When a private equity (PE) firm buys the controlling interest in a private business, the purchase often includes an earn-out provision which calls for the owner to remain active in the business for some period of time. The use of an earn-out provision can seem like a win-win for both parties, because it allows the PE firm to buy the company for a lower purchase price and provides the business owner with the opportunity to secure a substantial additional payment if the company achieves certain agreed financial performance targets after the sale.  The problem with this rosy picture is that earn-out provisions are a common cause of disputes and litigation over whether the earn-out requirements were met after the purchase and whether the owner is entitled to the additional payment.

This post focuses on conflicts that frequently arise between PE firms and owners over earn-out provisions and suggests changes for both PE Firms and owners to consider, which may reduce or eliminate these post-purchase conflicts.   Continue Reading PE Firms: The Earn-Out Conundrum—Avoiding Post-Purchase Conflicts With Private Company Sellers

In the private company world, the buck stops with the majority owners, who generally hold the reins to running the business.  In our experience, however, it is not uncommon for some majority owners to push the limits of their control by engaging in self-dealing transactions that are for their own benefit.  The self-interested transactions in which majority owners may engage can take many different forms, including paying excessive bonuses to themselves, directing the company to enter into “sweetheart” deals with their other companies, taking company opportunities for their own gain, and using company assets or personnel free of charge.

When minority investors seek legal recourse from abuse of authority by its majority owners, the controlling owners will often point to a little-known Texas statute, which they contend renders them immune from liability for their actions.  See Texas Business Organizations Code § 101.255.  As we say in Texas, that dog won’t hunt.  This post explains why the existence of Section 101.255 does not provide majority owners with a “get out of jail free” card, and why this statute does not validate their improper conduct when they engaged in self-dealing. Continue Reading The Private Company Cookie Jar: Who Decides How Many Cookies The Majority Owners Get to Eat (And Which Ones)?

By Sam Vinson and Ladd Hirsch

In his famous “To Be or Not to Be” soliloquy, Hamlet anguished over whether his future was worth living. [1] Hopefully, private company founders picture a future less bleak than Hamlet’s grim outlook. When the founders of fast-growing private companies accept new investment capital, however, they need to consider the future of the resulting ownership structure of the business, particularly when the financing involves issuing new company shares.

When a private equity investment is made in a private company, a balance must be struck between the competing interests of the company’s founders, on one hand, and the private equity or venture capital firm (the “PE investor”) on the other. From the PE investor’s perspective, an investment in a private company makes sense only if the founders maintain their continued commitment to the company’s success. Once the investment is made, founders will want to make sure they have an exit plan in place that provides them with ample rewards when they depart based on the financial success (hopefully) they helped the company to achieve.

This balancing of interests between founders and PE investors is often handled through a vesting process regarding the founders’ stock or equity ownership. This post, therefore, focuses on the use of vesting schedules by private companies when issuing stock. Ideally, the use of vesting schedules that apply to stock ownership is complimented by buy/sell exit planning, i.e., founders will want to secure some type of a buy/sell agreement that permits them to monetize their interest in the company at the time of their exit. Continue Reading “To Vest, or Not to Vest” —The Question for Company Founders Who Receive Equity/Stock In Connection with a New Private Equity Investment in the Business

By Jeff Balcombe [1]We are pleased to present this guest post from Jeff Balcombe, a highly regarded business valuation expert based in Dallas, who is a founding principal with his firm BVA Group.

In a perfect world, business partners who reach the point of parting ways would have a clear, unambiguous plan in place governing their separation.  Unfortunately, when they engage in business in the real world, many company owners who need a Business Divorce find that they never adopted any type of separation agreement or that the agreement they have is missing key elements necessary to facilitate a prompt, inexpensive separation.  This post therefore outlines a Business Divorce process designed to achieve a prompt, efficient exit plan for business partners.

