The perils of taking stock when you sell

Every entrepreneur, private equity and venture capital firm hopes that the “happy outcome” of any start-up, investment or venture will be an ultimate sale or initial public offering of the business in question. All too often, however, investors are asked to take stock as part or all of the consideration. Folks often wonder why professional investors balk at the concept, and here’s why.

For the entrepreneur who will stay with “NewCo”, taking back stock in a sale transaction isn’t generally a bad idea. He/she will remain in a position of influence and will be able to monitor the stake as the business grows. For the VCs, Angels and PE firms who were also given paper as part of their sale proceeds, it’s a much more complicated concept.

There are many reasons for this, but the primary concerns investors have are as follows:

1. As part of their original investment agreement, VC-types generally have Board level access, observer rights or, at a minimum, some degree of influence. More often than not, they actually sit on the Board and enjoy all of the appropriate tools to monitor their multi-million dollar investment.

2. Shareholders agreements add teeth to any Board role or similar direct investment relationship. If the investee company skates offside, VCs are able to swing into action. Generally, the big hammer is the ability to change management. But the muscle to block non-arms length transactions, for example, is another plus. Want to put your kids on the board of a VC-backed story? — not likely.

3. Financial oversight may be a subset of #1, but the audit committee, budget approval process, right to veto unusual expenses, etc., are just some of the tools that give the VCs comfort that precious investment capital won’t be wasted.

4. Lock-ups, escrow agreements, etc. invariably mean that original investors are unable to actually “cash out” of their investment should there be a public market to do so. All too often, an illiquid small cap public company’s shares don’t have sufficient volume or institutional investor interest to allow VCs to exit at the original acquisition price — which has the same practical impact as a formal lock-up. Sure, you may have the right to sell, but the lack of volume makes that unfeasible. If you want to exit, you’ll likely crater the stock, which means that hard-fought transaction multiple just went down…possibly below the point you would have sold at the outset.

There have been a litany of paper-type transactions. Pixstream’s ~US$200MM sale to Cisco (CSCO:NASDAQ) circa 2000 comes to mind. Although someone at Pixstream referred to Cisco shares as “being better than U.S. dollars” at the time of the deal, that sure didn’t hold true: Cisco shares dropped massively post-closing, and many investors couldn’t actually get out at anything close to the original share price. That wasn’t for lack of volume, of course. The collapse of the NASDAQ bubble generated plenty of volume — but many original investors had handcuffs on their stock for longer than they would have liked.

Investors in private co. Don Best Sports did far better when they sold to FUN Technologies (FUN:TSX). The investment dealer-enforced lock-up actually made for a higher sale return as FUN shares soared during that 1 year escrow period.

We had our own experience recently, as well. One of our favourite Wellington Financial Fund II portfolio companies, Top Aces, was acquired last summer by TSX-listed Discovery Air (DA.A:TSX). As a fund, you go from having a regular partnership-type dialogue with the founders, to being captive in an illiquid small cap stock. But once the deal closes, your access is awfully limited. Even if your investment group is the acquiror’s single largest institutional shareholder, as is our syndicate’s case with Discovery.

If you’re concerned about governance, you are free to write a letter. If you have questions about expenses, you can write a letter. But if there’s no answer coming back, or you don’t think the question was addressed to your satisfaction, you’re relegated to either i) burying your concerns, or ii) taking Conrad Black’s advice for disgruntled Hollinger shareholders: “If you don’t like how we’re running the company, you can always sell your stock.”

But that isn’t the point, replied Lord Black’s shareholders in that extreme case. All shareholders own the company, not just management shareholders.

There are the quarterly conference calls that all investors can dial into. But as a forum for getting good (any) answers to simple questions, it just doesn’t work. In part, that’s because most quarterly earnings calls are ultimately for the benefit of equity research analysts. Institutions rarely listen themselves…let alone ask questions.

Ask the part-time CEO what percentage of his/her time they spend on one CEO job versus another? Despite charging $400,000 a year for their services under a Business Advisory Agreement, they can just repeatedly dodge the question with “I have no estimate”. Ask the Board Chair why only a minority of Board members represent the interests of independent shareholders? “We have a subcommittee looking at the question of Board representation”.

Ask about progress on synergies, and the CEO has the luxury of comparing himself to Warren Buffet. The greatest investor of our time. Now that’s some serious firepower to haul out.

Speaking of big names, the Rockefeller Family is calling for change in corporate governance at Exxon according to the WSJ. Perhaps the trend of traditionally private investors speaking out on behalf of their capital is upon us. Discovery’s part-time CEO, David Taylor, should take note.

Exits are part of the VC and PE business. And there are no promises. But, never delude yourself that the exit is the end of the investing process if it involves paper as part of the consideration. Sometimes it’s just the beginning of a new adventure.

MRM