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.
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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.
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“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.

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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.
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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.
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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.
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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.
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By: Mark G. Johnson and Ladd Hirsch

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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.
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By Ryan Bruderer and Ladd Hirsch

Recognized by Texas Bar Today’s Top 10 Blog Posts

Just as an excessively lavish desert can ruin a fine dinner, including an overly broad indemnity provision in a private company agreement can prove to be too much of a good thing for the company.  The point of indemnity provisions is to protect company executives (e.g., officers, directors, managers) from claims made against them in the good faith performance of their duties.  To ensure the net is broad enough to include all types of claims made against executives, however, these clauses are often drafted quite broadly.  But when the provisions are so inclusive they exceed their intended scope, another truism may apply—the cure may be worse than the disease.  This post discusses the effective use of indemnity provisions in private company governance documents and reviews potential drawbacks that can result when these provisions are drafted without appropriate limits.


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July 2018

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.


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By Liz Monteleone and Ladd Hirsch

It is rare to find a business partner who is selfless. If you are lucky, it happens once in a lifetime.

Michael Eisner, Chairman and CEO of the Walt Disney Company from 1984 to 2005

Starting a company with a best friend or family member may sound like a great plan, because these new partners share a high level of trust and a close personal relationship, as well as excitement over launching a new business.  These co-founders foresee no problem in forming the company as a 50-50 split in which they expect to share equally in the company’s ownership, management and control.  In this heady state of forming a new company, akin to the bloom of a new romance, it may seem off-putting to consider and address a potential future ownership break-up in which one of the partners leaves the business.

But as former Disney CEO Michael Eisner notes, finding a selfless business partner is exceedingly rare, and the more likely result is that a serious rift will arise in the partners’ business relationship in the future.  It may be caused by a divorce, an unexpected illness or a change in business priorities that develops over time.  But realistically, the question is not “if,” but “when” a disagreement will arise, and how the business partners will handle this conflict and the potential need for them to participate in a business divorce.  The failure to acknowledge this risk at the outset and then address how to manage a deadlock or to structure the company to enable an amicable separation can result in significant cost to the partners and the business.
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