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For many majority owners of private companies, selling their business is a once in a lifetime event without “do overs.”  They want to secure top dollar when the company is sold, and this post reviews strategies that are geared to help the owner obtain the best sale price for the business. But there are other important issues in the sale process beyond price the owner must also handle carefully as well. Specifically, the owner will need to address: (i) the fate of key employees in the business after the sale takes place, (ii) the difficulty of meeting post-closing obligations that may be required by the buyer, and (iii) the warranties and representations the owner must make to the buyer in the transaction.  These issues do not take priority over securing a robust sale price, but if they are not dealt with carefully, the champagne popped in celebration at closing may turn sour as conflicts with the buyer drag the owner into a morass of legal problems that last for years after the sale.

Retain Experts to Secure a Sale to a Strategic Buyer

A strategic buyer is typically the most desirable purchaser for the company, because this type of buyer often pays a premium to save the time and money required to start a new company, and in order to remove a successful competitor from the marketplace. Thus, a strategic buyer is one who is seeking specific synergies from purchasing a company that will spur the growth of the buyer’s current business or complement that business. This is a targeted acquisition, because the buyer plans to fold the target company into the buyer’s existing corporate structure.

Tapping into the network of potential strategic buyers who may be available to buy the majority owner’s company, however, requires expertise that most owners do not have. That is why it is generally advisable for the majority owner to retain an investment banking firm, a business broker or another transactional advisor who has the information and the expertise necessary to source strategic buyers who are interested in buying the business. While these advisors will charge a substantial fee for this service, the advisor’s ability to secure a much more robust purchase price is almost always worth the required fee.

The transaction advisor does not serve as the outside legal counsel for the majority owner, but the advisor will provide the owner with expertise in negotiating financial and other sale terms, some of which are discussed below. In this way, the advisor serves as a buffer for the majority owner in contract negotiations with potential buyers, which is also helpful in securing the best price and terms for the sale of the business.  

Developing Hidden Value – Identifying Off-Balance Sheet Assets

Determining a company’s value seems like a purely formulaic exercise based on the company’s revenues and profits. But majority owners who are able to provide more than meets the eye may enhance the price paid by the buyer. This type of enhancement may be possible when the company has off-balance sheet assets that are valuable to the buyer. In addition, majority owners who are willing to accept a greater level of risk may be in position to secure more upside from the buyer in the transaction. 

Some examples of these non-traditional assets are intellectual property (IP) that has not yet been monetized and strategic initiatives or opportunities that have not yet been disclosed or realized. More specifically, many companies have patents or other IP rights they have not yet licensed, assigned or exploited. In the right hands with experts who know how to license and develop these IP rights, they can generate large financial returns for the business. Similarly, the majority owner may know about weaker competitors, unlisted property rights in adjacent venues or other business opportunities that the owner lacked the capital to exploit. If the owner can demonstrate to the buyer that these business ideas are tangible, they may increase the purchase price or as discussed below, they may open the door for the seller to generate additional, post-closing payments.

The financial upside aspect of the transaction involves earnouts that provide the owner with potential (contingent) additional payments from the buyer based on the future performance of the company. Earnouts are notorious for not being realized, and for this reason, the majority owner should exercise significant caution in structuring a purchase price that relies on them heavily. But, for an owner who has a management team that will continue in place after the sale, there may be a realistic opportunity to secure a significant post-closing payment if the team can deliver on performance after closing.

Checking All the Boxes, Not Just Securing the Best Price   

For a majority owner who developed a successful company through the efforts of a devoted team, the key employees of the business represent a close, cohesive culture, not just a company. In addition to key employee retention, the owner needs to negotiate post-closing owner obligations and owner/seller representations.

First, to ensure that key employees will remain with the business after the sale, the majority owner needs to discuss the potential sale of the company with the employees well before the sale takes place. This discussion permits the owner to determine whether any of the employees will resist working with a new owner, whether they are open to entering into employment agreements, and if so, whether they will seek increased compensation after a sale of the company.  This information enables the owner to factor the employees’ concerns into future negotiations with potential purchasers.

The majority owner’s consultation with the employees may also be an opportunity for the owner to consider providing them with phantom stock that will incentivize them in helping to complete the sale of the business.  Phantom stock permits the employees to receive a small percentage of the net sales price that the buyer pays for the company.  This effectively provides the employees with a well-deserved bonus for their efforts, which they will receive when the sale of the company is completed. 

Regarding post-closing obligations, these are often specific to the majority owner as the buyer generally wants the owner to remain active in the business for some period of time after the sale. Given that a major transition of ownership and management is taking place, however, the owner needs to require the buyer to detail the owner’s specific duties and responsibilities after the sale. Disputes between former business owners and buyers over post-closing obligations are common because the parties did not carefully define the role of the former owner after the buyer closes on the purchase. 

