The private company marketplace has become increasingly attractive to investors as the number of opportunities for investment has vastly expanded.  There are approximately 6 million companies in the US, but less than 1% are publicly traded on a national stock exchange and more than 85% of businesses with more than 500 employees are privately owned.  The attraction for investors is that private companies hold the potential to yield robust financial returns due to the fact that many private companies are family-run businesses with stable management and a long-term focus on growth.  As a result, McKinsey reports that private companies have outperformed the S&P 500 Index by an average of about 3 percentage points over the past ten years.

The counter argument is that private company investing can be risky.  The downsides include the potential for the loss of the investment when start-ups and early stage companies fail as more than 50% do not survive three years.  There is also a much greater potential for fraud as private companies are substantially less regulated than public businesses.  In addition, as private companies continue to raise capital, the investor’s ownership interest may be diluted unless the investor makes additional capital contributions.  Finally, the investment may be “dead money” for an extended period with no dividends being declared, which requires the investor to wait for years to receive any return on the investment.

The opportunity to invest in private companies therefore presents investors with a classic risk/reward scenario.  While a private company investment opens the door to the possibility of securing outsize financial returns, this potential can be realized only if the investor is willing to accept a much higher degree of risk.  Whether any private company investment is a good bet is beyond the scope of this post and the terms of an investment agreement cannot eliminate this business risk.  But an investor who obtains the contract terms that are discussed in this post in the investment agreement will be poised to secure all of the intended benefits of the investment if the company does achieve success in the future.

These investor-friendly provisions can be included in a shareholder agreement, in a LLC company agreement, in a limited partnership agreement or in the company’s original or amended bylaws.   The checklist that follows is not intended to be exhaustive of all terms that are included in an investment agreement, but it includes some of the most essential terms designed to protect the rights of investors who make private company investments. 

Investor Checklist

1.  Exit Rights

We have written extensively in previous posts about the importance of private company investors securing a buy-sell agreement or some other contractual exit right.

Investors who do not obtain a type of buy-sell agreement are at serious risk of becoming stuck holding an investment in a private company that is both illiquid and unmarketable.  Unless the majority owner or majority control group voluntarily agrees to repurchase the interest held by the minority investor, he/she has no legal right to demand that the majority owner or company repurchase the minority owner’s stock, LLC units or partnership interest.

2. Look Back Provision on Redemption

Private company investors should take steps to secure a buy-sell agreement that will permit them to monetize their ownership stake in the company in the future.  The majority owner who agrees to provide the minority investor with a buy out right, however, will insist on securing a reciprocal right to redeem the minority investor’s interest.  The majority owner is only being practical in securing the right to buyout the minority owner if the parties are not getting along.

When the investor agrees to provide a redemption right to the majority owner, however, the investor should secure a “look back” provision that lasts for a defined period, often for one year.  This term ensures that if the majority owner exercises the redemption right and buys out the investor’s interest, but then sells the Company for a higher value or issues new shares for a higher value within the 1-year look back period, the investor will be entitled to receive a further payment that provides the investor with the benefit of that higher realized value.

3. Distributions to Cover Tax Liability

The standard LLC Agreement, bylaws or LP agreement gives the majority control group the sole discretion to decide whether or not to issue any distributions or dividends and in what amount.  It is important to appreciate, however, that these companies are all pass through entities that require the owners to pay the taxes that are due on any profits generated by the company, and this tax obligation exists whether or not the company actually issues dividends to any of the owners.  Specifically, when a company retains earning for reinvestment, growth or any other business purposes, the owners are still taxed on those retained earnings. For this reason, investors may want to insist that the company’s governance documents impose a duty on the company and its owners to issue dividends or distributions that, at a minimum, will cover the tax liability of the owners based on the profits that were generated by the company.

