If the popularity of the ABC reality show Shark Tank is any indication, a lot of people have outgrown mom’s advice against taking candy or money from strangers. Week after week, viewers tune in to see entrepreneurs pitching a panel of four “sharks”—including billionaire and Mavericks owner Mark Cuban—on their business and product ideas. From gluten-free fudge to a rent-a-live Christmas tree service, the products and ideas touted by these wannabe innovators are subjected to the scrutiny of this all-star panel. The best pitches spark a feeding frenzy, as Cuban and company fight each other over investing in the Next Big Thing. Of course, these “sharks” want something in return for investing the cash needed to kick start the best of these business ideas—an equity stake in the venture.
Some think the show has created a “Shark Tank effect,” with big-dreaming entrepreneurs eagerly taking money from so-called “angel investors,” without looking closely enough at the terms of the deal. Legal experts and investors say such deals can sometimes lead to a nasty “business divorce” that leaves the entrepreneur with little to show for his or her hard work when things fall apart.
Business litigator Ladd Hirsch, a partner in Dallas’ Diamond McCarthy LLP, is no stranger to either the “Shark Tank effect” or the business divorces that can follow. Hirsch finds the program hard to watch, because he has seen the harsh reality that isn’t shown on the program—including business disputes involving entrepreneurs who belatedly realize they’ve given up too much control of their companies, or frustrated investors who have seen a startup soar quickly, only to crash and burn like Icarus.
One of the key problems, says Hirsch, lies in the structure of the investment. “If I were an entrepreneur, and I had a choice between taking on debt in the form of a bank loan versus giving up equity to an investor, I’d take the debt every time,” he says. “Getting to a debt position—a bank loan that you can pay off—is better than taking on a partner or investor.”
An investor has a say in how the business is run, points out Hirsch. For example, let’s say the venture hits a rough patch. If all you have to worry about is bank loan debt, you can often restructure that debt. “But equity holders have no obligation to restructure,” Hirsch says.
A key part of avoiding the angst and costs that accompany a business divorce is for entrepreneurs and their angel investors to agree on a corporate pre-nup, if you will–some form of contractual exit or redemption agreement. Those without a plan for buying out their equity investors often find they’ve given up a significant amount of control—sometimes 51 percent or more—to angels eager to monetize their investment. This loss of control, says Hirsch, can lead to lawsuits over shareholder oppression, a situation that results when the majority shareholders engage in conduct that squeezes out the minority investors.
“This can include denying material information to a minority shareholder, diluting his interest, refusing to declare dividends, siphoning off profits to the majority shareholder or control group through perks, removing the minority shareholder from the board or as a manager, reducing his compensation, and even completely terminating his or her employment,” says Hirsch.
He has had a trenches-eye view of such shareholder oppression. A case of his from 2009 involved a computer software business started by two men in 1980. For 26 years, as virtually all of the company’s profits were retained, the two shareholders (one with a 53 percent stake, the other holding 47 percent) were the only board members and received almost identical compensation. But then, says Hirsch, the majority shareholder allegedly began to engage in oppressive conduct toward Hirsh’s client.
These measures included self-dealing (such as billing personal trips to the company, and selling himself a condo owned by the company), concealing material information about financial matters (including an IRS audit) from the minority owner, reducing the minority shareholder’s compensation by 70 percent, and ultimately making a lowball buyout offer to the minority owner. Hirsch prevailed at trial, persuading the jury to award a mandatory dividend of $65 million. (Last August, the Dallas Court of Appeals rejected the jury’s verdict.)