Finally, every sale of a business requires the owner/seller to make representations and warranties about the operations and finances of the business. These representations can often became the subject of disputes, and the majority owner may therefore want to consider securing reps and warranties insurance, which provides coverage for these types of claims. In many cases, the purchaser will fund the premium for this policy, which largely mitigates the risk of the majority owner in providing these representations.

Conclusion

The majority owner’s primary goal in selling the business is to maximize its sale price, and achieving this goal is more likely when the owner retains knowledgeable advisors who bring potential strategic buyers to the table. But the sale price is not the sole factor that owners need to consider in the sales process. The owner must also consider how to retain key employees after the sale, how to avoid becoming subject to a host of rigorous post-closing obligations, and whether it is possible to narrow the scope of representations and warranties that the owner must provide or to protect against alleged violations through acquiring insurance that applies to these claims. These may seem like secondary issues, but if they are not handled thoughtfully, they can derail a transaction or create problems for the majority owner after the sale that result in protracted, expensive legal battles.

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Arbitration v. Litigation: Pros and Cons of Dispute Resolution

More than two centuries before Hamilton became Broadway’s most successful musical, Alexander Hamilton and his nemesis, Aaron Burr (sir), chose to resolve their disputes by dueling at dawn in Weehawken, New Jersey. This fateful duel, as we all know, mortally wounded Hamilton, one of our nation’s founders and greatest patriots. Fortunately, dueling long ago ceased to be used as a method to resolve disputes, but business partners today continue to have conflicts that require efficient resolution. This post reviews the two options that are available to resolve civil claims — arbitration and litigation — and considers the pros and cons from the perspective of both private company majority owners and minority investors. Neither fits all situations, but the choice could be outcome determinative in some cases, and it is therefore advisable for business partners to decide whether to resolve their future disputes in court or through an arbitration proceeding.

The most common agreement that business owners enter into with each other is a buy-sell agreement (BSA), although the company’s underlying governance documents (whether bylaws, an LLC agreement or LP agreement) will also include dispute resolution provisions. The BSA specifies how a majority owner can trigger the right to redeem the minority investor’s ownership interest in the company, and it also provides the means for the investor to secure a buyout of its minority interest. The specific provisions included in BSAs were discussed in a previous post. Before business partners decide to stick with litigation or choose to arbitrate their disputes under the BSA or company governance documents, they will benefit from considering the factors discussed below: (i) privacy or confidentiality, (ii) the scope of permitted discovery, and (iii) the speed to achieve final resolution and related cost.

The choice of the dispute resolution process is important because conflicts between business partners are common, and a protracted legal battle between co-owners can be very disruptive to the business. If the partners can select a process that enables them to resolve their internal disputes promptly and cost-effectively, they will be saving themselves both time and money, as well as preserving the value of their shared business.

Factor 1: Privacy and Confidentiality

  • Majority Owner Perspective: Values Privacy

Arbitration proceedings are conducted in outside public purview, while all court filings and hearings, as well as trials in litigation, are generally open or available to the public. This is an important factor but may be seen differently by the partners. The majority owner most often desires to maintain privacy regarding the dispute, so the company’s competitors and customers do not become aware of internal disagreements. In addition, the majority owner will want to ensure that sensitive information about the company’s finances and operations are not available to the public. For this reason, the majority owner may want to resolve all disputes with other partners through a private arbitration process.

  • Minority Investor Perspective: Publicity of Litigation May Provide Leverage

By contrast, although litigating claims may be far more expansive and drawn out than in arbitration, minority investors may decide that, for strategic reasons, they do not want to give the majority owner the opportunity to shield their disputes from the public. The minority investor may conclude that significant leverage can be gained in the parties’ later settlement negotiations if the majority owner has a strong desire to keep the minority owner’s claims and disputes away from public disclosure in litigation. 

Factor 2: Scope of Discovery

  • Majority Owner Perspective: Prefers Limited Discovery

The majority owner wants a prompt resolution of the dispute and does not want to allow the minority investor to use discovery to conduct a fishing expedition into areas that might cause discomfort and be distracting for the business. If the minority investor suspects that the majority owner engaged in some type of self-dealing with the company, however, the investor will likely seek discovery about ways the owner benefitted financially from dealings with the company.

Discovery can be restricted in arbitration if the parties each agree to accept limits in the arbitration provision. In litigation, the minority investor is more likely to be permitted to conduct wide-ranging discovery. Thus, the scope of discovery (and the related expense) is generally much greater in litigation than in arbitration, and the restrictions may be even greater if specific limits on discovery are included in the arbitration provision. 

