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Minority investors often purchase interests in private companies without securing a buy-sell agreement (BSA) at the time of their investment. After a few years pass, however, the minority investor and the majority owner may both want one, but for different reasons. The majority owner may desire to redeem minority interests in the company held by smaller investors, which will then enable the owner to offer a larger stake in the business to just one, well-funded investor.  The investor may want to secure an off ramp to be able to monetize the investor’s minority interest in the company at some point in the future.

When the business goals of majority owners and minority investors align, these partners can create a BSA in the nature of a post-nuptial agreement, which they enter into long after the purchase of the minority interest. This post reviews how to structure these after-the-fact BSAs between existing business partners.

Why Partners Consider a BSA Long After the Investment

When majority owners and minority investors first begin to see the need for a BSA years down the road, it is because they did not consider their long-term business goals at the time of the initial investment. The majority owner may have focused on the company’s immediate capital needs while the minority investor’s primary focus was on evaluating the quality of the business and whether to go forward with the investment. 

With the passage of time, however, the majority owner may conclude there are too many small investors in the company and the owner may therefore want to secure the right to redeem some of them to regain control over the company cap table. At the same time, the minority investor may realize that without a BSA in place, the investor will have to wait for some type of liquidity event to take place to be able to monetize the interest held in the company.  In short, the minority investor may want to secure a contract right to demand a repurchase of the investor’s interest in the business.

Under these circumstances, the parties’ separate but aligned interests may open the door for them to discuss negotiating and adopting a BSA. This post-nup BSA will allow each of them to achieve their business goals well after the investment was made. Reaching this type of agreement will be possible, however, only when the relationship between the partners is not already in crisis.

Key Features of the After-the-Fact BSA

There are four key components of the type of BSA that business partners enter into after-the-fact. These are (1) the timing, i.e., when either party is permitted to trigger the buyout right provided by the BSA, (2) the method for valuing the minority interest, (3) a look- back provision that protects the minority investor whose interest is being redeemed, and (4) the structure of the payment to be made for the purchase of the minority interest. 

The last two of these provisions are common in all BSAs, and we have covered them in a previous post that can be accessed here. We will therefore address just the first two, the timing of the parties’ right to trigger the BSA and the importance of the look-back provision. The partners who enter into the BSA after the initial investment will not want to permit the BSA to be triggered right away. If an immediate buyout was desired, the partners would simply negotiate the purchase of the minority interest, and they would have no need to create a BSA to be triggered in the future.

Thus, this type of BSA will include a delayed trigger, which means that neither of the partners will be permitted to trigger the BSA for a period of years, and the specific length before the trigger is permitted is subject to negotiation. It generally falls in the range of two to four years, and after this time period passes, each partner will have the option to trigger the BSA and require a redemption or buyout of the minority interest.    

The look-back provision specifies that if the majority owner triggers the BSA and then redeems the interest held by the minority investor, the investor will have a protected period of time (often for at least one year) after the redemption. During the protected period, if any transaction takes place at a higher share value than the minority investor received, e.g., if there is a sale of the company or a new investment in the business, the investor will receive an equalizing payment based on the value of the transaction during the protected period. In short, the investor does not have to worry that shortly after its interest was redeemed, the majority owner sold the business for a much higher value. 

Conclusion

The failure to obtain a BSA when an investment is made does not foreclose either the company’s majority owner or the minority investor from raising this new agreement as a possibility years later. But if the relations between the partners have deteriorated over time, the prospect of securing a post-nup BSA becomes remote at best. Therefore, business partners who are interested in potentially entering into an after-the-fact BSA need to act before the window closes as it likely will not stay open forever.

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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.

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Family members who enter into a private business together are taking on double risk. They face the same types of challenges that all owners and investors face in operating/investing in a business, but they are also exposed to the risk their personal relationships may suffer if the company does not fare well. For this reason, the decision to adopt a buy-sell agreement (BSA) – a type of corporate prenup – may be even more important for owners of family businesses. The BSA provides a clearly defined path governing how a partner exit will take place when the co-owners are in conflict about their roles in the business or the direction of the company. Family business owners are hardly immune to disagreements that can arise among business partners, and this post discusses some of the significant benefits that owners/investors in family businesses can secure by entering into a carefully drafted BSA. 

