Be Careful About Bringing in Equity Partners at 20 Percent Ownership or Greater
Not everyone has the aptitude, the savvy or the deep pockets to be able to start and manage a business on their own. Most of us are dependent on bringing along a partner (or partners) of some type to help finance and run the shop. And while those associates will likely expect – and deserve – a measure of equity in the firm, just how much of that share in ownership should you allow? What are the implications when that percentage surpasses a certain threshold? Should you be concerned, for instance, about taking on a single investor who has more than a 20 percent stake in your venture?
There are several points to consider, not the least of which is how much influence the stakeholder can exert on the company based on his or her level of equity. Owners of shares between 20 and 50 percent can often expect to shape operational policies and financial decisions surrounding issues like capacity expansion, pricing, outsourcing and research funding. If appropriate and available, they may rightfully seek representation on the board of directors. These are all factors that don’t usually come into play for owners whose investment percentage is less than 20 percent.
A correspondingly critical consideration in determining the level of equity partnership is that the Small Business Administration – and, in fact, most lenders today – require that all approved loans must also be personally guaranteed by anyone with a 20 percent or greater ownership stake. That makes sense; anyone at that level of active investment should have some skin in the game. Meanwhile, as an owner, the concept of multiple guarantors helps to minimize your overall risk.
Issues could arise, however, if the company is struggling or if the minority and majority investor have a falling out. Under those circumstances, the minority investor may refuse to provide a personal guarantee, thus limiting the Founder’s ability to obtain additional bank loans. But what, exactly, does that personal guarantee entail on the part of the investor, and why might they be hesitant to agree to one?
Frankly, personal guarantees and laying one’s own finances on the line is a common expectation in small business today – but one that neither lenders nor borrowers like to especially talk about. Almost by definition a personal guarantee is unsecured, which means it’s not tied to any specific asset. But by making a guarantee, an investor puts himself and his general assets on the hook by effectively acting as the loan’s cosigner. If the business dissolves and/or fails to repay the loan, creditors can go after the guarantor personal assets, which in some circumstances could include the guarantor’s personal residence.
One option around the personal guarantee is to split the minority owner’s capital contribution between debt and equity. With that approach, however, the investor has to be prepared to subordinate his loan to the senior lender, an arrangement that can usually be set up with the original financial documents.
Another option – and one of the best ways to prepare for any financial change in the business, both expected and unexpected – is through a buy-sell agreement among the partners. Such a buyout arrangement provides guidance as to when owners can sell their respective interests in a company, and a framework for governing the situation if a co-owner dies or otherwise leaves the business. For more on these and other issues surrounding equity partnerships and your business, contact Kaplan CFO Solutions.