If you're too busy growing your company to discuss ultimate financial goals with your partners, take heed. You could lose it all
Last year I almost lost the company I founded 10 years ago. Since then, in discussing that experience with other business owners, I've learned that it is more common than I had imagined. The great lesson I learned, and the advice I offer to help others avoid the same trap, is that when you bring partners into a company, be sure you all share -- or at least understand -- one another's expectations. That may sound simple enough, but in the early days of building a business, the day-to-day needs always end up taking priority over long-term objectives. Planning for the day when you might sell all or part of the company or allow the owners to cash out in some other way hardly seems all that urgent. But without that shared understanding among partners, problems may arise that can cause everything to slip away. That's what almost happened to me.
In 1985, while still going to school, I started what became System Connection, a vendor of computer cable and connectivity products, in a basement apartment. In those early days I was very frugal and grew the company carefully by reinvesting almost all the profits. By mid-1987 two good friends who had occasionally helped out with the business had joined me full-time and become equity partners, and we moved to our first real office. My new partners did not put money into the business but worked for low wages instead. While we never discussed our long-term financial expectations for ourselves or for the company, I think we all shared the same basic values: None of us had gone into the venture with the idea that we would get rich quick. We were more interested in building something for the long term that would provide us with a good living.
In early 1989 I brought another good friend into the business as an equity partner, again assuming that we shared the same values and expectations. I knew then that this new partner's eventual goal was a long-term career in financial planning. That was at least five years away, though, and at the time five years seemed like forever. The fact that he did not have the same long-term perspective as the rest of us should have been a signal to me to discuss our financial expectations more clearly, but I never thought to do so. Instead, we just plunged right back into growing the company.
The first hint of a problem arose in late 1989 when we tried to value the company for the sake of drawing up shareholder buy-sell agreements, which were intended to protect the remaining shareholders in the event of the death or departure, for whatever reason, of one of the partners. The fourth partner had a much higher expectation than the rest of us about what the stock should be worth. Again, we did not take that opportunity to address our long-term goals head-on.
By 1992, however, we began to have disagreements about how to manage our now $9-million enterprise. Eventually, the disagreements became so serious that we finally took a look at one another's expectations and started thinking about exit strategies. I have come to despise that term, which I associate with a single-minded quest to realize financial gain from a business while ignoring other valuable aspects of creating a company. But to accommodate the wishes of some of my partners, I agreed to pursue a three-to-five-year exit strategy. That triggered a chain of events that led to my almost losing our company and, in the process, taught me how much the company really means to me.
In the spirit of considering various exit options, in November 1992 we met with the owners of a company that made and sold modems for portable computers. They were interested in a possible merger with us. And here I made my big mistake. We rushed ahead without asking the right questions or structuring the right deal. I relied on oral commitments and agreements, and failed to write into the deal any protection from misrepresentations, intended or not. We gave up 49% of System Connection (no cash changed hands) and took on four new shareholders -- a number that soon turned into seven when one of the new shareholders sold some stock to three other individuals, despite a spoken agreement not to do so.
Then our real struggles began. Before the merger I had taken pains to make sure the new owners agreed with our three-to-five-year strategy and that they understood that going public (which had been mentioned a lot during the discussions) was not the only possible way to exit. But I erred in not putting those things down in writing and getting the others to explicitly agree to them. Despite our conversations and oral agreements, we soon disagreed about our so-called exit strategy once the deal was done. My new partners wanted to go public quickly to create liquidity for the stock. That conflicted with my desire to continue to grow the company and pursue a longer-term exit plan. I felt deceived, and the ensuing internal struggle ended up preventing either side from accomplishing its goal. Two years of bickering, distraction, and politics completely flattened the growth of a company that had made the Inc. 500 list four years in a row.
During that period it became clear that the fourth original partner's desires were more in line with those of our new partners, and basic control of the company now shifted to that group. Over my strong objections, a holding company was formed, with the above-mentioned partner named as the CEO. I remained head of System Connection, which was now a subsidiary of the holding company (as was our merger partner, the modem company). We completely disagreed about how to run the company. My own style is to avoid unnecessary red tape. The other faction pursued what I call the M.B.A. approach: spending enormous amounts of money on consultants and marketing studies, and generating tremendous redundancy in overhead costs. The modem company was encouraged to significantly increase its inventory and advertising expenditures in anticipation of a big sales push, and did, all in an attempt (I believe) to increase the value of the company quickly. Meanwhile we were not prepared for changes in the market, and because of all the added overhead and costs, the company began to hemorrhage red ink.
It was now clear to me that the two factions that had formed among the owners could no longer coexist. In August 1994, my two original partners and I began to discuss the possibility of buying out the other eight shareholders. Initially, the selling group asked for $50 a share (at one time they had put the value as high as $125 a share). I offered what I considered to be a very fair price of $20. Eventually, in light of the losses the company was then incurring, we settled at close to the $20 price. My group had three months to raise the money for the buyout, and we were given complete management control of the company for that period. My original two partners and I immediately began to eliminate unnecessary costs and to focus again on our business.
Even though we were able to return the company to profitability within a month of being back in charge (after six months of significant losses), we weren't able to raise the money for the buyout in the stipulated three months without paying onerous rates and giving up too much equity. Eventually, the three of us said we'd leave the company if we couldn't reach an agreement. We finally did settle on the terms this past February, and we got our company back. Today it's firmly back on track.
I hadn't realized how important the company was to me until I almost lost it. In retrospect I can see more clearly that some of my resistance to other managerial strategies (such as investing in order to make the company salable) came from my deep-rooted identification with the company and my inability to let it go -- or even to plan for letting it go. That's part of the reason I had regarded the efforts of the eight selling shareholders as being short-term oriented and self-serving. Right or wrong, my resistance to their efforts was at the root of most of our battles.
Much of that pain could have been avoided had we talked things through in the beginning. A clearly defined and articulated plan for financial expectations among owners, both in the very beginning stages of a business and as new shareholders are brought in, can prevent gross misunderstandings down the road. Without question, that would have prevented many of my troubles, and our company, I believe, would be much further along today had I managed to learn that lesson sooner. I hope this account will help prevent others from having to learn it the hard way.* * *
Rick McCloskey is CEO of System Connection, a $25-million computer cable and connectivity products company in Provo, Utah.