Listen to this post

One of the thorniest issues private company owners and minority investors may be required to confront in going through a business divorce is determining the value of the minority interest being purchased. It is not unusual for experts to disagree over the value of the minority interest, and this conflict can delay or even derail the business divorce from being completed. Going through endless rounds of negotiation over value may have both of the partners singing the blues. This post therefore focuses on practical solutions for business owners and investors to consider when they need to value a minority ownership interest in the process of a business divorce.

Reasons for Disagreement Among Experts

Business valuation experts generally follow a similar methodology, and as a result it may seem surprising that they can reach results that vary so dramatically. There are a number of factors, however, that help explain these conflicts. First, business valuation experts make assumptions that impact value, and these different assumptions can lead to substantially different results. As a key example, valuation experts will project the future growth rate of the business based on past trends and anticipated future events, and as a result, when the experts use markedly different projected growth rates for the business, they will reach results that have major differences.

Second, the valuation experts also typically apply substantial discounts to minority held interests, which are based on the lack of control and the lack of marketability of the interest held by the minority investor. These discounts are determined, in part, by reviewing previous transactions of similar companies, but selecting different discount rates will have a large impact on the valuation of the minority interest.

Finally, the valuation experts may rely on different data that also leads to wide variances in their opinions. In this regard, the experts will compare and apply the sales of other businesses, but they may include or reject certain sales as applicable, and using different transaction data impacts their results. Similarly, based on their own analysis, the valuation experts may use different industry multiples to apply to the company’s earnings, which is a key driver of total value of the business. If one expert concludes that the proper multiple is 5 and the other says it is 7, that difference may sound small but it will actually be quite large when the multiple is applied to the company’s earnings.

Practical Solutions to Apply to the Valuation Dispute

Given the potential, if not the likelihood, that valuation experts will reach different opinions regarding the value of a minority holding in a private company, majority owners and investors are well-advised to consider options that may allow them to avoid or at least limit these conflicts. These pragmatic approaches are discussed below.

Expert Report Averaging

If the parties anticipate that a large variance will result between the reports of the valuation experts, they can agree to a process in which three different experts are retained, and they can then average the results of all three valuation reports. Typically, this means that the company/majority owner will retain a valuation expert, the minority investor will retain a second expert, and the parties will direct those two experts to select a third, independent expert. 

Once all three valuation reports are issued, the partners can agree to one of the following options: (1) they can average all three of the reports, (2) they can decide that the valuation report of the party (either majority owner or investor) that is closest in amount to the third valuation expert’s report will be controlling, or (3) they can average the amount of the two reports that are closest in value to determine the final valuation number. Selecting any of these options in regards to valuation will avoid a legal battle.

Adopt Base Value Plus Earn Out

A second option to avoid valuation conflicts is for the parties to agree on a base price for the purchase of the minority investor’s interest that references the valuation, but that also provides for an additional payment to the minority investor. In this scenario, the minority investor receives a fixed price at closing, along with a carried (non-equity) interest based on the company’s future financial performance. This structure thus provides for the investor to receive somewhat less than the full amount of the valuation price at closing, but with the potential to receive an additional amount greater than the valuation price based on the company’s future performance.

As an example, the valuation report values the minority investor’s interest at $3 million, which the majority owner considers excessive. The parties therefore agree that the investor will be paid $2.25 million at closing (25% less than the valuation report) for its interest, but the minority investor also receives a contractual right to be paid 3% of the total revenues that are generated by the company over the next three years. If the company has generated at least $10 million in revenue during each of the past three years, this might be a win-win scenario, as applying to this formula would generate at least $900,000 in a further payment for the investor if the company continued to generate annual revenues of at least that amount over the next three years. 

Obviously, the potential variety of formulas that might work is infinite, but this type of win-win negotiating allows for the majority owner to push back on the total amount paid at closing to the investor while also providing the minority investor with further upside. To make this proposal work, the majority owner may need to establish a floor for the future payment, i.e., provide the investor with a guaranteed payment of at least a certain amount in the future so that the investor is not taking on a totally unprotected gamble. 

Arbitration Limited to Resolution of Valuation Dispute

The third practical option to consider involves a targeted resolution process. The manner in which an arbitration is conducted is subject to contract, so rather than engaging in protracted negotiations over a lengthy period, the parties could agree to submit their valuation dispute to a prompt one-day arbitration. This is simple and straightforward as the parties should not need to obtain any discovery if they have all of the financial information necessary for the valuation. The scope of the arbitration can be limited solely to resolving the amount to be paid for the purchase of the minority owner’s interest in the company. In short, the parties submit their valuation reports and testimony from the valuation experts to explain their opinions, and the arbitrator (or panel) issues a final, binding opinion.

