Raising money to start a business, or to expand business operations, is probably the greatest challenge business owners will ever face. Getting bank loans or traditional financing can be difficult, especially in times of tight credit like those our economy has experienced in the recent past. Banks require all sorts of documentation, good credit scores for both the business and its owners, and frequently require that the owners pledge their own personal assets as collateral for any business loan. Second mortgages on the owners’ residences, for example, are extremely common with banks and other traditional lenders. If the business’s owners have exhausted their own personal capital, where can they turn?
Friends and family are often good sources of capital, but in general the amount of available funds will be severely limited unless the friends and family in question are wealthy, sophisticated investors. The natural inclination, therefore, is for the owners of a business to turn to the private equity market and look for investors who will contribute significant amounts of capital to the business. These investors are usually very sophisticated and have been through the investing process many times. In other words, they know the risks involved in an uncertain investment, and along with that they also know all the ways to limit that risk. The mechanisms used to limit this potential downside are extremely disadvantageous to the original owners, and so anyone looking for private investment must be aware of these pitfalls and plan for them accordingly.
The goal of the original owners in acquiring private equity investment is, of course, to continue to run the business as they have been. In other words, they want the investors’ money, but do not want any input or other “meddling” from the new investors. Private investors probably will go along with this idea; after all, the decision to invest in the business is based, at least in part, on the investors’ assessment that the existing management of the business is competent and trustworthy. The investment agreement, however, will undoubtedly contain provisions allowing the new investors to step in and take control of the business under certain circumstances. For example, if the business revenues decline significantly, or costs increase dramatically, or the overall financial condition of the business declines, the new investors will want the opportunity to assume control over the operations of the business to protect their investment. These provisions may even extend so far as giving the contractual right to the new investors to buy out the original owners or otherwise reduce or eliminate their interests in the business.
Even in situations that do not necessarily allow the new investors to assume full control of the operations of the business, there will be times in which the new investors will at least have “veto power” over certain decisions of the entity. Any effort to incur new debt, for example, or to issue additional stock or other interests in the business, will undoubtedly trigger the rights of the new investors to veto such a decision if they choose to do so. This might even extend to obligations in the ordinary course of business. A line of credit with a particular vendor, for example, might trigger the new investors’ rights, even though such lines of credit are routine in the business’s history and constitute no real threat to the business’s financial integrity.
A business cannot grow without capital. Private investors can serve a crucial purpose for small businesses, but there are attendant risks that the original owners of the company cannot afford to ignore.