How to raise business capital without losing control of your company.

Twin Cities Business Magazine
June 2006 | by Ingrid Case
If you’re a business owner who is in need of investor cash but does not want to sell a majority share of your firm, you have lots of company.

Consider the Minneapolis seafood restaurant Oceanaire, which in 2004 began fishing for money to help it grow. The catch—a $20 million equity investment from New York–based Clarion Capital Partners, LLC—allowed the restaurant to nearly double the number of cities it serves. “When we did their refinancing, they were in five markets,” says Peter Bennett, a managing director in New York for Goldsmith Agio Helms, the Minneapolis-based investment banking firm that arranged the match. “Now they’re in nine.”

Best of all—from Oceanaire’s point of view—that $20 million investment represents a minority stake. The business was able to attract and secure financing without giving up either financial or operational control.

There are a lot of private equity groups seeking high-quality deals, and there are not a lot of high-quality deals. If you own a strong business, you’re in the catbird seat. People will be knocking on your door.
Money and control are an important combination to a lot of business owners. Fortunately for them, this is a relatively easy time to find minority equity investments. “It’s a strong market today,” says Bill Cavanagh, a partner at Edina-based Counsel Funding Partners, an investment bank and management consulting firm. “There are a lot of private equity groups seeking high-quality deals, and there are not a lot of high-quality deals. If you own a strong business, you’re in the catbird seat. People will be knocking on your door.”

Successful businesses typically look for equity financing after they’ve exhausted their own resources, loans or investments from friends and family, and bank loans. Some business owners might seek investment money in order to expand the business. Others want to acquire a second business and work to synergize the two. Still others want to buy out an existing investor—perhaps a friend or family member—or get the majority owner, who typically has a great proportion of his or her personal wealth tied up in the business, some liquidity. “It allows a business owner to diversify wealth,” Bennett says.


Business owners also use investor money to pay down bank debt if they are overextended, and to get more favorable bank terms. “A lot of banks ask for personal guarantees from CEOs of early-stage and emerging-growth companies,” says Sima Griffith, founder and managing principal of Aethlon Capital, an investment bank based in Minneapolis. Banks may remove that requirement once an outside equity investor is part of the picture, allowing the owner to separate personal and business liabilities.

There are a number of places to find minority financing. In such a strong market, business owners have choices to make. Understanding possible minority funding sources and their relative strengths and pitfalls will help make those choices good ones.

 

Early Stages: Angel Investors and Venture Capital

For some companies, high-net-worth individuals—also called angel investors—are the first place to look for funding after friends, family, and bank-debt options are exhausted. Angel investors can be a good choice for companies who want to raise less than $5 million.

Duluth’s Cirrus Industries, the world’s second-largest producer of single-engine, piston-powered aircraft, raised a total of $2.5 million from 12 current and retired CEOs, most of whom are private pilots. The CEOs “understood the huge market opportunity,” says Griffith, whose company arranged the deal.

Angel investor money isn’t cheap. Ted Christianson, managing director and group head for the private placement group at Piper Jaffray, a financial services company in Minneapolis, estimates that a typical individual investor might expect a 50 percent annual rate of return, particularly if the investment is made during an early stage of the company’s development.

Companies that want to raise $5 million or more, however, will find it much more efficient to locate a single institutional investor, Chistianson says. Having one investor also simplifies investor relations.


The next stop for an early-stage company might be a venture capital firm. With an expected return between 30 percent and 50 percent, venture capital money can be expensive, too. (A more developed company is apt to pay less than one at an earlier business stage.) And a venture capital firm may value a company for less than the owner thinks it’s worth, meaning that the investment would represent a larger equity stake than the owner might like.

But venture capital allows a company to deal with just one investor. Venture capital involvement also typically gives companies added credibility, which can help secure the next round of financing.

Courting venture capital probably means organizing the firm’s accounting, patent, and copyright status to industry standards, says Steve Hanson, partner and co-chair of the private equity practice group at Minneapolis law firm Dorsey & Whitney, LLP. “Friends and family aren’t going to do much due diligence, but venture capital companies are,” he says. Getting your house in order is likely to be a part of any future capital campaign, Hanson says, so it’s smart to begin using standard procedures early in the life of the firm.

 

The Next Step: Private Equity

A company with an established product, client base, and cash flow is likely eligible for private equity investment (or late-stage venture capital). Both are cheaper than capital from angel investors, with an expected return between 15 percent and 30 percent.

In the past, private equity firms mostly purchased companies outright. Recently, however, they’ve been more willing to consider minority equity in- vestments. “Most of these guys originally stuck to buyouts, and that’s still often true,” says Christopher Kampe, a director in Boston with Grant Thornton Corporate Finance, LLP, an investment banking firm owned by Chicago-based accounting firm Grant Thornton, LLP. “But the market has become more competitive, and so many private equity groups will consider minority investment.”

