Following a challenging year for business owners, the time to decompress and celebrate with family and friends this holiday season provided a necessary respite. When business resumes, however, there are important action items for majority owners to consider implementing in the new year. This post reviews several steps business owners can take to position the company for future success by streamlining operations and avoiding internal partner conflict.
Resolution No. 1: The Buy-Sell Agreement/Partner Exit Plan
Ideally, majority owners negotiated and adopted the terms of a buy-sell agreement at the time they brought any minority partners into the business. If that did not happen, this discussion reviews the business issues that majority owners need to address in planning for the potential future exit of minority partners. The take-away here is that even when partners did not enter into a buy-sell agreement when the minority investment was made in the company, co-owners in the business continue to share a mutual business interest in putting this type of agreement in place.
For the majority owner, the Buy-sell agreement provides assurance that he/she will have the right to buy the minority partner’s interest in the company if this partner becomes a problem in the future. Specifically, if the minority partner becomes dysfunctional and/or disruptive to the business, the majority owner can exercise a redemption right that requires the minority partner to transfer his/her interest to the company (or to the majority partner). For the minority partner, if the majority owner takes the business in a wayward direction, the minority partner will want to exercise a buyout right to secure repurchase of his/her interest in the company.
Putting in a buy-sell agreement after the investment has been made often works best if the co-owners adopt a delayed trigger for exercising the buy-out right. Under this option, the majority owner has the right to exercise a redemption right to purchase the minority interest, and the minority partner has the right to demand the purchase of his/her interest. Because the parties agree to a delayed trigger, neither partner will be permitted to exercise the option for a specified number of years after the Agreement is signed. Thus, in perhaps 2 or 3 years, and after the party who is exercising the option provides advance notice (usually at least three months), either the majority owner can exercise the option and redeem the minority partner’s interest or the minority partner can exercise the option and demand a buyout of his/her interest. The partners will also need to reach an agreement on how the the minority interest will be valued when the option is exercised, and the purchase terms, i.e., the buyout term, the interest rate and how collateral will be handled.
It is also crucial for the minority partner to require a “look back provision” to be included in the buy-sell agreement, which will apply if the company is sold within a set period (often six months to a year) after the majority owner has exercised the option to buy the minority partner’s interest. Under this scenario, if the majority owner buys the minority partner’s interest and then sells the company for a higher price within the look back period (six months to a year), the look back provision will require the majority owner to issue a “true up” payment to the minority partner. The purpose of the true up payment is to prevent the majority owner from buying the minority partner’s interest for a low amount and then quickly selling the company for a much higher value. Stated another way, the look back provision protects minority partners from a quick, post-transaction sale by the majority owner that saddles them with a low value.
Resolution No. 2: Review/Revise the Company’s Governance Document
As the new year begins, the majority owner may realize that a lot of time has passed since he/she last reviewed the terms of the Company’s governance document or requested outside counsel to do so. The company bylaws (for corporations), the company agreement (for LLCs), or the partnership agreement (for limited partnerships) may need serious updating in a number of important respects. The entire agreement should be subject to review, but some of the key provisions that should be re-examined are highlighted below.
- The size of the company’s board or the number of managers may need to be increased to allow for the inclusion of more expertise and knowledge on the board, the length of the terms for board members may need to be shortened or extended, and the schedule and arrangements for the governance meetings may also need to be revised.
- The company board or managers may need an expanded scope of liability protection. Certain types of fiduciary duties that are imposed on directors, officers or managers can be eliminated or reduced depending on where the company has its principal place of business. For example, governance document can expressly provide governance persons with the right to engage in certain transactions with the company that would otherwise be viewed as subject to a conflict of interest.
- Similarly, the scope of the indemnity provided to directors, officers or managers may need to be expanded to provide more protection. Related to indemnity protection, the majority owner should meet with the company’s insurance broker to discuss the scope and amount of insurance coverage for officers, directors and managers, and confirm who is subject to coverage under the scope of the existing insurance policy.
