Founder Control in PE: What the Numbers Don't Tell You

Start With Your Goals

If your goal is to sell your business, then the calculus is different. You are shopping for a buyer. Presumably, you’d want to maximize valuation. Beyond that, you would want a private equity buyer who would responsibly steward the business you have built, take care of your team, and successfully grow your business. If you’re not looking to sell out, why are you considering a PE partnership? Liquidity? Access to capital for accelerated growth? Help with scaling your business? Capital markets expertise? These are all good reasons to consider bringing in a private equity partner. New Harbor exclusively partners with founders to help them scale their businesses to the next level. We’re not looking to buy companies that are FOR SALE—we’re collaborative partners that exclusively work alongside founders to grow their companies.

Alignment is Essential

In any type of partnership, alignment is essential. Whether it’s a private equity partnership or a marriage, picking the right partner makes all the difference. Do you have the same goals? Is your vision of the future aligned? Are you compatible? Do you have complementary strengths? Partnering with a private equity firm isn’t much different than a marriage: your day-to-day quality of life and satisfaction will depend on who’s at the table. Dating is important due diligence (meetings, dinners, etc.), but checking references and track record matters even more. Talk to other founders the PE firm has worked with. Ask about whether the private equity firm delivered on promises. How were they involved? How did they communicate? What demands did they place on the business?

The bottom line is that not all PE firms are created equal. It is also about more than just money. Some are helpful and good to work with, and some are not. In the end, any PE firm that has been around for a while leaves relationship breadcrumbs that will lead you to the right answer. Don’t be distracted by fancy presentations—do your homework. When New Harbor is courting a business owner, we provide a comprehensive list of all the founders and CEOs we have worked with over decades of experience. Be wary of any firm that is not willing to do this. Obviously, not every investment goes according to plan. How a firm has behaved in good times and bad will tell you what you need to know.

Majority vs. Minority Investments

Most private equity firms are focused on acquiring majority control of a business. This is what their underlying investors (their Limited Partners) have hired them to do. Some firms will also consider minority investments, but not many. Often, there is a general reluctance to investing institutional capital behind a founder-entrepreneur because goals, objectives, and decision making may not align. As such, when a private equity firm backed by institutional capital structures a minority investment, there will typically be several protective provisions, such as:

• Negative Control Rights: The minority partner has a right to block decisions related to acquisitions, divestiture, hiring and firing key executives, significant CAPEX, etc.
• Affirmative Control Rights: The minority investor is typically required to approve the budget.
• Liquidation Preference: Often, the PE firm will structure their investment as debt with equity warrants. Even if structured as equity, the minority investor will typically get their investment back ahead of the founder either through preferred equity or a different class of common shares. Further, occasionally a structure will be put in place which gives the PE firm a disproportionate share of the return until certain targets are met, after which returns are rebalanced based upon ownership percentages.

Board Seat(s): The minority private equity partner will always get one or more Board seats and will have fairly extensive reporting and information rights (audited annuals, quarterly/monthly financials, budget/plan, inspection and books-and-records access, and compliance certificates, etc.).

Investment Management Plan

Most firms will develop an Investment Management Plan (“IMP”) ahead of making an investment. This plan would typically get approved by the firm’s Investment Committee and might even get published to its underlying investors. The IMP is a roadmap for the investment and spells out the goals, objectives, and sometimes the anticipated timing of the IMP initiatives. For New Harbor Capital, this document is critical to foster alignment. We develop our IMPs in close collaboration with our founder partners and their management teams to ensure that everyone’s best ideas are incorporated. In the end, the IMP becomes a common definition of success, and effectively, a prenuptial agreement. We believe that co-authoring this document and spelling out initiatives, timing, and responsible parties is good for planning and accountability, fosters healthy relationships, and mitigates relationship failure. A marriage could be difficult if one spouse wanted lots of kids while the other wanted only one, or where one wanted to adventure travel and the other preferred doing puzzles at home. Clarity and alignment are fundamental.

Economic Alignment

When a founder brings in a capital partner, it’s typical for them to receive some liquidity. Obviously, in a majority deal, the quantum of upfront liquidity is higher than in a minority transaction. Many private equity sponsors want the founder to retain equity ownership to ensure that they remain motivated to drive value creation in alignment with their investment objectives. Sometimes, in view of the significant payout that a founder receives at the time of investment, various structuring techniques could be used to enhance alignment:

• Different Classes of Stock: (1) The private equity firm could have preferred equity, or a different class of common stock with a liquidation preference, or (2) the founder might be awarded incentive equity tied to the performance of the PE firm’s equity.
• Earn-Outs: When there is a large gap between the founder and the PE firm’s expectations of future performance, this is sometimes bridged with an earn-out tied to future performance, which pays out in cash when the performance criteria are met. This could be in addition to equity and equity incentives.
• Seller Debt: Sometimes obtaining financing for smaller, founder-owned companies can be difficult, and a PE firm may require the founder to defer some of the purchase price in the form of a seller note.
• Employment or Consulting Agreements: Depending on the role of the founder post-closing, there could be a contract for compensation tied to that role which could be at, above, or below market rates depending on the transaction.

