This is a tale of two growth strategies — minority equity investment and debt investment — each of which involves an injection of capital from an outside source but each of which also entails very different considerations and potential consequences.
Minority equity investment and debt investment: an overview
Registered Investment Advisor (RIA) owners who pursue a minority equity investment sell a non-controlling equity interest in exchange for growth capital, liquidity, and potential strategic expertise. Because minority equity investment involves an external investor acquiring less than a 50% stake in the company, this approach allows owners to maintain economic control while still gaining access to the financial resources, operational support, and technology that can accelerate growth. Minority equity investments have become increasingly common, with multiple transactions now announced monthly, according to Fidelity.1
Debt financing, on the other hand, allows RIA firms to raise capital without giving up equity ownership (or corporate governance control – except in situations of default). This typically involves borrowing funds from a lender, such as a bank, private credit provider, or specialized financial institution, with an obligation to repay the principal plus interest over time. Debt can be structured as term loans, revolving credit facilities, or mezzanine financing, depending on the firm’s needs and financial profile. Unlike equity investments, debt does not dilute ownership or introduce external influence over business decisions. However, it does require firms to manage cash flow carefully to meet repayment obligations and debt covenants.
There are a number of factors a firm must take into consideration when selecting a partner. Ultimately, the choice will depend on the goals, strategy, and vision of the firm.
Weighing minority equity investments against debt capital
When weighing these two options against each other, the first consideration is availability. Minority equity investments are less readily available and usually reserved for firms with higher annual revenue (likely in the range of $10 million), since these businesses tend to have a stronger infrastructure to support growth potential. On the other hand, debt financing is more broadly accessible from a wider variety of sources and in a broad array of structures.
The second consideration is the amount of capital needed. While debt capital can be a good option, it typically reaches capacity at 3-5x leverage, meaning the total debt is 3-5x its free cash flow (FCF). And a firm needs to be able to support that leverage from a cash flow perspective. Thus, the amount of funding the firm can acquire may be more limited under a debt financing scenario than under a minority equity investment. If that’s a concern, then a minority equity investment can be a better choice.
The third consideration is consequences. Because debt financing doesn’t require any ownership stake in the firm, there’s less third-party influence over the business and there’s also no dilution. However, with a minority equity investment, the minority shareholders tend to acquire between 20% and 49% of a firm’s shares, which gives them influence and creates dilution but does not cede complete control. However, in some cases minority equity investors will have put rights, allowing them to sell the firm after a certain time period if the minority equity investors cannot achieve liquidity without a full sale. Minority shareholders may also have seats on the boards of firms they partner with.
Debt financing is, in essence, simply the act of taking out a loan, which is far more familiar to most business owners than bringing in a minority partner. Therefore, what follows is a deeper dive into the minority equity investment approach.
Focusing on minority equity investments: key benefits and considerations
Before firm owners take on any new investments, it’s critical that they first determine whether the opportunity is a good fit for the business’ goals, then ask these key questions that will help identify next steps:
- What’s the level of financial or strategic support offered by the investor? The firm’s needs must drive this process. Does the firm need a financial investor that provides capital or a strategic investor that offers additional benefits, including industry expertise, operational and strategic support, and a network of contacts? Minority equity investors may have some non-capital resources in place to help firms grow – but may also have varying levels of interest in providing anything beyond financial support.
- What’s the size of your firm? Minority equity investors tend to focus on firms with roughly $10 million or more in revenue as they view scale as the foundation upon which they can accelerate growth, acting as the foundation that allows supplemental capital to be leveraged for enhanced performance and growth.
- How much control are you willing to cede? The flipside of this question is: How much outside involvement do you prefer? While minority equity investors are generally less disruptive and allow the firm to continue along established lines, it is fair to acknowledge that their involvement will inevitably introduce certain changes to the business.
- Will the investment offer the necessary liquidity? Once again, this comes back to needs and purpose. Minority equity investments can provide a source of growth capital for acquisitions and/or infrastructure or subsequently can be used towards liquidity that allows a senior or founding advisor to attain liquidity in a way that debt financing may not. In many situations, due to the enterprise value of the firm, the other advisors are not in a position to buy out a senior advisor, so minority equity can be brought in to keep the firm operating while a senior or founding advisor converts some (or all) of their equity to cash.
Key terms to consider when negotiating minority equity investments
- Purchase price involves the valuation at which the minority stake is sold, typically driven by a multiple of revenue or EBITDA (earnings before interest, taxes, depreciation and amortization), but also involving other critical performance indicators. It’s crucial that any price reflects both current performance and future potential.
- Ownership rights (or equity rights) further defines the investor’s rights as a shareholder, including voting rights, access to financials, and influence over major decisions. Minority equity investors typically receive a pro-rata share of profits, earnouts, or other contingencies.
- Management entitlements outlines whether the investor has any say in operations or board representation. Some may request observer rights or advisory roles. Firms should assess how much input aligns with their culture and governance style.
- Exit provisions are the terms that govern how and when the investor can exit. Common structures include buyback rights, tag-along or drag-along rights, and sale triggers (known as “put rights”). These provisions ensure clarity and protect both parties during transitions.
In summary, across a landscape of increasing competition and rapid macroeconomic shifts, RIAs also face key decisions around financing growth, both organic and inorganic. Debt investments and minority equity investments are each potential ways for firms to source capital (and sometimes strategic support) without ceding control.
