Listen to this post

We have been enjoying a nice spring in Dallas – moderate temperatures, not too much rain and mostly sunny skies. In the investing world, these conditions signal that the time is ripe for a private company investment. But just as gardeners inspect the soil, check on the sunlight, and consider the available water sources before planting, investors need to be careful that their spring enthusiasm does not blind them to warning signs regarding a private company investment.  This post considers key aspects of a target company’s ownership and management to determine if red flags are present, which suggest that the investment is high risk and may be better to avoid.

Red Flag No. 1: Decision-Making Paralysis

Decision-making can be a red flag if the company’s leadership makes decisions in a haphazard way. Lack of decision-making creates conflicts or indecisiveness that can lead to missed opportunities and the failure to deploy the company’s capital and resources effectively. This is a problem for any business striving for robust growth, but a flawed decision-making structure is not always easy to discern by a potential investor during due diligence. 

Sussing out the effectiveness of the company’s decision-making (or problems in this area) takes effort and the willingness to ask good questions. To get to the heart of this issue, investors should (1) request a list of the top strategic decisions that the company’s management has made over the past three to five years, (2) meet with current investors, and (3) also meet with current managers or board members. These meetings will be critical to discuss how the decisions were made, how long it took for decisions to be made, and how the company’s management dealt with challenges when some of their decisions did not work out as planned.

A well-managed company should be able to demonstrate how its management makes effective decisions, and indeed, a company that cannot explain how its decision-making process works productively is showing evidence of a red flag.

Red Flag No. 2: Investors Treated as Mushrooms

 Minority investors appreciate they will not be running the show and that they will take a back seat to the company’s majority owners, who control the business. But substantial investors expect to be able to express their views to management about the company’s major decisions, to be kept informed about developments that impact the business, and to avoid surprises in the form of negative results regarding the company’s performance. Stated more simply, it is a red flag if a sizable number of the company’s current investors feel they are marginalized and unappreciated by the company’s management.

To evaluate the transparency of company management and the opportunities for minority investors to participate to some extent in decision-making, investors need to consider engaging in at least two different approaches. First, investors need to review the company’s governance documents to determine the extent to which (i) the company is required to conduct meetings on a consistent basis with investors, (ii) the company regularly issues management reports to investors regarding the company’s financial performance and operations, and (iii) the company holds votes on important measures. Potential investors will want to confirm that the required meetings are held, that the management reports are issued, and votes are held. If the company fails to conduct regular meetings with investors, lacks a consistent reporting system, and operates without any formal structure, the absence of good “corporate hygiene” poses a serious concern.

The second track for investors is to consider the experience of the company’s current investors. If they are disgruntled at how they are being treated, it will be hard for them to mask their frustration with how management conducts business. It is also a red flag if the company refuses to permit a potential investor from meeting/speaking with current investors or designates just one owner as the sole person for investors to speak with during the due diligence process. If the company tries to “hide the ball” regarding the views held by current investors, this lack of transparency is a notable red flag.

Red Flag No 3: Distracted/Conflicted Management

Majority owners who manage the business and have their fingers in many pies can also pose a significant concern. The ideal private company investment is one where the ownership (and managers) maintains a laser focus on guiding the business to success. By contrast, when the members of management split their time between different companies and/or engage in deals with other companies in which they also own an interest, this may create a serious problem for the business. When managers have dual responsibilities or their loyalties are divided among a number of different companies, this situation can result in distraction for the target company’s operations, as well as conflicts of interest that make investment less desirable.

The potential dual or divided loyalty question can be challenging for investors to evaluate because current management typically does not volunteer this information, and managers may be blind to the problem. The investor needs to seek disclosure of financial information from the company that details outside business activities by the company owners and managers, including related party transactions. Specifically, the investor will want to understand what role the target company’s managers have in other businesses and what level of ownership they have in other affiliated companies. More generally, the investor should assess how focused the management team is on the business in which the investor is considering an investment. 