4. No Dilution

As noted earlier, one of the risks of a private company investment is that the percentage ownership that the investor receives in the company may be reduced (diluted) if the investor does not agree to contribute additional capital to the company when requested in the future.   This situation can be avoided if the investor insists on having an anti-dilution provision included in the company’s governance documents.  If there is an anti-dilution provision in the governance documents, any shortfall created by the lack of additional capital from the investor will have to be covered by other investors.  These investors will then have this amount paid first before any distributions are made to any of the other owners of the business.

5. Amendment Only By Unanimous Consent

If minority investors do not limit the “right of amendment” in the company’s governance documents, majority owners will have the right to rewrite fundamental terms that directly impact the investor’s rights.  Specifically, majority owners can use the power of amendment to remove minority investors as managers, directors and/or employees, and even change the terms under which the majority owner redeems the investor’s interest resulting in a smaller payment for the minority investor’s ownership interest in the company.  All potential investors should therefore confirm that unanimous consent is required from all shareholders, members or partners before there are any amendments that are made to the company’s governance documents.

6. Tag Along Rights

When an opportunity arises to sell the business, the majority owner is not required to sell the entire business to a third party or to sell all of the shares/units in the company to this third party buster.  Instead, unless the transfer is prohibited by the terms of the company’s governance documents and requires unanimous consent, the majority owner can agree to transfer his/her interest to a third party leaving the minority investors behind with the new owner.  This type of transfer by the majority owner to a third party be prevented through transfer restrictions included in the governance documents or through what are called tag along rights.  These rights require the majority owner to allow all owners in the company to “tag along” in a sale transaction, and receive the same price for the sale of their shares/units that the majority owner is receiving for the sale of his/her interest as part of the transaction.

7. Annual Written Reports

Private companies do not operate with the same level of formality as large public firms, which is generally a positive as it gives them the potential to be more relaxed in culture, more responsive to the needs of customers and more collegial.   One of the ways private companies are less formal is that they have less paperwork and a less formal reporting process.  The lack of big business formality does not mean that private businesses should eliminate all reporting, as these reports are helpful to investors who may not be active in the operations of the business.  One way to strike a good balance is to require the company in its governance documents to provide all of the owners, at a minimum, with annual written reports that review the company’s financial performance and key developments that took place during the preceding year.

8. Books and Records/Audit Rights

Going beyond the information included in an annual company report, investors may have valid and specific questions about the company’s performance.  Texas law provides company shareholders and members with the right to access certain business records, but the law is not expansive as to the specific materials that the company is required to produce to the investor in response to request.  The investor will therefore want to make sure to include an obligation in the governance documents that requires the company to provide the investor with access to a broad range of the company’s books and financial records.

9. Mandatory Arbitration of All Disputes

The investor should discuss with counsel whether or not to require the company, and the majority owner to resolve any disputes that arise between them through binding arbitration.  The benefits of arbitration, when structured properly, are that it is much faster, less expensive and leads quickly to a final, non-appealable result.  In addition, arbitration proceedings are private and not open to the public.  These features may make arbitration a better option in some cases for some types of disputes, but not in others.  These pros/cons of arbitration as compared to litigation should be considered by the investor before any investment is made.

10. Prevailing Party

A final point to consider is that if a dispute arises in the future that requires the investor to pursue legal action against the company or majority owner, the investor will want the right to recover the legal fees that are incurred in this legal proceeding if the investor is the prevailing party.  This will be two way street, of course, that would allow the company and/or the majority owner to recover legal fees from the investor if the company or the majority owner was the prevailing party in any litigation/arbitration filed against the minority owner.

Conclusion

Investments in private companies are increasing and are being recommended regularly by wealth advisors as an additional category for their clients in which to invest as a means to diversify investment portfolios. Assessing the business risk of any private company investment will require significant and careful due diligence, but the legal risk involved can be limited, if not eliminated, by adopting, in some form, a version of the provisions discussed above. The cautious investor who makes sure these provisions are included in the company’s governance documents or in a shareholder agreement will be much better positioned no matter what the future holds for the company.