Private equity groups structure minority investment in a variety of ways. Some might initially buy a majority stake and then offer the firm’s original owners a chance to earn part of the company back by meeting a series of performance targets, Cavanagh says.


Other private equity groups, Cavanagh says, serve as mezzanine debt lenders. Mezzanine debt—a middle layer of debt between equity and senior debt (which has the highest claim on the assets of the company, should it be liquidated)—includes interest on debt and warrants that convert into equity ownership. When a private equity firm acts as a mezzanine lender, it makes part of its return when the company pays interest on the loan. It makes the rest of its return when the company buys back—or when it exercises—its equity option. Mezzanine debt is typically structured with a scheduled balloon payment of principal that’s funded by company resources, a sale, or a refinance.

A private equity or venture capital group might also create a payment in kind (PIK) investment. In a PIK, the investor typically receives preferred stock with a fixed interest rate. The business owner doesn’t pay the interest in cash; instead, the interest converts into additional stock, which is paid off when the company is sold. The investor may also negotiate the right to demand payment if the company fails to meet certain financial tests or isn’t sold within a set period of time. “They can force the company owner to buy back their interest at a price formula agreed upon in advance,” says Matthew Knopf, a partner at Dorsey & Whitney.

Those arrangements, however, are departures from the most common private equity model in which a private equity firm invests in a company and gets actively involved in the way it’s run. The investors plan to improve the firm through injections of capital, partnerships with other firms, or adjustments to the firm’s operations. Then, within five to seven years, the private equity group sells its interest and returns the profit to its investors.

Structured this way, a private equity investment can offer a business many benefits. The first and most important, of course, is the money. A private equity deal can allow a firm to fund new research and development, stores, distribution, and hiring, all of which could fuel growth that would be all but impossible without that investment.

However, majority owners must feel comfortable with the other things these investors bring to the company. A private equity group can serve as a mentor to the company’s majority owner. It might introduce the company to new consultants and employees, or offer relationships with other companies it owns. “There’s a forced management-consulting approach that gets layered on top of the money,” Kampe says. “For some, that’s a burden. They just want to run their business; they don’t want the other stuff. For others, this is great—now they have guidance and a sounding board. They’re not alone anymore.”


It can be a comfortable relationship—as long as the primary owner never loses sight of the private equity group’s motivation. The groups make their money when they sell, and they only realize expected profits if businesses grow substantially during their investment terms. “You can’t have the business on idle,” Kampe says. “They want to know how the company is going to grow and how they’re going to get their expected return. You’ll be giving them a seat on the board, and they’ll want regular reports.”

As a result, private equity firms will only let a majority owner run the company without interference if that arrangement yields an expected growth rate. If the business hits a rough spot, a minority investor may try to change the company’s management team. If the majority owner resists these efforts, there will be conflict.

“Some are more patient than others,” Griffith says. “Some, at the first sign of a hiccup, might be quick to judge you and your management team negatively.” Their ability to change company management depends on the percentage of the company they own and the number of board seats held by outside investors.

Majority owners must also be mindful of potential difficulties when the private equity group sells its interest—maybe to another private equity group, or perhaps to an industry competitor. If a business owner wants to sell the entire business at this point, then business and investor interests are aligned, with both looking for the best financial deal.

A business owner who plans to stay on, though, may have a strong interest in having another private equity group as an investor. But the initial private equity investor will ultimately sell its interest to the highest bidder. “If a strategic buyer is at the table and is willing to pay $100 million, and the private equity group is willing to pay $60 million, the original private equity group is going to push you toward the $100 million,” Kampe notes. “And that may affect whether there’s a place for you and whether your employees keep their jobs.”

That’s a lot of power for a minority investor to hold over you and your company. In return for it, make sure the investor you choose offers more than just money. “There might be five different groups that offer you the same economic deal, at least on the front end,” says Knopf. “Look past that. It’s a little like a marriage, and it’s so important to understand your partner and their investment goals.”


Ask potential investors what experience they have in your industry and business type. Can they add value to help you move to the next level of success? “In addition to their checkbook, do they bring their Rolodex and their industry expertise?” Griffith asks.

Their answers will tell you a lot—and so will conversations with the senior management of other companies where they’ve invested. “Push them to tell you the other companies they’ve invested in, and contact those other firms to find out what this investor is like to work with,” Knopf says.

You should also ask those other companies how investors have handled business downturns. “Are they quick to change management at the first sign of a hiccup, or do they have a history of partnership with their portfolio companies?” Griffith asks.

This research can make the difference between keeping control of your company and ceding that control to someone else—and in the end, keeping control is the goal.