  • Minority Investor Perspective: Broader Discovery Allows for a More Thorough Investigation of the Majority Owner’s Conduct and Financial Dealings

The minority investor may decide to require litigation as the dispute resolution method in order to ensure that sufficient discovery can be obtained to establish that the majority owner abused control over the company to obtain improper financial benefits. Litigation is the clear choice if the minority investor wants to be in a position to conduct thorough discovery regarding the majority owner’s conduct if a dispute between them later arises.

Given that litigation is so expensive, the minority investor may ultimately agree to accept arbitration to resolve disputes, but still include specific provisions in the BSA that will permit the investor to conduct the discovery necessary to ferret out fraud or other types of misconduct by the majority owner. For example, while it is common for arbitration provisions to limit the total number of depositions to just two or three and to restrict the number of document requests to 10 or 15, the minority investor may insist on obtaining a broader scope of discovery. In this regard, the investor may insist that the arbitration provision permit 30 or more document requests to be served, as well provide for the opportunity for each party to conduct five or six depositions. In this manner, the minority investor preserves the right to conduct enough discovery in the arbitration proceeding to be able to support future claims that are made against the majority owner.

Factor 3: Speed of Resolution and Cost

            These final factors often provide the greatest consensus between the majority owner and the minority investor. Both parties typically want to resolve their disputes promptly and in a cost-effective manner. One variable, however, may be if the majority owner has substantially greater assets and the minority investor has limited resources. In this situation, the majority owner may believe the investor would be hard-pressed to engage in a drawn-out legal dispute, and the owner therefore may decide to select litigation as the dispute resolution mechanism. 

            One important note here is that for the parties to achieve the prompt resolution they both desire, they need to specify in the arbitration provision that the final hearing will take place in a short timeframe, perhaps 90 days after all arbitrators have been selected. The arbitrators who are appointed will enforce this timetable in the contract, and it assures the parties that they will not become involved in a lengthy arbitration proceeding that drags on for months.  

Conclusion

Business partners today can choose non-fatal ways to resolve their disputes. But before they select either litigation or arbitration as the dispute resolution process to include in a BSA or in the company’s governance documents, they need to consider how factors like privacy, the scope of permitted discovery. and the speed and expense of the resolution process may help them achieve their strategic goals. 

Majority owners who want to preserve confidentiality about the business and promptly resolve disputes with a minority investor are likely to conclude that arbitration proceedings meet their objectives. The selection of arbitration will avoid a long and public court battle that could expose the company’s sensitive business information and publicly reveal the investor’s claims. On the other side, minority investors may conclude that resolving disputes in litigation will provide them with broad access to discovery and a public forum for their claims, giving them some advantages and leverage in litigation that they would forego in an arbitration proceeding. 

The bottom line is that majority owners and minority investors need to decide how they want to resolve any potential future disputes between them at the outset — and long before they have conflicts that arise in their business relationship.

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In the final quarter of the year, many private companies will accept new investments that accelerate their growth. But new investments are not guaranteed to create lasting relationships, and that may be the case when new investors join the company. Here, if the majority owner’s relationship with the new investor sours in the future, both parties will want to have an exit plan available. To secure this contractual exit right, the parties will need to negotiate and sign a buy-sell agreement or similar provision, which we refer to as a business prenup. 

For the majority owner, a buy-sell agreement (or BSA) enables the owner to purchase the ownership interest held by a minority investor who becomes disruptive to the business. For the minority investor, the BSA assures the investor of the right to a future buyout if the owner takes the business in a direction opposed by the investor. In light of the importance of the BSA, this post reviews the key terms the owner and the investor need to include in the agreement.

Who Can Trigger the Buy-Sell Agreement and How

Most BSAs include provisions known as the “4 Ds” that permit the majority owner to trigger a buyout of the minority investor, which all come into play when the investor leaves the business. The right to trigger the BSA in these circumstances exists because the majority owner does not want to allow former shareholders to remain owners in the company after they are no longer present and active in the business. The 4 Ds are:

  1. Death – Death of the minority investor
  2. Disability – Permanent incapacity of the minority investor
  3. Departure – Resignation or retirement of the investor from the business
  4. Default – Breach of agreement terms or company policies by the investor

There is also a fifth “D” provision in the BSA — disruption. When the majority owner believes that the minority investor is causing discord in the business, the owner will want to be able to remove the investor from the company who has become a thorn in the owner’s side.