The Exit Plan Should be Approved When the Investment is Made

For an exit plan to work effectively, it must be adopted in advance, because a successful Business Divorce involves far more than determining a buyout price based on an appraisal that supports the buyer’s or seller’s notion of value.  In fact, a “ready-fire-aim” approach that calls for getting an appraisal, and then starting buyout negotiations is almost certain to result in a drawn-out, expensive process that may end with the parties in dispute.  To minimize costs and reach an agreed outcome, both parties must adopt a process with a definite end-point—a successful separation. Continue Reading Avoiding Business Divorce Disaster: A Business Valuation Expert’s View

“The bad things you can see with one eye closed. But keep both eyes wide open for the little things. Little things mark the great dividing line between success and failure.”
Jacob Braude, Author and Humorist (1896-1970)

By Sean Brown[1] and Ladd Hirsch

In business, an eyes wide open approach is essential to the successful purchase of a private company. When the purchaser of a private company enters into a letter of intent (“LOI”) or reaches a handshake deal to buy a private business, the little things often have not yet been fully disclosed and it therefore remains to be seen whether the transaction will fail or succeed. This post reviews focuses on little things that a private company buyer should make sure to address to achieve an optimal outcome, including steps to be taken after the parties have signed the LOI.

Recognized by Texas Bar Today’s Top 10 Blog Posts

Little Thing No. 1: Conduct Adequate Due Diligence

Due diligence, in the context of mergers and acquisitions, is commonly referred to as the process by which the buyer gathers information about the business or the assets for sale. It is crucial for a buyer to conduct sufficient due diligence to establish the following information, a minimum, before closing on the purchase:

Confirm the seller has the authority to sell the stock or assets of the target company;

  • Identify and investigate potential liabilities or risks;
  • Identify necessary steps to integrate the target business into existing business; and
  • Identify any obstacles to closing the transaction, such as shareholder consents, third-party consents, or prohibitions on transfer.

Establishing this information requires the buyer to review the seller’s organizational documents, such as formation documents, bylaws or operating agreements, benefit plans, vendor contracts, supply contracts, and customer contracts. Some of the common issues the buyer will need to focus on are: (i) ownership of the target company, (ii) existing management of the company, and (iii) necessary consents from third-parties in connection with key contracts. Continue Reading Buyer Beware: Purchase a Private Company With Both Eyes Wide Open

By Ladd Hirsch and Trip Dyer[1]

“There is no such thing as a free lunch.”  It is a common expression with a clear meaning— don’t expect to receive something for nothing.  But there is an important corollary expressed less often: it is possible to receive something that will have value in the future, but without having to pay for it now.  Like seeds waiting to sprout, the concept of a private company profits interest fits this description of an asset with no current worth, but which may become quite valuable over time.  The profits interest therefore has an important role to play in the private company context, but what exactly is a profits interest and how does it work?

Defining a Profits Interest

In brief, a profits interest is a creative way for private company business owners to provide their employees with a significant financial incentive—an ownership stake in the company—but without saddling them with a tax burden when they receive this interest.  A profits interest can serve a purpose that is similar to a stock option by granting an equity interest in the company to the employee, but unlike some stock options, the employee does not recognize income or pay taxes on the grant of a profits interest because the profits interest has no value when it is granted.

The absence of value is because a profits interest is forward-looking; it provides the employee with a share in: (i) the company’s future profits and (ii) the appreciated value of the company.  If the company was liquidated on the day that the profits interest was granted, the employee would receive no proceeds from the liquidation.  The employee receives financial benefits only when the company’s assets are sold for a higher value than the date the profits interest was issued or when the company makes distributions with respect to future profits.  Further, the employee is not required to contribute any capital and is awarded a profits interest based on the services that the employee has provided or will provide to the company. Continue Reading The Equity Profits Interest: Giving Seeds Time to Sprout, Incentivizing Key Employees, and Keeping the Tax Collector at Bay

By Ladd Hirsch[1]

“Water, water, everywhere,
And all the boards did shrink;
Water, water, everywhere,
Nor any drop to drink.”
The Rime of the Ancient Mariner, Samuel Taylor Coleridge, published 1798

This riveting poem by Coleridge relates the story of a sailor who is cursed for killing an albatross, which results in the ship’s crew nearly dying of thirst while they are surrounded by the great expanse of the ocean.  While not nearly as dramatic as this scene from the poem, divorcing spouses who own substantial interests in successful private companies do commonly experience a similar dilemma.  The couple’s interest in a private company may be a highly valued asset that is worth millions of dollars, but the spouses and the company lack the cash necessary to fund the purchase of the interest held by the selling spouse.   In the Coleridge vein, there is value value everywhere, but no cash to pay for it.  Without a creative solution in place, this lack of liquidity creates a significant problem for the divorcing couple in achieving a “just and right division” (as required by the Family Code) of what may be the most valuable asset in their marital estate.