Evaluating this issue will require pointed discussions with current management about their bandwidth, the existence of divided loyalties, and potential conflicts with other companies. The bottom line is that managers who have their fingers in multiple pies can create unwelcome distractions for the business and also become subject to direct conflicts of interest that will be a drag on the company’s performance. 

Red Flag No. 4: Uncertain Partner Exit Rights

We have covered in other posts the importance for investors to secure an exit right in the form of a buy-sell agreement at the time of their investment. This is a “put right” that authorizes minority partners to trigger a buyout of their interest requiring a purchase by the company or the majority owner. The specific process for valuing the minority interest will be set forth in the agreement as well, after the minority partner triggers the buyout. 

Before investing, the potential investor therefore needs to carefully scrutinize the terms of the buy-sell agreement, whether it is contained in the company’s governance documents or set forth in a separate owners agreement. Some buy-sell agreements are so poorly drafted they cause the buyout process to become protracted or, worse, they are so complicated the buyout right almost becomes illusory. The investor should seek the following in the buy-sell agreement: (1) a clear statement as to when and how the investor can trigger the buyout, (2) the elimination of all discounts that reduce the value of the minority interest based on lack of marketability or lack of control, (3) a requirement for valuation disputes to be subject to a prompt arbitration hearing that avoids a lengthy, expensive court battle, and (4) the obligation for the company to reimburse the investor’s legal fees if the investor prevails in the valuation dispute.

The buyout right protects the minority investor when conflicts arise with management, and it ensures that the investor will not be required to continue indefinitely holding an illiquid interest in the company. This exit right is therefore critical for the minority investor to obtain at the time the investment is made. A company that refuses to provide this exit right is presenting a red flag right from the outset. There is a caveat here, however, that involves timing. It is not uncommon for a company to provide a buyout right to the minority investor, but to preclude the investor from exercising that right for some period of time after investing. A buyout right that the investor cannot trigger for two to three years is much less of a red flag as the company is seeking to avoid the duty to return funds to the investor in a short time after receiving the invested capital.

Conclusion

Spring sunshine will not make plants grow from infertile soil and in the absence of water, and similarly, a business needs more than a promising product or service to achieve success. The most successful businesses avoid becoming mired in dysfunctional management conflicts that cause companies to languish or fail regardless of the benefits of their products or services. These successful businesses also promote a good, transparent relationship with their investors. 

For the potential investor, it is crucial to inspect the garden closely before planting any seeds of capital. Investors should be cautious about investing in companies that lack a clear decision-making process, that do not provide transparency to their investors, and that do not stay focused on the goals of the business. And securing an exit “put right” on the way into the investment is the wisest course regardless of the attractiveness of the garden.

Listen to this post

When longtime business partners in private companies go through a business divorce, emotions often run high. One or both of the partners may be seeking a “revenge premium” in the business divorce process based on their perceived mistreatment by the other partner during their time together. While the urge to extract a pound of flesh from a soon-to-be former partner during a business divorce is understandable, it is likely to be self-defeating. Seeking pay back from the other partner is likely to result in heightened conflicts, a longer time to complete the process, and more distractions for the business. By contrast, when partners keep their emotions in check, they can achieve mutually positive financial outcomes and increase the opportunity to preserve their business and personal relationships.

Introduction – The Costs of Pursuing a Revenge Premium

Securing a revenge premium from the other partner during a business divorce is not just difficult to obtain; the decision to go down this road virtually guarantees that both partners will be engaged in a more protracted, expensive process. These negative results include: (1) incurring substantial legal fees that may escalate rapidly into six figures (or more), (2) participating in multiple rounds of negotiations that do not produce a financial windfall, and (3) dealing with the negative reactions from other key stakeholders in the business, including employees, clients and other owners. In addition, the company’s performance and total value may decline precipitously in the midst of a contentious business divorce because management will be focusing on conflicts between the partners rather than prioritizing the company’s operations. 

The lose-lose type of scenario described above is one that both partners should take pains to avoid. Pursuing a business strategy that is guaranteed to increase conflicts, expense and time away from a focus on the business is akin to voluntarily jumping into quicksand. The remainder of this post therefore focuses on strategies for business partners to consider in efforts to optimize the outcome of their business divorce.  