Considerations That Apply to Valuation Conflicts

Whatever path the parties decide to go down, they need to set guidelines that will help limit the disputes between them regarding the valuation and the ultimate cost of achieving their business divorce.  The procedure for dealing with valuation is generally set forth in some form of a buy-sell agreement. 

First, the parties need to set firm deadlines for issuing all of the required valuation reports. Second, they need to provide a mechanism and timetable for the minority investor to obtain access to the financial information that is necessary to determine the value of the investor’s interest, which the investor will likely provide to its own independent valuation expert. Third, they need to decide who pays the costs for the experts. Often, the company will prepare the first valuation at its sole cost, but if the minority investor then wants to secure a separate valuation, that comes at the expense of the investor. If there is a third valuation, the cost of the third valuation expert is shared equally by the parties. Finally, if there are disputes over the valuation, this is where the arbitration provision will specify how any/all disputes will be resolved promptly and efficiently.

Conclusion

The business divorce process can be frustrating, particularly when valuation disputes arise, but these conflicts can be anticipated, and they should not derail the parties’ efforts to achieve their desired business separation. The key is to be proactive.  Business partners need to agree in advance on an approach to valuation before disputes take hold, because once they are in conflict, it will be extremely difficult for them to reach consensus on any form of resolution. If the partners plan ahead and implement one of the practical paths to resolution reviewed above — averaging expert reports, adopting a base value/earn out structure, or implementing a targeted arbitration — they will have a much better chance to avoid singing the valuation blues. 

Listen to this post

Business divorces often involve turbulence as business partners go through this process. But partners who plan ahead can navigate through their business divorce to avoid capsizing the company or frustrating their personal business objectives. This type of planning requires each of the partners to (1) review and understand the terms of the agreements in place that govern their separation, (2) develop a real world, objective appraisal of the value of the interest that is being transferred, and (3) consider the business issues that may arise for both sides after the divorce, e.g., future competition by the departing minority partner. 

The change and separation involved in a business divorce can be hard for all parties, but anticipating the issues that are likely to arise provides a compass for partners that will help them chart a predictable course to smooth sailing on the other side of the transaction. In the following post, we will consider the goal of becoming prepared for a business divorce from the perspective of both the majority owner purchasing the interest of the departing partner and the minority investor whose ownership interest is being purchased.

Step 1: Closely Review the Written Agreements That Apply to the Business Divorce

The first step in approaching any business divorce is to know the rules of the game.

The Majority Owner

The majority owner needs to understand whether a buy-sell agreement exists that allows the owner to redeem the interest held by the minority investor or that will permit the investor to demand a buyout. If this type of agreement is in place, it governs the manner in which either party can exercise a call or put option that will result in a redemption of the minority interest. In either case, the agreement will address how the value of the minority interest is determined, and it will also set forth the payment terms after the value of the interest is determined.

In the absence of a buy-sell agreement, the majority owner does not have the right to trigger a repurchase of the minority interest and therefore has to negotiate with the investor to find terms that are acceptable. If the investor demands payment of an excessive amount or insists on including unreasonable terms, it is likely that a buyout will not take place in the near term. In this scenario, the majority owner will have to consider taking actions that cut off all further economic benefits to the investor before a liquidity event takes place that cashes out the investor’s interest in the business. This is known as a freeze out or squeeze out situation.

Minority Investor

The minority investor also needs to determine whether a buy-sell agreement exists that permits the majority owner to exercise a call right to redeem the minority interest or that authorizes the investor to exercise a put right, which requires the majority owner to purchase the investor’s interest. The terms of the buy-sell agreement are therefore critical to fully appreciate before a business divorce is considered.

If no buy-sell agreement is in place, the good news is that the minority investor cannot be forced out of the business by the majority owner on terms the investor considers unfavorable.  The bad news, however, is that the investor cannot require the majority owner to purchase the investor’s interest for the price desired by the investor if the investor wants to exit the business for any reasons. Without a buy-sell agreement, the minority investor must assess whether leverage can be obtained that will bring the majority owner to the table to discuss a buyout. This leverage may be available if the majority owner has engaged in self-dealing in managing the business. The bottom line is that the minority investor needs to evaluate the majority owner’s conduct to determine whether any misconduct by the owner will provide some leverage that the investor can apply to facilitate a buyout discussion with the owner.