A Road Less Traveled—Postponing Asset Division Can Pay Dividends

The conventional wisdom is that all marital assets must be divided at the time of divorce.  But, when a liquidity problem exists in divorce cases that involve the ownership interest held in a substantial private company, the best solution for the couple in some situations may be to continue their joint ownership of the business for a period of time.  This approach to the division of a marital asset can be termed a “phased buyout,” and this settlement structure provides the spouse who is acquiring the full ownership interest in the company (the buying spouse) with the time necessary to secure the capital  required to purchase the other spouse’s interest in the business (the selling spouse). Continue Reading Family Law Post: The Liquidity Problem In Divorce Proceedings – High Value, But No Cash to Pay for Private Company Business Interest

The statistics are grim on relationships remaining intact between business partners.  This month’s edition of Inc. magazine cites Noam Wasserman, entrepreneurship professor at USC’s Marshall School of Business, reporting that 10% of co-founders end their business relationship in less than one year and 45% break-up within four years.  While these statistics are focused on two-person owned companies, break-ups are at least as common among businesses with multiple owners.  Faced with these distressing figures, this post focuses on concrete actions that business partners can take at the outset when their company is formed or when an investment is made, which our experience teaches will improve their prospects for maintaining long-term business relationships.

Operational issues and the vision for the company can definitely lead to disputes, but in many (if not most) cases, the crux of the conflict between business partners comes down to a disagreement over money—how the financial pie will be split.   Our suggestions therefore key on how the company’s finances are handled.  The starting place is to put an exit plan in place at the outset of the relationship —a Buy-Sell agreement that governs any future Business Divorce.  This “corporate pre-nup” will help avoid litigation and a huge distraction for the company when a partner departs.  We have written extensively on this topic in previous posts (see links below), and adopting a partner exit plan is essential.

But the Buy-Sell Agreement only comes into play when business partners are separating.  There are three specific steps that partners can take when their relationship begins, which will help limit their conflicts and, perhaps, avoid the need for a Business Divorce in the future. These steps are: (1) adopt a dividend/distribution plan, (2) implement an executive compensation plan or formula and require annual valuations of the company prepared by an independent business valuation firm.  Each of these actions is discussed below. Continue Reading Can We Keep the Band Together: Seeking Long-Term Harmony Among Business Partners

By Brad Monk and Ladd Hirsch

People change, and not always for the better. Which leads to the question:  what is the best course of action when a trusted business partner turns out to be a rotten egg?  The answer is not easy, but usually the best course of action is to promptly remove an untrustworthy partner from ownership in the business and also from participation in the company’s management.

Removal Provisions Need to be in the Governance Documents

The process of removing a bad business partner is often unpleasant and difficult, but it is likely unavoidable.  To prepare for this type of risk, diligent majority owners will want to include “removal rights” in the company’s governing documents (the LLC agreement, the partnership agreement, or corporate bylaws) that provide for the removal of business partners who go off the rails.  By the same token, minority investors will want to closely review all “bad boy” provisions to insist on changing these terms if they give the majority owner unbridled power that could be used abusively to harm the minority investor. Continue Reading Be Careful With the Rotten Egg: Removing a Bad Business Partner From the Company is Difficult

By: Mark G. Johnson and Ladd Hirsch

Recognized by Texas Bar Today’s Top 10 Blog Posts

In Edgar Allan Poe’s short story, the Purloined Letter, his fictional sleuth, C. Auguste Dupin, successfully located a stolen letter the thief had cleverly concealed by hiding it in plain sight.  In the legal world, letters of intent (LOIs) are used to form partnerships, raise funds, and add investors, among other things, but the common use and non-binding character of LOIs does not mean they are problem free.  This post takes a look at LOIs and focuses on issues that may be overlooked, but which can create significant legal problems in the use of LOIs.

Letters of intent are referred to by many different names, including memoranda of understanding, term sheets, agreement in principles.  Whatever it may be called, an LOI is simply a summary description of the essential terms of a business transaction.  In most cases, the parties intend that the LOI will be non-binding and will not establish an enforceable agreement between them except as to one or two provisions, such as confidentiality and exclusivity.  Due to the non-binding nature of LOIs, and the fact they “have no teeth,” business owners and investors may conclude there is no need for or value in retaining legal counsel to negotiate and draft LOIs.    This common sense assessment, however, actually reflects a risky business strategy.  Whether the proposed transaction involves the start up of a new company or the investment in an existing business, hiring an experienced business lawyer to assist is a wise, cost-effective decision. Continue Reading Hiding in Plain Sight: Often Overlooked Problems with Letters of Intent