Selling a minority interest in an investment advisory firm to an external investor is a strategic decision that can bring growth, capital, and expertise to the business. However, this process involves complex considerations, from selecting the right investor to negotiating the terms of the transaction. These considerations must be carefully considered particularly since the minority investor will typically want some say in the advisory business given the need to protect its minority investment. Making mistakes in bringing on a minority investor can lead to adverse outcomes and potentially, a business divorce.
In this article, we will explore the key considerations for investment advisers when selling a minority interest in their firms to maximize the likelihood of success, including discussing how to choose the right investor, a blueprint for the process in negotiating and closing such transactions, and key terms to negotiate with such investors.
How Should Investment Advisers Approach Selecting the Right Minority Investor for Their Firm?
Selecting the right external investor is a pivotal decision that can shape the future of the investment advisory firm. Here are some key factors to consider when selecting the appropriate investor:
- Alignment of Interests. The investor’s goals and values should align with the long-term vision of the firm. Consider their investment horizon, risk tolerance, and strategic objectives. A mismatch in interests can lead to conflicts down the road
- Financial or Strategic Investor. Advisers must understand whether they are seeking a financial investor that can simply provide additional capital to support the business or a strategic investor that can bring non-financial benefits to the table, such as industry knowledge, a network of contacts, and/or operational support or other resources. Advisers evaluating the benefits of a strategic relationship touted by external investors should verify claims relating to such benefits by evaluating the investor’s track record in similar investments, including obtaining references with respect to such investments, etc.
- Investment Terms. Advisers must evaluate whether the economic and other rights granted to investors as well as the obligations that they must undertake in connection with the investment are in line with the firm’s needs and goals.
- Reputation and Credibility. The investor’s reputation and credibility in the industry are crucial. Advisers should conduct through due diligence to ensure the investor has a clean track record and a history of ethical business practices.
- Cultural Fit. Because invariably minority investors will have some say in how the firm operates, a harmonious working relationship is essential for the success of the relationship. Advisers must assess whether their values, work culture, and communication styles align with those of the investor.
What Does the Process Look Like for Negotiating and Closing a Minority Investment in an Advisory Firm?
The negotiation process for selling a minority interest in an investment advisory firm typically involves several key stages:
- Preliminary Discussions. The process typically begins with initial discussions with prospective investors where advisers can gauge interest and compatibility. At this stage, advisers will share high-level information about their firm’s financials, operations, and future plans. Non-disclosure agreements (NDAs) are typically appropriate to protect sensitive data.
- Due Diligence. If preliminary discussions warrant further exploration with an investor, the investor will then conduct due diligence to assess the risks and opportunities associated with the investment. They will typically review financial statements, material contracts, regulatory disclosures and filings, and other relevant information. Advisers should be prepared to provide a significant amount of data pertaining to their practices.
- Term Sheet. If the parties express a commitment to move forward following preliminary due diligence, a term sheet is typically drafted. This non-binding document outlines the principal terms of the transaction, including the purchase price as well as the rights and obligations of each party. Once the term sheet is accepted, more in-depth due diligence may also follow.
- Transaction Documents. If the parties decide to proceed following signing of the term sheet, transaction documents are then drafted, reviewed, and negotiated. These documents typically include:
- Purchase Agreement. The purchase agreement outlines the terms and conditions of the investment, including the purchase price, equity stake, closing date, and representations and warranties of both parties.
- Amended Operating Agreement. If the advisory firm operates as a limited liability company (LLC), amendments to the operating agreement are typically needed to reflect the new ownership structure and to define the rights and responsibilities of all members, including the new external investor.
- Closing. Upon finalizing and executing the transaction documents, the closing takes place. This involves the transfer of ownership, funds, and any other assets or liabilities associated with the investment.
- Post-Closing Transition. Depending on the circumstances, if the transaction involves implementation of new governance or operating structures or procedures, the parties will move to adopt and implement such structures and procedures after the closing.
What Are the Key Terms Typically Negotiated in Connection with Minority Investments in Advisory Firms?
While each transaction can vary, typically there are six categories of terms that are negotiated in connection with a minority investment in an advisory firm: (a) the purchase price for the investment; (b)the economic rights granted to the investor; (c) the management or consent rights granted to the investor; (d) other rights granted to the investor; ((e) terms addressing the ultimate exit of the investor from the investment; and (f) the obligations imposed on the adviser and its personnel, including restrictions on engaging in certain activities that could be adverse to the interests of the investor.
The purchase price is typically the first issue addressed as it lays the foundation for further discussions. Parties may value the firm based on traditional metrics such as a multiple of gross revenues or earnings before interest, taxes, depreciation, and amortization (EBITDA) . Alternatively, they may seek independent third-party valuations of the advisory firm to derive the ultimate purchase price.
Second, when it comes to negotiating economic rights, minority investors may want more than a pro rata share of distribution of firm profits. They may desire a preferred return in the form of a fixed rate of return or a minimum distribution amount prior to distribution of profits to other equityholders. Investors may also desire a liquidation preference, which is the right to receive their ratable share of distributions prior to such distributions being made to all other equityholders upon dissolution of the firm. Sometimes, there may be earn-outs or other contingencies that can impact the distribution of profits to the minority investor. Negotiations may also center around when the purchase price is paid and whether a portion of the purchase price will be paid following the closing.
Third, minority investors are likely to request either direct management rights or, at the very least, consent rights over major decisions. If the advisory firm has a board of managers, minority investors may want the right to appoint a member to such board. With respect to consent rights, minority investors could request that important decisions regarding annual budgets, changes in business strategy, large capital expenditures, major hires, changes in employee compensation, significant borrowings, sale or merger of the firm, admission of new equityholders, amendments to the firm’s operating agreement, and litigation be made only with the consent of the investor.
Fourth, minority investors may request other rights in connection with their investment including protection against dilution of their equity interest, the right to receive certain information or reports, the right to increase their investment at their option, and/or tag-along rights.
Fifth, the parties will often negotiate terms relating to the minority investor’s exit from its investment. In some circumstances, the parties may define the specific term for the investment. In other circumstances, the parties may negotiate for rights to terminate their relationship. The advisory firm may negotiate for a “call” right to purchase the investor’s equity stake at a pre-defined purchase price or a price to be derived utilizing a formula delineated in the operating agreement. On the flip side, the minority investor may negotiate for a “put” right to sell its equity stake back to the firm at a pre-determined purchase price or a price to be derived utilizing a formula delineated in the firm’s operating agreement.
Sixth, the minority investor may require that the firm or key personnel undertake certain obligations as a condition of the investor’s investment in the firm. The investor will typically require key personnel to devote their full time and attention to the firm’s business. Minority investors will also typically require key persons to agree to restrictive covenants such as agreements not to compete with the firm and agreements not to solicit clients or employees of the firm.
There are many moving parts when it comes to onboarding a minority investor, and therefore, it’s vital for advisory firms to carefully navigate the process to maximize the likelihood of a successful outcome. Therefore, it’s vital that advisers seek experienced legal counsel that can help them navigate the process and to negotiate the terms that best serve the firm’s interests.
What questions do you have about selling an interest in your advisory firm? Please reach out and hopefully we can answer them for you.
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