Every board of directors (“Board”) regardless of industry or ownership structure encounter similar challenges. For example, every Board must conduct an appropriate level of instruction and supervision to management. Likewise, every Board must provide guidance on long-term goals and company direction.
However, at the end of the day, a Board owes its fiduciary duties to one constituency: the company’s owners, the shareholders. Consequently, in real life—if not in theory—the question of “who” is ownership matters greatly. In this article, we briefly explore the role of the Board in a partially or wholly fund-owned business.
A fund’s ”mandate” and culture dictate most everything about the Board’s role in the context of a fund-owned business that is wholly owned by a fund. When the business is wholly owned by a fund, the goals of the fund usually become the goals of the company. For example, if a private equity fund has a five-year life span, the fund will seek to extract as much value out of the company as it can during that five-year period (typically by growing and re-selling the company before the term is complete), rather than investing in the company for the long-term.
If a traditional family office or another investment vehicle is the owner, the Board will align company goals with a long-term view of ownership, likely beyond a five-year period. The goals will be based on how the company fits within the family office’s overall investment portfolio and ownership objectives. This later scenario usually results in the Board seeking to build and maximize long-term company value outside of a predetermined time frame, much like a typical business enterprise.
Fund dynamics should be recognized to a potential seller of a business. If the goal of the current owner(s) is to merely cash out, then private equity may be the best solution, because sales to private equity often yield the highest multiples. However, the current owner(s) may wish to preserve legacy, take care of employees and/or ensure that the company or brand name will continue. In that case, “strategic and patient capital” (i.e., traditional model family offices, employees or a strategic buyer) may be the better approach. These guidelines typically hold true regardless if it is a sale of 100% or something less than 100% of the ownership or assets of an operating company.
One of the most important tasks of the Board, regardless if this is the first sale to a fund or from one fund to the next, is to work with the owner(s) to evaluate their sales options (including potential fund purchasers) and to guide the owners down the most appropriate path to best accomplish their goals.
If a fund is the sole owner of a company, the fund will obviously control the Board, and the Board will be tasked with fulfilling the fund’s mandate. Things become more complicated if the fund is not the sole owner, as each member of the Board has a fiduciary duty to act in the best interests of all of the owners, not just the interest of who may have appointed them (i.e., where the fund has the legal or contractual right to appoint x out of y members of the Board). While arrangements can theoretically be put in place to overcome this problem, such as provisions in the Articles and Bylaws, and/or consent of all of the shareholders, these mechanisms to allow directors to represent interests other than the owners remains untested. Nevertheless, in these instances, there may not even be an alignment of interests between the fund/its Board appointees and the company/all owners.
An example: if the company’s capital equipment needs to be replaced towards the end of the fund’s investment cycle, the fund would likely prefer to distribute those funds rather than make the capital expenditure (unless of course the purchase of the equipment would result in a larger sale price). The company, however, may feel that the capital expenditure is necessary to continue operations over the coming years. This example is representative of a misalignment between the company’s best interest and the fund’s goals and could be a source of conflict among the Board.
Another example: assume that the company is in financial distress, headed towards a sale or liquidation. The goal of the fund will likely be to proceed in a manner that allows it to recover as much capital as possible—oftentimes taking into account its secured/unsecured claims or its superior claim on equity based on the type of equity it holds. Meanwhile, the Board is tasked with proceeding in the manner that is ultimately best for the company (i.e., preserve/receive as much capital as possible for everyone that may have a claim against the company).
Non-fund owners, on the other hand, may prefer the business to take a strategy that risks the return to the fund (as a holder of preferred equity) but that may result in a greater return to common stockholders. While interests could potentially align, if the wind-down could result in different outcomes/recoveries for the fund and other owners, it may become impossible for the Board to arrive at a solution that satisfies all stakeholders.
When the Board of a fund-owned business experiences tension among the fund, other shareholders, management and the company, the Board must remember that it has a fiduciary duty to act in the best interest of all of the owners at all times. While there are ways to minimize this tension, such as with contractual requirements in a shareholders’ agreement or operating agreement, it is not possible to contractually eliminate all circumstances that might lead to conflict. As such, it is in the best interest of everyone involved—the fund, other owners, directors, officers, etc.—to maintain an open line of dialogue and agree on a predefined path to success.
The Board is essential to the company’s success, as it is tasked with compliance, risk assessment, hiring and firing of senior management, budgets, capital expenditures, capital infusions and issues related to corporate finance. To the extent the Board is successful, the interests of the parties should be better aligned, and conflict should be minimized. However, the Board (often as a reflection of the owners that have elected or appointed them) must remember their duties are to the company, and it should balance the needs of all constituencies.
Boards are always tasked with making decisions that are in the best interests of a company and its owners. But with a fund-owned business, the dynamics of the fund and its relative ownership of the company will nevertheless impact what the Board deems to be the best decision for the company.
Editor’s Note: Get additional information about the role of the Board in Jeremy Waitzman’s previous article, “The Basics of the Board of Directors – Roles, Structures and Duties.”
To learn more about this and related topics, you may want to attend the following webinar series: Board of Directors Boot Camp.]
©All Rights Reserved. January, 2021. DailyDACTM, LLC d/b/a/ Financial PoiseTM
Jeremy chairs the Corporate Group at the Sugar Law Firm (Sugar Felsenthal), a national boutique serving the affluent and the companies they own or otherwise control. He advises his clients on significant transactions and operational issues in their businesses. Described by clients as "an essential business advisor" and "a partner in the success of my…
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