Step 2: Develop a Real World (Objective) Assessment of Value

The next critical step for the partners to prepare for a business divorce is to understand the actual fair market value of the minority interest that will be changing hands.

The Majority Owner

If a buy-sell agreement exists, it will specify the method the parties must use to determine the value of the minority investor’s interest that is being purchased in the business divorce. If no buy-sell agreement exists, the majority owner will need to negotiate the purchase price directly with the minority investor. At the outset, the majority owner typically directs the company to retain an independent valuation expert to determine an objective value of the minority interest that the parties can use as the basis for their negotiation of the purchase price.

Under these circumstances, however, the majority owner should expect the minority investor to demand payment of a premium for the minority interest, because the investor has no contractual duty to sell. As long as the minority investor’s proposed purchase price is within the realm of reason, the majority owner who wants to purchase the interest should seriously consider paying a premium of some amount, because (1) the owner will secure the return of the investor’s equity in a manner that avoids a prolonged exit, (2) the purchase of the investor’s interest will avoid incurring any legal fees dealing with claims or litigation by the investor, and (3) the owner will capture all future appreciation in the value of the business.  

Minority Investor

As noted above, the minority investor cannot renegotiate the purchase price for his or her interest in the company if a buy-sell agreement exists that dictates the process for determining the value of the investor’s interest. When there is no buy-sell agreement, the minority investor can choose to hold out to secure a purchase price that reflects full market value of the investor’s interest. As a cautionary note, however, the majority owner has no contractual obligation to purchase the investor’s interest in the absence of a buy-sell agreement. Therefore, if the investor drives too hard a bargain in the negotiations, the owner may simply walk away from buyout discussions and also terminate all distributions or dividends to the investor. As a result, the investor who insists on receiving top dollar for his or her minority share of the business, must be prepared to wait a very long time to be in a position to monetize his or her interest if the majority owner is not prepared to pay what the investor perceives as full value for the minority interest.   

Step 3: Consider Post-Separation Business Issues

The final step in preparing for a business divorce concerns the need to consider what will take place after the business divorce has been completed.

The Majority Owner

For the majority owner, the planning process needs to address how the company will operate after the minority investor departs, which is more of a significant issue if the investor had an active role in the business. If so, the majority owner will need to take steps to arrange for a smooth transition of all duties previously handled by the investor relating to customers, vendors and the supervision of other company employees.

The majority owner will also want to ensure that the departing minority investor does not create problems for the company after leaving. First, the majority owner will want to retrieve all confidential information that is held by the investor as part of the business divorce. Second, the majority owner needs to consider whether to request the minority investor accept restrictive covenants that prevent the investor from competing with the company and from soliciting its employees for some period of time.

If the majority owner believes these restrictions on the investor are necessary, the owner will likely have to pay additional consideration to obtain them in addition to the purchase price that is paid to the investor for his interest in the business. The majority owner should require that this additional amount be paid to the minority investor over time so that the unpaid amounts can be withheld if the investor fails to comply with the restrictive covenants during the period that they remain in force.

Minority Investor

The minority investor does not need to retain confidential information that belongs to the company, but the investor does need to decide to what extent she has any interest in remaining active in the same industry as the company. If the investor wants to remain active in the industry in some capacity, the investor needs to make sure that complete clarity is reached regarding the exact scope of any restrictive covenants that the owner seeks to impose on the investor’s future conduct. The extent of the restrictive covenants will also impact the amount that the minority investor seeks as additional compensation for accepting these new restrictions. 

But, if the minority investor is receiving a fair price from the majority owner for the purchase of the investor’s minority ownership interest in the business, the investor should be wary of overplaying his or her hand. If the minority investor seeks too much compensation from the majority owner in payment for the restrictive covenants that are requested by the owner, the investor may cause the entire deal to fall through and lose the opportunity to monetize the minority  interest in the business for a reasonable price.

Conclusion

Most business divorces include some rough waters to cross for the partners, but if they plan ahead, they can successfully weather the storm. This advance planning requires the partners to (1) develop a keen understanding of their contract rights based on the terms of the agreements in place, (2) determine the objective, fair market value of the minority interest that is being sold in the business divorce, and (3) consider the business goals of the other partner after the business divorce has been completed.

This careful planning by business partners will enable them to navigate their way through a business divorce in a manner that saves them time and expense, preserves their relationship, and also avoids running the business into rocky shoals.

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.