstances evolve in different ways over the lifetime of a company, and whatever the original intention everyone may not be on the same page when you are ready to sell.
A recent meeting with a potential client brought this into focus.
John had been building his industrial service company for almost 30 years and was ready to explore the potential for a retirement sale. On the face of it he had a business that was worth at least two million dollars. There was just one catch – a poisonous dispute with a minority stockholder that had been festering since the early days of the business.
The origins of the story are not that unusual. As the business grew John needed to add expensive sales resource to take advantage of a fast growing market. Cash was tight but he found a young, ambitious salesman willing to take a below market salary in return for a 30% equity stake.
Things started out well, but volume was being chased at the expense of margin, leading to an inevitable cash flow crisis. It took John almost three years to dig out of the resulting mess.
John blamed his co-stockholder and dismissed him from the sales role as soon as the problem came to light. There was much bitterness on both sides, and despite several attempts no agreement could be reached on buying out the minority stockholder.
For more than 20 years John ran the company to avoid any possibility of paying a dividend to his former employee, at considerable personal expense in additional taxes.
With John’s agreement we met with the minority stockholder, but it was clear that even for a 30% share of the proceeds he was in no mood to cooperate with a sale. An actual offer on the table may or may not have softened this position, but I wasn’t prepared to take that risk on a success fee basis and decided not to take John on as a client.
John’s problem was an extreme case but every year we see any number of situations where differing motivations within groups of stockholders prevent an exit sale:
- One stockholder looking to retire, but his co-owners needing to work on;
- Family companies where second generation stockholders have varying levels of involvement and emotional commitment to the business;
- Divorced couples unable to agree on the future and value of a co-owned business;
- Majority owners having to deal with the grieving spouse of a deceased co-stockholder;
- A minority shareholder with unrealistic expectations blocking acceptance of a fair offer.
In the interests of balance we also see businesses where a third party investment has been the springboard for rapid growth, or where an employee retained with an equity stake has become the driving force behind a company’s success.
The truth is that there are some situations where diluting the founder’s equity is the only way forward. If you find yourself in this place get legal advice on drafting a stockholder agreement at the start of an arrangement, with detailed rules about stockholder disputes and exit arrangements.
In the enthusiasm at the start of a new project this might seem unnecessary, or a waste of scarce money on legal fees, but in circumstances where you just can’t avoid diluting your equity position it is the best way to prevent future problems.