For the majority owner, the right to trigger the BSA to redeem (buy out) the interest held by the minority investor is referred to as a “call right,” and it authorizes the majority owner to call/purchase the investor’s interest. The minority investor wants to be able to demand a buyout of its interest, which is referred to as a “put right,” and it authorizes the investor to exercise the right to require the majority owner to purchase the minority interest.

The timing of the ability to trigger the BSA is a critical part of the agreement. The majority owner may not want to permit the minority investor to cash out of the investment a fairly short time after it was made, because this can create a capital crunch. Similarly, the minority investor may not want to be forced out of the business too quickly — just when things are starting to take off for the company. Given this alignment of interests, the parties can mutually agree to include a “delayed trigger,” which prevents either side from exercising the buyout right for some period of years after the investment (but this provision would not trump the 4 Ds reviewed above). 

The Look Back Provision – A Trap to Be Avoided for Minority Investors

A final important point regarding the BSA concerns the minority investor’s need to secure a look-back provision that will protect the value of its investment. This provision will prevent the majority owner from purchasing the minority investor’s interest in the company for a modest value and then selling the company for a much higher value just a few months later. As a result, this provision kicks in when the majority owner triggers the BSA, purchases the minority investor’s interest and then, during an agreed time period after the purchase, the owner sells the company or brings in a new investor within that specific time period for a higher value than the minority investor received. In these circumstances, the minority investor will receive a true-up payment from the majority owner.

In other words, if the price the majority owner paid to the minority investor for the purchase of its interest is less than the value the company received when it was sold during the look-back period or less than the amount paid by a new investor within the look-back period, the minority investor will receive another payment to true up the payment to the investor to the level of the company sale price or the value paid by the new investor. The look-back period is often one year, but the parties can select a shorter or longer time frame.

Determining the Value: The Make-or-Break Element

Determining the value of the minority investor’s interest in the business is one of the most challenging issues that owners and investors will confront in a business divorce. The BSA tackles this issue head on as it sets forth a defined procedure that the parties have agreed to adopt to determine the value of the investor’s interest in the business. The valuation approach we have found that leads to the least amount of conflict is described below. 

Once the BSA is triggered, the company (at the direction of the majority owner) will retain a business valuation expert at the company’s expense to determine the value of the interest held by the minority investor. The BSA must state clearly whether the valuation expert retained by the company will apply minority discounts to the interest to be valued. The majority owner may want the expert to apply discounts for both lack of marketability and lack of control to the minority interest, because these discounts will dramatically reduce its value. For this reason, the minority investor will be strongly opposed to applying any minority discounts and will insist on the expert presenting an undiscounted value. Therefore, the parties must decide at the outset and specify in the BSA whether or not to apply minority discounts to the valuation, which will avoid major conflicts between the parties once the BSA is triggered.

After the company-retained expert has issued the valuation report, if the minority investor is dissatisfied with the conclusions in the report, the investor will then be permitted to retain his or her own valuation expert to provide a competing valuation at the investor’s expense. Once both valuation reports are issued, if the resulting values are too far apart (the parties will have to decide the specific percentage of difference and state it in the BSA), the BSA will provide that the two different valuation experts themselves (and not the parties) will appoint a third expert to conduct another valuation. At that point, the parties will have three different valuation reports, and they will have the following options to consider to reach a final determination of value:   

  • Average all three reports to achieve one final value
    • Adopting the valuation amount (company or minority investor) closest to the third valuation expert’s reported value will be the value that controls
  • Average the two closest reports to determine the final value
  • Allow the third valuation expert’s report to determine the final value

            The parties will choose this option to include in the BSA, which ensures that they will secure a final value that determines the purchase price for the investor interest. 

            A relatively small number of parties will opt to dispense with using valuation experts at all, and instead, they will select and include a specific formula in the BSA that determines the value of the departing investor’s minority interest. This formula is usually tied to the total revenue of the business as it is harder for the owner to manipulate revenue than earnings.

Payment Structure

Once the value of the minority investor’s interest is determined, the parties will need to specify for the payment structure in the BSA, because the purchase price is almost always paid to the investor over time rather than in a single lump sum. This installment payment plan raises the possibility that the majority owner will need to provide some form of collateral to protect the investor if there is a payment default. The collateral could be the stock in the company, but that will complicate things as it would bring the investor back into the company. Alternatively, the majority owner may be willing to personally guaranty the company’s payment obligation.

Conclusion

The excitement the majority owner and the minority investor share in ending the year with a new investment may tarnish over time, which is why they both need to hammer out and sign off on a BSA that governs this investment. The adoption of a BSA ensures that each of the new business partners has an exit plan available if their new relationship runs into problems. The BSA therefore reflects the type of careful, advance planning that both parties will appreciate if they ever need to seek a business divorce in the future.