Peace is not the absence of conflict, but the ability to cope with conflict by peaceful means.
— President Ronald Reagan, Commencement Address at Eureka College in Illinois, May 9, 1982.
The business relationship between private company majority owners and minority investors does not have to be a zero sum game—there are positives available for both sides in their business dealings. But, a win-win approach for majority owners and minority investors needs to begin at the outset when they negotiate and adopt a buy-sell agreement at the time the investment is made in the company, which provides terms that will govern the eventual exit of the minority investor from the business.
A buy-sell agreement will not eliminate all conflicts between company owners and investors, but signing off on a “corporate pre-nup,” which carefully balances the rights of both parties should help lessen the potentially contentious nature of the investor’s ultimate departure from the company. This blog post therefore reviews some of the critical terms that majority owners and minority investors will want to include in their buy-sell agreement to provide for a more peaceful future Business Divorce between them. Those terms are listed and discussed below:
- Trigger Rights – Who Can Trigger the Buy-Sell and When
- Lookback Provision – Payment Applying to Later Sale of Business
- Structured Buyout – Providing Terms for Repurchase of Minority Interest
- Minority Discounts – Eliminating or Reducing Minority Discounts
Trigger Rights – Who Can Exercise and When
Majority owners want to secure the right to redeem (repurchase) the ownership interest held by the minority investor, because the investor may become difficult or disruptive to the future growth and/or operations of the business. By the same token, the minority investor wants to obtain an “exit right” or a “put right,” which provides the investor with the right to demand and secure a buyout of the investor’s interest in the business. The minority investor does not want to remain stuck in the business holding an illiquid, unmarketable ownership stake with no ability to monetize the interest.
The foregoing rights are known as trigger rights because the majority owner and the investor each want the right to either trigger a repurchase (majority owner) of the minority interest or trigger a sale of the minority interest (investor) in the business. Even when these rights are included in the buy-sell contract, the parties may also require the exercise of these rights to be delayed for a period of time. First, the minority owner may want to prevent the majority owner from exercising a right of redemption for 3-5 years until the investor’s ownership interest has appreciated significantly in value. Second, the majority owner may want to preclude the minority investor from exercising the right to demand a buyout of the minority investor for a period of years so that the majority owner is not required to keep cash on hand to pay for a sudden buyout requested by the minority investor. Third, both sides may want to require the other party to provide notice of the exercise of the buy/sell far in advance of the actual date—at least six months or a year before the transaction takes place.
Look-Back Provision Applies to Future Sale of the Company
A majority owner who has the right to redeem the minority investor’s interest at any time has the opportunity to exploit this right to an unfair advantage. Specifically, the majority owner could purchase the minority investor’s interest just before the sale of the entire company for a higher value. Under these circumstances, the minority investor would be paid a smaller amount than if the investor had been permitted to continue to own his/her ownership stake in the business when the company was sold. This is the proverbial situation where the minority investor is bought out at one value, and then the company is sold just a week or a month later for a much higher price.
This situation is avoided is by including a “lookback” provision in the buy-sell agreement. The look-back provision provides for the minority investor to receive an additional payment if the business is sold a short time after the investor’s interest in the business was purchased by the majority owner. If this term is included in the buy-sell, this additional payment provides the minority investor with the benefit of the increased value of the company the majority owner also received when the business was sold.
The length of time for the lookback provision is negotiable, but it is common for this provision to last for at least a year. Therefore, if the time period for the lookback provision is one year, the majority owner must pay an additional amount to the minority investor: (i) if the business is sold within a year after the minority owner’s interest was repurchased and (ii) the value paid by a third party for the company is greater than the value the majority owner paid in repurchasing the investor’s ownership interest.
Terms of Structured Buyout Used to Repurchase Minority Interest
The terms under which the majority owner repurchases the minority investor’s interest are subject to negotiation, but virtually all buy-sell agreements permit the majority owner to repurchase the minority interest over a period of years rather than in a lump sum. The minority investor will often require some form of collateral to ensure repayment, and again, the nature and terms of the collateral will be subject to a negotiation process. At the end of the day, the majority owner needs some flexibility in purchasing the minority interest in a manner that does not cause financial hardship to the business, but at the same time, the minority investor is entitled to be assured of full payment without a default taking place.
Eliminating or Limiting Minority Discounts
The provision in the buy-sell agreement addressing minority discounts applicable to the value of the minority interest is especially critical for minority investors, because valuation experts typically apply steep discounts to the value of minority interests in private companies, which can reduce the value of the minority interest by 50% or more. The “bus val” experts apply discounts to the minority interest for lack of marketability (DLOM) and lack of control (DLOC), because minority interests are not viewed as readily marketable and minority investors lack control over the business. In negotiating the buy-sell terms with the majority owner, the minority investor will want to eliminate these discounts from the valuation of the minority interest, if possible, or at a minimum, limit them, perhaps by removing one of the two discounts from the valuation process.
In most contracts, there are areas of mutual agreement that provide the opportunity for a win-win outcome which is beneficial to both parties. That is certainly the case in regard to buy-sell agreements in which private company majority owners and minority investors have key points of mutual interest. While adopting a buy-sell agreement will not guaranty a conflict-free relationship between owners and investors, it is an important first step in the right direction that will benefit both parties when they face the prospect of a future Business Divorce.