- The process for amending the company’s governance document is often overlooked, but it may become critical if a dispute arises between the co-owners. Once a conflict exists, amending the agreement will be difficult, if not impossible. The majority owner will want the right to amend at least some terms of the governance document based on the ownership of a majority interest in the company rather requiring all amendments to the controlling document to be subject to a unanimous vote of the company owners.
- The existing governance document is likely to require that disputes between co-owners be subject to litigation. If so, the majority owner may want to transition to a new dispute resolution procedure that requires arbitration of disputes rather than litigation. This is not to suggest that arbitration is always preferable to litigation, but there are attributes of of an arbitration proceeding that may make it more consistent with the majority owner’s business goals. Some of these attributes are noted below:
- The arbitration provision can include a “fast track” requirement that requires the arbitration to be held on an expedited schedule that is much faster than litigation
- Arbitration provisions can also limit depositions and the extent of discovery
- Legal fees incurred in arbitration are usually recoverable by the prevailing party
- Arbitrations are conducted in private – the filings are not publicly available
- Arbitrators are experienced lawyers rather than lay people who serve on juries
- Arbitration results are final – there is no right of appeal
The majority owner will want to discuss the pros and cons of litigation versus arbitration with counsel before making any change to the dispute resolution procedure. The decision will consider a few key factors, including: (i) whether the majority owner expects to be the plaintiff/defendant in litigaiton or claimant/respondent in arbitration. (ii) whether confidentiality is important in resolving the conflict. (iii) whether completing the dispute quickly is important, and (iv) whether the majority owner would prefer the claims/conflict to be decided at trial by a jury rather than by a panel of arbitrators.
Valuation of Company: Start the Process/Set the Standard
The majority owner may want to consider securing an annual company valuation that is provided to all owners of the company. This existence of this annual valuation will be helpful in any future conflict with the minority partner after the buy-sell agreement is triggered. When the company has a track record of issuing annual valuations for years without objection, it will be much harder for minority partners to effectively challenge the amount or the methodology that was used to value the Company. If the partners do agree to rely on on the annual valuation as the benchmark for determining the value of the business once the buy-sell agreement, this should be referenced in the provisions of the Agreement.
Further, if this annual valuation is adopted, it is not necessary for the majority owner (or the company) to incur the expense of retaining an outside business valuation expert to conduct a new valuation each year. Instead, the partners can retain the expert just one time and then have the company’s Board or managers update the various inputs each each year for the next 3 or 4 years. Then, every third or fourth year, they can bring back the valuation expert to conduct a more thorough valuation. Alternatively, the partners can adopt a formula to determine the company’s value each year.
As just one example, they can select a multiple or a percentage of the company’s annual revenues to determine its value. The value could be based on: (A) 1.5 times the revenue of the company or (B) 25% of revenues up to a certain amount and 15% of revenues above that set amount. Thus, this formula could be 25% of revenues up to $50 million and 15% of all revenue above that amount. If the company generated $100 million in revenue, it would have a value of $20 million (25% x $50M = $12.5M + 15% of $50M = $7.5M for a total of $20M). Valuation experts use earnings multiple more often than revenue multiples, but earnings are subject to manipulationand ,therefore, using revenues is a more reliable indicator of value.
Finally, to avoid disputes about valuation, the partners may choose to use three years of data rata rather than a single year when determining the company’s value because a single year could skew the data in one direction or the other. Using three years of financial data should help smooth out the valuation to provide fairness to both sides. This is especially true if the parties are using a December 31 valuation date to determine value and one of the partners triggers the buy-sell agreement in September resulting in a buyout later in the year. The partners can either agree to update the figures when the buyout takes place after June 1 of the calendar year, or they can agree that the December 31 financial figures from the previous year will be used without any updates regardless of when the buyout right is exercised. But the valuation will still encompass data from the previous three years.
When the toasts are completed and 2023 begins, majority owners would be wise to give thought to action items that will help position the business for success for years to come. These include negotiating and implementing the terms of a buy-sell agreement with all co-owners of the business, reviewing and revising the company’s governance document and putting in place a process for issuing annual company valuations. These are all significant steps to pursue and the goals are to avoid or limit future conflicts between business partners, to streamline the business for efficiency and to adopt good governance practices.