Bringing in outside investors into your fast growing company is one of the toughest things you can do. It’s like a marriage. Do it right, and the experience can be wonderful. Do it wrong, and the experience can be excruciating. For us, it was both.
The personality and attitude of our investors have been quite different, and our experiences reflect the best and worst of the Small Business Administration’s (SBA) Small Business Investment Corporation (SBIC) program. These privately managed, profit-motivated investment firms licensed by the SBA use their own capital together with funds obtained through the SBA to provide venture capital to small, independently owned and operated businesses. SBICs receive up to approximately two thirds of their capital from the SBA in the form of loans at below market rates. They then invest or loan that money to small businesses.
SBICs are generally organized and operated like any other venture capital firm except that they tend to focus on investing in small businesses with reasonably dependable cash flows that can afford to pay a regular interest or dividend in addition to a portion of equity. The interest or dividend payments are used by an SBIC to pay interest to the SBA and generate operating profits while the SBIC waits to cash out on the equity portion of its investments.
Regardless of how they work technically, SBICs, like other types of investor groups, are only as good and productive as their investor members. In one instance, we had an SBIC that was great to work with, was extremely supportive during the life of the investment and was reasonable on the exit. In another, we had an SBIC whose representatives threatened lawsuits and shared our company’s financials with competitors in an effort to create an early liquidity event for its firm.
Though technically, each team worked the same, the way the individuals in each group approached their investment in our business was quite different. Consequently, we wound up with very different relationships with each group: one good marriage and one bad one.
A Match Made in Hell
We had expected, perhaps naively, that all SBICs were going to be constructive and supportive in how they approached their investments. The SBA was created to support small businesses, and we thought that SBICs, by extension, would as well. Our hope was to bring in financial partners who could provide advice and contacts that would help us grow our business. In turn, we would execute our plan to the best of our abilities, offer the information our investors required, and listen to their criticism and advice. Ultimately, we felt our responsibility was to make money for everyone.
Instead, one of the SBICs we worked with drained our team of time and resources because the investors spent much of their time pushing an agenda designed to better their position at the expense of management and other shareholders. They continually looked for ways to extract fees and expenses out of the company. Instead of working cooperatively with management, they treated management with contempt and distrust causing additional stress.
The difficult SBIC originally required two board seats on a seven-person board. The investor members of the SBIC required the company to pay their board representatives fees for attending meetings (even though they were full-time employees of the SBIC) plus their expenses for flying their private jet up to our meeting. It turned out that they were from a small city without direct or reasonably cost flights to almost anywhere, so we wound up funding their private jet flights. We repeatedly asked them to do meetings by telephone but at least twice a year they felt it was their “duty” to fly the private jet up to our offices to attend the meetings.
In board meetings, the SBIC board members focused more on their roles as company auditors instead of their roles as management advisors and strategic planners. Despite EBITDA margins in excess of 20%, board meetings would be spent justifying financials and explaining to the SBIC board members why management was not interested in moving forward with a liquidity event. At least once a year, one of the SBIC representatives would lead a discussion regarding whether our industry or company was relevant in the marketplace. He would regale us with stories of well-run, profitable companies that ran into tough times. It didn’t matter to him that our company was doing better and getting stronger every day, every month and every year. He was going to do what he could to convince us to execute a liquidity event early, so they could take their profits and see the result on their stock price.
Not once in the six years of our relationship did these board members ever offer a suggestion to management on how to make the company better or stronger. They never made suggestions to help grow or build the company and only once did they ever refer a potential customer to us.
The biggest insult came when we had a chance to buy a division of a large, well-known public company. I called the SBIC board members to see if they knew of anyone who might make an investment to help us purchase the company (their company had reached their investment limit). One of the board members immediately told me he knew of a couple of people or companies but insisted that we first sign an investment banking document requiring us to pay him fees and expenses before he would tell me their names. Like everything else they did, the document was one-sided and it took more then two days to negotiate. Suffice it to say, someone else purchased the company because we were unable to raise the money necessary and the SBIC board member/investment banker never referred even one potential investor to us during the process.
In addition to adding no strategic value and acting like auditors, the SBIC representatives were often caustic and antagonistic towards management. They justified this behavior by claiming they had a “duty” to shareholders to act aggressively toward management shareholders. This became laughable in the last two years of our relationship when all of the shareholders were on the board. (We had repurchased all other outside investment except the management shareholders and them.) I’ll never forget the meeting where they aggressively questioned the management shareholders about the company’s expense verification processes. They wanted the board to put processes in place to protect the company from possible abuses in the payment of expenses to the management shareholders. They ultimately admitted that they had no specific expense or expense category in mind when they brought this up but still felt that the company needed to be protected from the management shareholders. After a long speech where they essentially accused all management shareholders in every company they’ve ever invested in of being thieves, they found out that our management team had repeatedly failed to submit any expenses. In other words, the processes didn’t matter because none of the management shareholders were actually submitting expenses or getting reimbursed.
As we began to unwind the investment and pay them out, the relationship with the difficult SBIC continued to be tragic. They ultimately negotiated a buyout for themselves that required a marshalling of the cash flow to them at the expense of the management shareholders. While this might be justified in a situation where the cash flow wasn’t stable or the company started showing lesser results, it wasn’t justified as the company continued its trend of increasing cash flow and positive, stable results.
A Match Made in Heaven
Our other set of investors was the ones we had hoped for when we first began our fundraising process. They asked questions, made constructive suggestions and provided excellent advice. This SBIC let us get on with the business of management, and did not demand fees not directly related to the goals of the company.
These investors did not ask to be on the board nor did they ask to be involved in corporate governance. While they had observation rights, they never exercised them. Instead, one of the managing partners and I would have breakfast once every three or four months to discuss what was going on and to explore how they might be able to help the company.
At these meetings, the managing director would often give me ideas on how to approach difficult situations (including situations caused by the other investor) and also would give me the names and contacts for people who might be able to help the company as an investor, advisor or customer. Additionally, I felt comfortable calling the managing director for advice on a whole range of matters, and he never complained when I called him on his cell late in the evening or early in the morning. In fact, I still call him regularly. In all the time we worked together, he never asked for a fee for meeting with me or discussing the company. In fact, he always offered to pick up the tab for our breakfasts even though I would never let him.
When I called the managing director for approval of corporate activities (as required by our agreement), the approvals would be fast and wouldn’t cost a dime. Often his insights into ways to structure things helped me make solid transactions even better.
Finally, upon exit, the investors were incredibly flexible in allowing us to repurchase our equity at reasonable prices and on reasonable terms. The terms of the repurchase did not require any security other than a pledge of the repurchased shares. They placed no restriction on our use of any other funds, and they allowed us to continue operating the company as we saw fit because their payments were being made on time. In the end, they were paid every dollar we had agreed to pay, and they were pleased with their total returns.
Getting funding is hard work and will affect your enjoyment of running the business. For as much due diligence potential investors do on your business, be sure to do your own to determine whether the investors are the type of people you want to do business with. After all, there is nothing better than a happy marriage—and nothing worse than a bad one.