Hirsch points out that in shareholder oppression cases, “what you’re asking for are equitable measures,” and that whether oppression exists is a legal question for the court to decide, as opposed to a fact question for the jury to determine. Although Texas courts have wrestled with exactly what constitutes shareholder oppression, Hirsch says that “any way that a majority owner takes advantage of that status in order to convey something to himself that isn’t conveyed to the minority shareholder” can give rise to such claims. However, the law in this burgeoning area may soon change. In early 2013, the Texas Supreme Court is scheduled to consider Ritchie v. Rupe, a case from the Dallas Court of Appeals in which a claim of shareholder oppression (where a minority owner’s wifewas “landlocked” from selling her stock interest to a potential third party buyer) was upheld. Hirsch predicts, “I don’t expect the court to turn its back on 25 years of case law and throw the baby out with the bath water and reject the claim in its entirety. I can’t say that I will be surprised, however, if the court decides that the time has come to narrow the legal standard that applies to the claim.”
So what advice do seasoned attorneys like Ladd Hirsch and prominent angel investors have for entrepreneurs and investors alike? Part of avoiding the “Shark Tank effect” that can lead to a business divorce consists of prior planning such as making sure the deal has exit provisions like a redemption agreement. Dallas financier Alan Thomas started the Barley House concept in Ohio, and is currently involved with investments that range from a storage and mining company in North Texas to one of the first children’s hospitals in mainland China. Thomas urges entrepreneurs to closely study their agreements with investors. “Watch out for any convertible features such as debt turning to equity in a project that could dilute your stake within the company,” he says. Avoid the kind of hasty decisions one often sees on Shark Tank as money is being thrown the investors’ or entrepreneurs’ way, Thomas cautions. “The goal is to raise the money, but you don’t want to sell your soul to the devil,” he notes.
Continuing the relationship analogy, both litigator Hirsch and investor Thomas believe the best way to prevent the ugly business divorce is to follow the same rules you would when dating. “When you do a business deal with someone, you are married to them for that project. When choosing the right partner, it’s important to see if they’re the right fit for you. Loyalty, honesty, trust, and work ethic are all desirable qualities someone wants to jump in bed with in both business and dating,” observes Thomas.
Hirsch agrees that both entrepreneur and angel investor need to do their homework on each other. “Some entrepreneurs or investors have great knowledge and vision, but they don’t understand business. Some of the most creative folks are ones you wouldn’t want running the company,” he points out. Another key element that both Hirsch and Thomas stress for a successful entrepreneur/angel investor relationship is shared knowledge or understanding of the field itself. “Do they know your space?” asks Hirsch. “The investors on Shark Tank didn’t all acquire their wealth in the same way. Can the investor bring knowledge capital and not just investment capital?” Thomas concurs, adding that investors should “understand what they are investing in. You cannot make informed decisions if you don’t understand the business you are investing in. It’s very helpful if you have an investor who understands the nuances and intricacies of the business.”
Managing expectations—on both sides of the table—is another crucial factor. Both entrepreneur and investor should avoid having unreal expectations and “understand that most startups don’t make it,” Thomas says. He recommends that investors “look for something cutting-edge, such as a niche business with a tough barrier to entry; don’t try to chase the same dollar as everyone else.”
Hirsch says it’s a good sign when the entrepreneur has a good sense of his or her own limitations. “Is this someone who can be a good business partner, or is at least realistic enough to know that they need help in being a good steward of investors’ money?” he adds.
And although the business landscape is littered with the remnants of startups gone bust and deals gone bad, both Hirsch and Thomas remain optimistic about the potential upside for entrepreneurs and angel investors. For both the entrepreneur and investor, Hirsch says, the secret is in “the 3 C’s: capital, control, and conclusion.” Being smart about bankrolling the business, what level of control an investor can expect, and on what terms an investor will exit the company is paramount.
Thomas describes himself as more proactive in his investments, but there are many deals where a mere cash infusion will make all the difference. “I have seen investment deals where just a single injection of capital has turned a company from a standstill to a thriving business. I see it all the time,” he says.
Just be sure to watch out for sharks.
John Browning is a partner at the law firm of Lewis Brisbois Bisggaard & Smith LLP in Dallas, an award-winning journalist, and the author of The Lawyer’s Guide to Social Networking.