“Investing in my employer owned by new Private Equity; any concerns?”

Question: My company (small, privately held) is in the process of being purchased by a “private equity” firm. I own options and am being asked to “invest” 50% of the cash proceeds I will receive when the sale takes place into the new company. You have written doing that can “turn out to be a kind of fraud.”

Why do you refer to this as a “possible fraud” and how can I get more information? 

Brian
Windham, New Hampshire

Answer: Dear Brian: For three decades now I’ve seen many employees in your circumstances invest along with Private Equity purchasers of their employers. My experience has been that a clear majority have been sorely disappointed with the results. Why do I say “this may turn out to be a kind of fraud?” Here’s why:

1. “Fraud” includes making promises you don’t intend to keep. In my experience, Private Equity companies are interested in one thing, and one thing only: Return On Investment, or “ROI.” To put it bluntly, “Their God is Green.” This is how they attract investors, this is how they view success in their work, and to attain increased ROI they will do almost anything. It is uncanny how often, in the end, the results of investments by employees in your shoes are disappointing to them, if not infuriating, and far, far different than you have been led to expect by Private Equity owners. This is often due to promises made with no intention to keep them, which is a kind of fraud.   

2. The company you know now will not be the company you will later own. You know the present state of affairs of your company, and you have been told that the new Private Equity owners will (a) invest money into the company, (b) bring in their special business expertise and professional management, and (c) make it a stronger, more valuable company, to the benefit of all. Quite, quite often, this is horse manure of a different color. Instead, (i) salaries will be slashed, resulting in many of the best employees leaving, (ii) benefits will be eliminated entirely, (iii) smaller customers – the essential ingredient for future growth – will be ignored, (iv) necessary maintenance on critical infrastructure will be put off, and (v) the Private Equity owners will pay themselves exorbitant consulting fees, salaries and expensive perquisites. It is short-term thinking in the extreme. This is all intended to make the company appear healthy to sell, but usually results in the company becoming sick. It’s what Wall Street pros call “putting lipstick on a pig,” although in these instances, the original company was a thoroughbred. Is that a company you want to invest in? Trust me, the Private Equity owners will not tell you of these plans. That is a kind of fraud.          

3. It is likely the equity you purchase will be both subordinate and inferior to the equity to be owned by the Private Equity investors. “Smart” corporate lawyers know how to draft stock documents so that their clients – the Private Equity owners – can (a) wiggle out of promises made, (b) claim that the promises made gives them discretion to do anything they want, (c) change the governing documents without your approval or even knowledge, (d) issue new shares of stock, or grant their own stock certain preferences, and (e) one way or another, deny you the “grand benefits” they assure you that you will receive. That is a kind of fraud.

4. Trust me: the Company Operating Agreement will give the Private Equity owners complete control and total discretion. One thing you may or may not notice, or appreciate, is that the Operating Agreement (or Shareholder Agreement) for the company will be changed to ensure that the Private Equity owners, or their representatives, will have complete dominion and control over the management of the company. So, for example, if they choose to sell the company’s brand new 100,000 square foot factory to themselves (or an affiliated company) for $500, do not be surprised, and do not be upset, for their decisions will be, in all probability, unreviewable. This you will not be told about beforehand. That, to me, is a kind of fraud. 

5. You will be given minutes or hours to review complicated documents, making it near impossible to understand them, and totally impossible to negotiate them. The most common scenario in this respect is the Private Equity owners stalling and delaying in getting to you or your attorney copies of critical documents for review until moments before they “must” be signed. Then, at the last minute, you will be scolded, threatened, and warned that, if you need time to have your attorney review what you must sign, (a) “You don’t trust us, do you?”, (b) “You are going to ruin this for everyone,” and (c) “You must be out of your league.” Sadly, many people are pressured and bamboozled into just signing the documents. This is classic “flim-flam” behavior, and most definitely described as a kind of fraud.

I’ve written an article entitled “Negotiating Employment with a Private Equity Firm: 7 Surprises to Expect.” To read it, just [click here.]       

6. While you are being pressured to “put your skin in the game,” the Private Equity investors will likely load debt on to the company, and then take their own investment moneys out as soon as they take control. One of the first things Private Equity owners often do after purchasing a company is to have the company borrow money and give it to the Private Equity owners, so that they have no longer paid a nickel for the company. Their “skin” is out of the “game,” while your “skin” is still in the “game.” In this way, you have helped purchase the company for them. They will not tell you that this is their intention. That is a kind of fraud.

7. Watch out for “Repurchase Rights” and other “trap door conditions.” A common trick of corporate lawyers in preparing Operating Documents for their Private Equity clients is to insert “Repurchase Rights” which are rights of the company to repurchase your equity for some insanely unfair repurchase price, at any time they wish. Or, they will have the right to cancel your equity if you are fired, and you will be fired just before the sale takes place. The most common time for this is (a) after you have worked 80 hours a week for 4 years to build up the company, and (b) two weeks before the company is being sold for hundreds of millions of dollars. The Private Equity investors will do fine; you will have nothing or next to nothing for your efforts. If you complain they will say, “Your lawyer should have protected you.” I would characterize that as a kind of fraud.  

I’ve written an article entitled “Robbery by Repurchase Rights.” To read it, just [click here.]

Brian, these seven kinds of common fraud by Private Equity purchasers of companies is just a start. I could go on, and on, and on. Frankly, if this blog post is read by Private Equity executives, I am confident they will say to themselves, “What is wrong with those things? They just increase ROI. They should hire lawyers to protect themselves. People who fall for these things are . . . well . . . not as smart as I am.” I truly believe that is how they see things.  

It is hard to beat Private Equity purchasers of companies at their own “game.” You can prevail, but it does take the assistance of an attorney experienced in these matters, and a whole lot of patience. I am not a pessimist, but rather an “optimist with experience.” I have just seen so many employees in your shoes be tricked in these, and scores more, ways. Truth be told, I am a bit predisposed to distrust Private Equity “sharpies.” While I do not mean to characterize all Private Equity firms and their legal counsel as fundamentally dishonest, in my own experience many, many, many are, and they seem to enjoy the characterization.

If Private Equity investors are buying your employer, you can proactively request protections be put in place to protect you from probable changes. We offer a Model Memo to Managers Seeking Protections When Private Equity Investors Approach Ownership. “What to Say and How to Say It.”™ To obtain a copy, just [ click here.] Delivered by Email – Instantly!

I truly hope this helps you. Good luck, no matter what investment decision you may make. And, to improve your “luck,” you might consider consulting with experienced legal counsel, while you are still “have your shirt on your back.”   

Best Regards,
Al Sklover

 

Repairing the World –
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