Ownership and Voting Rights: Not Always the Same Thing

Private equity investments often introduce new equity classes with distinct ownership and voting rights. Investors often receive equity that carries specific approval or consent rights.

These rights may apply to fundamental decisions such as:

• Issuing new equity
• Selling the company
• Taking on significant debt
• Altering capital structure

Even in minority investments, these provisions can give investors influence disproportionate to ownership. That influence is usually focused on protecting downside risk, not managing daily operations—but founders should understand where voting rights override simple ownership math. Fundamentally, control resides with the Board of Directors, and voting rights and Board seats are typically legislated in the transaction documents and are sometimes independent of ownership percentages.

Founder Role

One of the reasons to consider bringing in a private equity partner is because the founder desires to transition out of day-to-day leadership of the business. This might happen at closing, mid-stream of the investment, or just prior to the PE firm’s exit. Most PE firms have extensive experience building management teams and thoughtfully navigating these types of transitions. Established firms like New Harbor Capital also have extensive executive networks that they can tap into for executive roles, Board roles, and operational support. This is a core benefit of working with a private equity partner. In the end, being clear, upfront, and honest about personal goals and objectives is critical to developing the right plan and fostering alignment.

Why Bring in a PE Partner?

There are many good reasons to consider bringing in a private equity partner:

• Liquidity: Most founders, especially those that have bootstrapped their business, have the overwhelming majority of their net worth tied up in their business. Eventually, this can lead to risk aversion, as founders feel like they are gambling with their net worth when making significant decisions. As the risk-taking behaviors that made the business successful begin to change, the business can stagnate, thereby affecting its value. Bringing in a PE partner enables a founder to diversify their risk by taking some chips off the table and restores their appetite to take risk and grow.
• Acceleration: Great PE firms have relevant ideas, experience, and relationship networks that can be very helpful in growing a business. They also have access to capital to fund growth, which can make a major difference relative to a founder that is otherwise forced to fund growth from their personal balance sheet. PE sponsors also are motivated to generate results quickly since most have a five-year target investment horizon.
• Capital Markets Access: Founders have difficulty accessing debt and equity capital markets to support growth objectives. Having a professional PE partner is an endorsement that capital providers take confidence in, which can be a major unlock. Capital providers recognize that a PE partner ensures professionalism and accountability for all stakeholders.
• Growth by Acquisition: Most founders do not grow through acquisition because of lack of experience in M&A, lack of access to capital, and risk aversion. Growth through acquisition is a foundational part of a PE firm’s growth and value creation playbook. Often, growth and diversification that would take years on an organic basis can be accomplished quickly through acquisition. The best add-on acquisitions also typically have synergies that can lead to accelerated earnings growth. The accelerated growth, scale, profitability, and diversification can lead to both absolute and relative valuation increases, thereby driving equity value.
• Thought Partnership: Being a founder can be lonely. Having a PE partner with relevant experience and aligned incentives can lead to highly productive collaboration. The PE firm becomes a true partner and a sounding board—someone to stress-test ideas with and lean on for support.
• Becoming a Market Leader: A well-executed PE partnership can lead to accelerated growth, profitability, and diversification, and can transform a small, growing, founder-led business into a true market leader. At New Harbor, this is central to our business model. Our mission is to transform businesses into enduring market leaders in partnership with business founders.

Many founders of small and growing companies suffer from FOMO (fear of missing out). They worry that taking on a private equity partner now might be too soon because of all the growth and opportunity they see in the near term. In truth, that is typically factored into the valuation, and as stated above, growth with a PE partner is often greatly accelerated relative to what a founder could achieve on their own. In a well-structured transaction with meaningful founder retained equity, a founder can take 60%-80% of the value of their business in liquidity upfront, and the rollover ownership can materialize into multiples of that liquidity over the five-year target investment horizon of the PE partner. Ultimately, this roundtrip value can be substantially higher than what could have been achieved over the same timeframe independently.

PE done right can be a beautiful thing that benefits all involved!

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Questions? Reach out to us at info@newharborcap.com today. 

DISCLOSURE: The opinions expressed herein are subject to change at any time without notice.