In the world of private companies backed by institutional investors — venture capital, growth equity, private equity, etc. — board guidance and strategic direction are too often influenced by investor board members’ who are driven by the dynamics of their investment funds. These institutions raise capital in closed end funds with anticipated holding periods. During their hold period, the fund makes investments and supports companies with the goal of selling the companies and returning capital in a timely manner to the limited partners who invested in the fund. For most institutions, the cycle repeats over and over. Raising capital for the next fund is predicated on successful outcomes from prior funds.
Typically, these institutions insist on board seats as a condition of their investment, and their fund dynamics become external influences on the strategy and direction of the companies they invest in. The goals of the investment funds are not necessarily aligned with what is best for all of the shareholders or the long-term success of the business. Here are a few examples:
An investor board member representing a fund that is nearing the end of its holding period, wants to exit remaining portfolio investments. In this situation, the investor board member will guide the company toward a near-term exit, and guide decision making to maximize enterprise value at the point of exit. That may mean reducing risk, avoiding any actions that could lower value in the near term, and reducing investments in long-term growth initiatives as a means to increase near-term profitability. However, if the company takes a longer-term strategic view, perhaps an acquisition or market expansion makes the most business sense, even if it will take a few years to materialize in expanded enterprise value. The investor’s fund dynamics are driving a short-term view that does not maximize shareholder value in the long-term.
The company needs to raise cash to fund ongoing operations. A key investor either has no more capital in their fund because it is fully invested, or has fund limits that prevent them from investing a greater percentage of the entire fund in one company. A new external investor may lowball the valuation and dilute the existing investors, so the existing investor is unwilling to let the company raise external capital. Instead, the investor’s fund dynamics will drive board decisions toward reducing costs, eliminating innovative new projects, or whatever other actions are necessary to avoid the need for external investment. Because of the fund limitations, the company may be forced to cut back at exactly the time when it should press forward. The result is that its growth will be stunted, to the detriment of all shareholders as a result of the fund dynamics of a key investor. As in the first example, this can become particularly acute as the investor’s fund reaches the end of its lifecycle, but it can also occur at any point if it is being driven by fund rules and limitations.
The company has an opportunity to make a significant acquisition that will require a major cash infusion. One investor has the money and is eager to invest, but another investor is capital constrained and is not in a position to make their pro-rata investment. The second investor is also nearing the end of their hold period, and recognizes that the acquisition and capital infusion will lower near-term value and start a new multi-year clock for the company to maximize its value. Their fund dynamics and potentially their blocking rights may prevent the business from making the bold acquisition that could change the trajectory of the company forever. As a board member and a significant shareholder, the fund’s input is self-serving, and not in the interest of maximizing value for all shareholders.
In each of these examples, the investors’ needs are inconsistent with the optimal strategic decision for the company and the benefit of all shareholders. Instead of looking at a company as a ‘forever’ business, the investor is guiding the company to maximize value in the timeframe of their investment fund, and depending upon when the initial investment was made in the fund’s lifecycle, that timeframe could be relatively short.
When companies are considering accepting a new investor, they need to be wary of these dynamics. It is important to probe for transparency about where the fund is in its lifecycle, availability of future capital, and fund rules that may limit the fund’s ability to continue to support the business. If there is a lack of alignment of goals and measures of success between the existing investors and the new investor, it is a recipe for trouble. However, even if the goals align, fund dynamics can still derail the strategic path of the business. It all needs to be on the table before a company marries a new investor.