Opt-In Strategies

When a business divorce takes place, the majority business owner may have become frustrated by the minority partner’s conduct and therefore insist that the minority partner accept a purchase price for the partner’s interest in the business that is less than its fair market value. That is what we refer to as a revenge premium. To head off the serious conflicts likely to ensue from the pursuit of a revenge premium, however, the majority owner may want to consider an entirely different strategy and approach to the business divorce.    

Majority Owners: Paying a Peace Premium to Departing Minority Partners

Specifically, the majority owner is advised to consider paying a purchase price for the minority owner’s interest that is well above its fair market value (FMV), which we refer to as the “peace premium.” We are not suggesting that the majority owner deliver a huge windfall to the minority partner, but instead to consider a purchase price that is 20%-35% larger than the FMV of the minority interest. The majority owner’s initial reaction to this suggestion may be that making this “excess” payment is rewarding bad behavior by the minority partner in the past, but for the reasons set forth below, the majority owner may want to consider biting the bullet and paying the peace premium to the minority partner.

  • A prompt exit that results from the payment of the peace premium to the minority partner will save the majority owner both time and money because it will lessen the legal expense involved and remove a significant distraction for the owner in the operation of the business. When the minority partner’s exit from the business results in addition by subtraction, securing the benefits of this exit as promptly as possible is good for the company (and the majority owner).
  • If the business is on a positive trajectory, the longer the minority partner remains part of the company, the higher the price the majority owner will have to pay to purchase the minority interest. Stated another way, if the business is appreciating in value, all of that appreciation (or the lion’s share of it if there are other partners) will be going to the majority owner once the minority partner has been bought out.
  • To the extent that other owners and employees in the business learn that a peace premium was paid to the minority investor, this will serve as an incentive. It will show that the company is healthy, that the returns on exit from the business will be substantial, and that departing partners are treated fairly and with respect. 
  • Finally, paying a peace premium to the departing minority partner should also engender some good will from that partner. This payment will tend to make the minority partner a continued positive spokesperson for the company, and it will help to maintain a good personal relationship between the partners themselves.  

 Minority Investors: Buying Into a Soft Exit From the Business

For minority partners, their approach may be to demand an exorbitant purchase price for their interest, which is paid to them promptly. If the minority partner has not secured a buy-sell agreement from the majority owner, however, the minority partner has no contractual basis to issue a buyout demand to the majority owner. Therefore, making a demand like this would be akin to seeking a revenge premium because the minority partner has no legal basis for it. Indeed, in response to demands of this nature from the minority partner, the majority owner may elect to remove the minority partner from all operational and management roles in the business. When this type of squeeze out is implemented, the minority partner will be left with no access to further compensation, distributions or dividends from the company, and the partner may have to wait for years for some type of liquidity event to take place to monetize the investment in the business.

While the minority partner who has no buy-sell agreement in place with the majority owner can resort to a litigation strategy in efforts to bring the owner to the bargaining table to secure a buyout, a more effective, less contentious approach should be considered. Specifically, the minority investor could propose a soft exit from the business that permits the investor’s interest to be purchased over time by the company and on terms that do not create a financial hardship for the business.

This type of structure might involve a combination of a cash payment that is paid to the minority partner over time, as well as a revenue share for some period of years. All of these terms are subject to negotiation, but a soft exit for the minority partner could look like this:

  1. The minority partner accepts a purchase price of an amount that is below the FMV of the business, which is paid out over five years with 20% paid up front. This would not be a steep discount, but perhaps 10-20% below the FMV;
  2. To balance the shortfall in the purchase price for the minority partner’s interest, the company also agrees to pay the minority partner a set percentage of the company’s revenues for three years; and
  3. The minority partner and the company agree on a ceiling and a floor for the revenue share. In this regard, the company guarantees that the total amount of the future revenue share paid to the partner will not be less than a set amount, and the parties also agree that the amount of the revenue share will not exceed a capped total amount. Thus, the parties agree to a range of additional potential payments to be made to the minority partner after closing.

