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Scaling down multi-company corproate structures

21.11.2010

Scaling Down Multi-Company Corporate Structures

I have noticed a relatively new trend within smaller companies in that they seem to be more willing to experiment with ever more complex ownership and legal structures.  I imagine that this is partly a fashion thing associated with the recent “Decade of the Banker”.  Another influence is the European tax optimization tradition that encourages more complex legal and cross boarder structures, and finally Silicon Valley stock options and shared ownership have been a model for how to motivate the latest generation technical talent.  The consequences of such complexity are often not felt until many years later.

During the height of the Dot.com boom and its fashionable stock option plans, I worked as a division manager for a company owned by Bill Conway (Carlyle founding member). Bill is probably the single most talented businessman I ever met.  For this company, he created a very generous corporate cash bonus plan that every worker could participate in, but he was insistent that all new shares only go to people who were risking company equity that they already own.

Management teams evolve, change, and business divorces happen.  When the company is publicly traded and relatively large, it is likely that any shares owned by the departing manager will be sold quietly and thus any disturbance to the rest of the company will be short lived.  By contrast, a colleague of mine recently went through an ugly, emotional management divorce within the small company he worked for.  Since he and the founder both owned a large percentage of the company, the only option was for one to buy out the other.   Emotions were high during the negotiations and consequently, little focus was paid to the core business during this time.  Moreover, the discussions took far longer than anyone expected.  The “winner” was left with a damaged company that will affect its future for years to come.  The “loser” spent so much of his energy preparing for takeover that in due course he created a semi-competitive company in this already crowded market.  The original company had been in a profitable second position, but the resulting two companies were fifth and sixth with far more limited outlooks.  I saw similar disastrous results with another non-listed IT company I worked for.  Contrast this to Bill Conway who retained 100% ownership in Brashear LP, paid generous cash bonuses to retain key employees when were they were succeeding and ultimately sold the company to a larger corporation.  The lesson for me was clear: any splitting of shares of a non-listed company becomes a “marriage contract”– even if you give only 0.1% to someone.  It is critical that the number of active owners in a small company be kept as few as possible.

There are many other examples of complex split ownership situations.  For example, I have also seen a number of companies that legally split their sales/commercial business from their development, branding and corporate business.  Normally, one might consider this as an intelligent way to focus business priorities, but when the ownership structures are adjusted as well, then things become more complex.  In one case I am aware of, the owners pre-sold sales territories to investors in a way that investors pre-purchased software licenses that they could resell within their exclusive geographic territories.  In another company, regional sales/commercial offices were legal entities created as joint ventures with local investors.  At first thought, both looked like only examples of the balance of dependence principle and a company valuation problem.  It also looked like a great way to finance company growth.  The problem was that the companies “sold” permanently and forever essential sales territories.  This created massive limitations on their flexibility and agility.  In the global technology world, there are few things more valuable than flexibility and agility.  When licenses are pre-sold and the sales agents are acting independently, it is very difficult to diagnose a global sales problems — each territory owner will typically wait for another to fix the problem first.  Additionally, if the business should be adapted to a completely different sales approach, pricing, or business model, then each investor/sales entity must consent to arrangements that may make their other local sales interments worthless.  More likely, the group of companies will continue with the “wrong” approach that was originally envisaged in the contracts between each other.

Joint venture sales/commercial companies are limited in other ways.  The smallest strategic initiative change requires that both the regional commercial offices the corporate office both benefit if it is going to be constructive.  For example, cutting back on corporate testing and quality in one company I was involved with had only long term consequences to the corporate office, while regional sales offices had strong and immediate hits to their bottom line.  Similar effects happen with new product entries, price discounting, and new delivery models.  The lack of agility, the cost of negotiation, the balancing of the competing motivations, and the costs of administering the system are often not worth the potential benefits, especially when the company is small.  In fact, I would argue that “hard laws” (rigid legal contracts of indefinite nature) are what often make large company non-competitive and targets for more agile start-ups.  For the small company, the consequences of extreme creativity in financing and in corporate structures will likely, at some time in the near future, lead to severe limitations on their flexibility and agility.

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