A search for the perfect buy-sell provision for use by private company owners and investors may be akin to hunting for a unicorn, because the business objectives of majority owners, on one side, and minority investors in the business, on the other, are rarely, if ever, fully aligned. But, if this search is limited to focusing solely on the terms of a buy-sell provision that addresses the critical business concerns of both majority owners and minority investors, that task is not beyond the rainbow. What is clear is that majority owners and minority investors share an interest in putting a buy-sell agreement in place at the start of their business relationship. This post therefore covers the essential terms that owners and investors will both want to consider in a provision that strikes a balance in a mutually acceptable buy-sell agreement.
Buy-Sell Agreement is Essential for Both Parties
The need for a buy-sell agreement between majority owners and minority investors is paramount because without one, they will have no contractual exit strategy in place, which will often lead to conflicts and/or litigation between them in the future. The essential purpose of a buy-sell provision is to govern the timing and the terms under which the minority investor leaves the business. Each of the parties has a primary goal in this regard: the majority owner wants a “redemption right” to secure the departure of the minority investor under certain conditions, and the investor will insist on securing “put right” to permit him/her to secure a buyout and avoid being stuck holding an unmarketable minority ownership interest in the business. By definition, the redemption right gives the majority owner the right to redeem, (or purchase) the investors’ stake in the business, and the put right authorizes the investor to put (or sell) his or her equity ownership and requires the majority owner to purchase that interest on defined terms.
Trigger Rights for Redemption or Put of Minority Interest
The majority owner of a private company does not want to be stuck with a minority investor who is no longer contributing anything to the business or, worse, who is disruptive or hostile to the majority owner. For this reason, the majority owner wants to secure the right to redeem the investor’s stock in the company if the business relationship with the investor goes sour. The buy-sell provision will therefore include triggering events that permit the majority owner to exercise a right of redemption to acquire the minority investor’s stock in the future.
By the same token, the minority investor wants to secure the right to exit the business and cash out whenever the investor deems it necessary. That may be when the investor decides that it is an optimal time to realize the value of the investment in the company, or it may be when the investor concludes that the majority owner has begun acting in ways that are detrimental to the company, including if the owner is engaging in self-serving conduct that benefits the owner at the expense of the company and the other investors in the business.
The checklist of issues related to trigger rights to be negotiated by majority owners and minority investors includes all of the following:
- How quickly can the majority owner exercise redemption rights to purchase the interest held by the minority investor
- When does the minority investor have right to exercise put rights
- Will the minority investor have “look back” rights to receive an additional payment if majority exercises a redemption right to buy the minority interest and then promptly sells the company for a higher valuation than the owner used to calculate the purchase price that was paid for the minority interest
- Do the redemption rights and put rights apply to the entire minority interest, or can these rights be exercised to authorize a purchase of some, but not all, of the interest
Valuation of Minority Interest
Once a redemption right has been exercised by the majority owner or a put right has been invoked by the minority investor, the second critical issue in negotiating the buy-sell agreement is how the parties will determine the value (purchase price) for the minority interest. The most critical issued the parties must decide in this regard is whether any “minority discounts” will be applied in calculating the value of the minority interest.
It is common for business valuation experts to apply discounts to the value of a minority held interest in a private company based on the lack of marketability of the minority interest and the lack of control that the minority investor has in the operations of the business. These minority discounts can be very steep, as much as 60% from the market value of the interest, which is why the measure and method of valuing the minority interest is such a vital issue to be dealt with by the parties at the time the investment is made in the business.
In the negotiations, the minority investor will obviously seek to have no minority discounts apply to the value of the minority interest. The majority owner may seek to have one but not both of these discounts apply, or alternatively, the majority owner may agree that no discounts will apply, but only if the investor does not trigger the put right for a period of years. By way of example, the buy-sell provision may provide that no minority discounts will apply if the investor waits a minimum of five years before exercising the put right, but if the investor exercised the put right during this initial five year period, the discount for lack of control will apply.
Structuring the Terms of the Buyout/Purchase Price
The third issue the parties need to negotiate are the terms under which the minority interest is purchased by the majority owner. It is rare for the minority interest to be purchased in cash for one lump sum at closing. What is far more common is for the purchase price to be paid to the minority investor in a structured buyout over a number of years. The negotiation of the payout will include a number of factors, including: (i) what amount is paid up front to the investor as the initial cash payment, (ii) the length of time the majority owner will have to pay the balance of the amount owed for the minority interest, (iii) whether interest is paid to the investor on the balance due and, if so, in what percentage, and (iv) what sort of collateral, if any, will the majority owner provide in the event there is a default in the payment of the purchase price.
Bad Boy/Girl Provisions
The last issue that the parties will want to consider including in the buy-sell agreement is whether the purchase price for the minority interest will be impacted by misconduct on the part of either party. This is likely to be the most difficult issue to resolve in the parties’ negotiations, and for that reason, not all buy-sell agreements include this type of provision. But, if the parties do the heavy lifting to address these issues, they may avoid a highly contentious legal battle and the many thousands of dollars in legal fees that this kind of lawsuit entails.
What is involved in the negotiation of this provision is the ability of the majority owner or the minority investor to obtain prescribed relief if the other side engages in serious misconduct. For the majority owner, this provision would authorize the purchase of the minority investor’s interest for a substantially discounted amount. This would typically be permitted if the minority investor misused or misappropriated the company’s confidential information or engaged in other improper actions that would breach fiduciary duties the investor owed to the company.
On the investor side, this “bad boy/bad girl” provision would authorize the majority owner to be removed from control of the company. These provisions are most commonly seen in limited partnership agreements and authorize the limited partners to remove the general partner from control of the partnership when the general partner has seriously abused the authority granted to the general partner in the partnership agreement. In limited partnerships, the general partner almost never owns a majority of the company, but does control and operate the business. This provision therefore authorizes a majority of the limited partners to vote to remove the general partner based on the specific bad acts that are specified in the partnership agreement.
The hunt for the unicorn remains ongoing, but negotiating a buy-sell agreement that covers the terms of critical importance to majority owners and minority investors in private companies is not only possible, but a necessary to head off future disputes. If business partners invest the time to negotiate and adopt an exit strategy for minority investors when the investment is made, they will put themselves in position to avoid litigation over a future investor exit that will result in considerable disruption to the business, as well as hefty legal expenses.