This type of soft (negotiated) exit from the business provides an opportunity for the minority partner to secure an exit from the company for a value that may meet the investor’s financial objectives, but without bankrupting the company. 

A Third Path: An Exit Facilitated by Third Parties

Another path for business partners to consider when they need a business divorce is one facilitated by third parties. The agreements the partners entered into may require them to attend a pre-suit mediation, but even if a mediation is not required by contract, there is generally little downside to attending a mediation with a business mediator skilled in facilitating business divorces. This type of pre-suit process is non-binding, and it will permit the mediator to help the parties explore efforts to resolve their claims/differences in a creative manner, which will avoid the time, substantial expense, and inconvenience of engaging in litigation. 

If a mediation is not successful, the partners may also consider submitting specific issues to arbitration. It is not unusual for the main conflict between partners in a business divorce to be the value of the business, and if they are at an impasse regarding valuation, they may end up in court over this issue. When litigation is the only option, that will result in a battle of the experts where both parties hire business valuation experts and present competing valuation reports to the judge or the jury for resolution. That approach will involve years of costly litigation, which will require the partners to incur the fees of both their legal counsel and valuation experts. 

One alternative is to limit the partners’ dispute to the issue of valuation and submit that issue for resolution by a single arbitrator or arbitration panel. This type of arbitration is much faster than litigation as it can take place in a matter of a few months rather than over multiple years; the company’s value will be determined by experienced business lawyers or former judges selected by the parties; and the arbitrator’s determination will be final without any appeal. If the partners are confident in their determination of the company’s value, this may be a better, less costly option to consider when company valuation is the primary conflict between them.   

Conclusion

Businesspeople are not immune to emotional reactions, and business divorces tend to magnify the feelings of the partners that caused them to separate. That is why it is common for business partners in this situation to pursue outcomes that seek to extract some type of revenge premium. But when partners ratchet down the emotions and engage in efforts to find pragmatic solutions — such as peace premiums, soft exits or the use of mediation or arbitration — they can save themselves from severe financial headaches and lasting emotional heartaches. 

Partners who are able to control their emotions during a business divorce can achieve outcomes that produce an array of positive benefits, which extend beyond their own transaction. More specifically, partners who focus on securing a win-win outcome in their business divorce place themselves in position to secure reasonable value for themselves; they will maintain (and perhaps enhance) their professional reputations; they will protect the enduring value of the business; and they will preserve their personal relationships. Setting aside the urge to obtain vindication is not just an appeal to the better angels of business partners, it is a strategy that is designed to produce the best possible outcome for them and also for the business. 

This focus on the continued success of the business also applies to the departing minority partner, who should care about the business even after the partner’s interest has transferred. First, the departing partner may have a revenue share that is directly tied to the future performance of the business. Second, even if the departing partner does not have a revenue share arrangement in place with the company, there is likely a payout of the purchase price, and the partner will not want to deal with a monetary default if things go south in the business. Finally, if the business does continue to flourish, the departing partner should be able to point to his or her role in the business with legitimate pride in having contributed to the company’s success.

Listen to this post

Throwing the baby out with the bath water is a pithy expression that suggests exercising caution when business partners in private companies are seeking to achieve a business divorce.  The majority owner and the departing minority partner in the business may both see this process as a “take no prisoners” type of battle. But adopting the view that a zero-sum outcome is the only possible result when a business divorce takes place — with just one clear winner and loser — is not just unnecessary, it can be destructive to the parties’ relationship and to the business. When parties instead consider creative strategies that are designed to optimize the result for both sides, they will ratchet down the emotional tensions involved, preserve their long-term relationship, and avoid doing serious damage to the company’s reputation and performance.

In this post, we consider a variety of approaches to business divorce that provide for a partner exit based on objectively reasonable terms, which will help preserve the company’s value and provide a structure that enhances the company’s longevity. 

A Phased Buyout with Security Protections

A business divorce involving a full cash payment up front is rarely optimal for either the majority owner or the minority investor. The company will be reluctant to fund an immediate cash buyout from the business, because this sudden removal of the cash on hand will negatively impact the company’s ongoing operations. The departing minority partner will also likely be concerned that insisting on an all-cash buyout will result in an effort to apply deep discounts to the purchase price, i.e.,force a buyout of the minority interest “on the cheap.”

The reluctance of both parties to push for an immediate payment is why it is customary for business divorce buyouts to take place over an extended period. The parties will implement a valuation process using an objective third-party valuation firm to determine the enterprise value of the company; in some cases, both the company and the minority investor will retain business valuation experts to compare reports to achieve an objective resolution of the company value.  Once the value has been agreed on, the parties will put in place a multi-year payment plan for the purchase of the investor’s interest. The investor will also want some form of security in the event of a default in payment, and this can be provided in a number of ways. Some examples include providing a pledged interest in some of the company’s assets or receivables, the majority owner providing a personal guaranty, or the unpaid purchase amount due could be subject to a security interest in a portion of the company’s stock.  

Performance Based Buyouts

When business divorces do become contentious, the business partners are usually in conflict over the company’s value — typically when the majority owner has presented a buyout figure that the minority investor considers much too low. When this valuation dispute results in an impasse between the parties, the filing of a lawsuit may seem like the inevitable next step. But moving to the courthouse is not the only way to resolve this valuation conflict. .

One way to head off litigation over valuation is to provide for the minority investor to receive additional payments that increase the total purchase price paid for the investor’s interest based on the company’s future performance. The majority owner (or company) still acquires the full ownership interest of the minority investor at a closing, but the investor will also receive a (negotiated) percentage of the company’s future revenue for some period of time.

This is known as a revenue-sharing agreement – the purchase price involves payment to the investor of a fixed amount with additional payments that are based on the company’s future performance. The percentage of the revenue share does not have to be flat, i.e., it could be 15% of the revenues the first year, 10% in year two, and 5% in year three — all of these amounts are subject to negotiation. Further, the parties can also include a high-low arrangement that adds both a floor and a ceiling for the future payments. In this scenario, the investor is guaranteed to receive a total minimum amount based on future payments that are made regardless of the company’s actual revenue, which sets the floor for the total purchase price to be paid. If the investor negotiates to include a floor as a guaranteed minimum payment, however, the majority owner will then include a cap that will establish the maximum amount that the investor has the potential to receive based on the revenue share. 

Dividing Assets, Markets or Clients Than Cash

One of the most creative approaches to achieving a business divorce is to structure the buyout based on the assets of the business rather than using cash alone to fund the purchase of the departing partner’s interest. This is an unusual option that will not work in many companies or where partners do not wish to continue operating any part of the business, but when the facts make it possible, this path may help to avoid conflicts and/or a legal battle between the partners. 

In this type of business divorce, the parties will evaluate all the parts of the business and then divide certain company assets between them. There are no limits to the creativity involved in this process, and the partners can decide how to divide assets, including, but not limited to, the geographic regions or territories in which the company operates, the company’s different product lines, different groups of employees working at the company, or different customers the partners are working with in the business.

When the partners divide assets, they will both usually continue to work in the industry, and they will divvy up the company’s territories, product lines, customers and/or its employees in a manner that they determine is appropriate. This is obviously a more complicated scenario than a simple monetary buyout, but if the partners remain on good terms when they are conducting their business divorce, this type of asset division may be less contentious because each partner will receive the assets they need from the company to be successful as they move forward in the same or similar industry.

Conclusion

Business divorces often present emotional challenges for the partners, particularly when they have been in business together for years. But if the partners approach their separation in an effort to secure a win-win outcome, they can achieve a productive transition and avoid personal animosity that could negatively impact the business. These creative exits include a variety of potential structures such as phased buyouts based on future performance, asset-based divisions, and longer-term buyouts. These approaches share the common goals of preserving the value of the company and achieving a reasonable exit price that is acceptable to both partners.