What Are the Advantages of a Buy-Sell Agreement?

According to Forbes, as of in 2021 there are nearly 32 million small businesses in the United States. Yet, the Small Business Association estimates that only a fraction of these closely held companies have a BSA entered into by the owners. These sobering statistics may be even more applicable to family businesses, because in our experience, most family business owners do not take the steps required to evaluate and adopt a BSA before forming their companies or taking in family members as investors in the business. 

We view the BSA as a critical step in careful business planning. Family members, like other business partners, may enter into a business venture together with the best of intentions, but people and their financial needs can change over time. We are all subject to the four Big Ds: divorce, disability, dysfunction and death. And any of these may lead to a fifth D – departure from the business. A business divorce between partners may become a necessity if any one of these four Big Ds takes place, which can impact family members just as they do other partners. When a separation becomes necessary, having a defined partner exit plan in place – a form of BSA – will limit the conflicts that arise as the partners go through the business divorce process.  

For majority owners, the BSA provides owners with a contract right and mechanism to remove minority investors from the business who have become too difficult or demanding. For minority investors, the BSA provides them with the right to secure a buyout that enables them to monetize their ownership interest in the business if they become dissatisfied with the actions of the majority owner or of the management team. Thus, the BSA limits conflicts when a business divorce becomes necessary, because it provides for the orderly removal of partners and governs the specific terms on which the exit of a business partner takes place.

When business partners have not adopted a BSA, the likelihood of conflicts between them leading to litigation increases dramatically. And litigation among business partners is often bitter and prolonged, which may severely damage, if not end, close relationships among family members. Internal disputes and litigation between business partners will also likely cause major disruption to the company. Thus, having a well-drafted BSA in place almost always outweighs any possible disadvantages that may result. The following discussion reviews some of the most important benefits that can be achieved when partners make the decision to enter into a BSA:

  • BSA provides a clear path forward – The BSA provides for the departure of partners in a manner that limits conflicts between them. When no BSA exists, minority investors may become disgruntled because they have no path to an exit, and they may engage in disruptive actions that create problems for the business in efforts to force a buyout of their interest. Similarly, the majority partner may become frustrated no means exists to secure the removal of a minority partner, who is causing problems for the business and the other partners.
  • BSA sets forth a transition plan – In addition to providing co-owners with a clear exit path, the BSA also assures continuity of the business for its customers, creditors, and employees. A BSA defines the manner, method and timing of partner exits, including how the partner’s interest in the business will be valued at the time of exit. Thus, a BSA provides a clear set of rules that govern when a partner retires, dies, becomes disabled, is subject to a divorce, or is terminated. The BSA also applies when a voluntary sale of the business takes place, and in all of these instances, the BSA limits disagreements between the partners.
  • BSA establishes price point and exit process – A well drafted BSA sets forth the payment terms for the minority interest after the value is determined, along with the method for funding the payment. Valuation is often a hotly contested issue, but the BSA will specify in detail how the interest of the departing partner will be valued to avoid these conflicts as much as possible.
  • BSA creates an effective dispute resolution mechanism – To the extent that disputes arise between co-owners, the BSA sets forth a clear method for resolution, which is generally through a fast-track arbitration process. Thus, a comprehensive BSA helps partners to address disputes in a way that either avoids or reduces the time, stress and substantial cost that would otherwise result from becoming involved in litigation.   

Key Elements of a Buy/Sell Agreement

There are four chief elements of a BSA, which are discussed below. These are not cookie-cutter documents. Terms need to be considered by the co-owners with input provided by counsel who are experienced with these agreements, so they are able to reach an agreement that meets their specific needs. Each of the parties is advised to have separate counsel to provide them with guidance that helps meet their business objectives.

Determine how the BSA may be triggered

The first key provision of a BSA is the trigger point, i.e., the point at which the BSA can be exercised by either party to the agreement. Generally, majority owners will have the right to buy the minority owner’s interest when he or she (i) files bankruptcy, (ii) gets divorced, (iii) dies or (iv) leaves the company. These are private companies, and the majority owner does not want to be forced to accept strangers injected into the business, as these situations could lead to that possibility. But majority owners also want to have the right to pull the trigger and buy out the minority investor at their option so they can remove any disgruntled/difficult minority partner.

On the other side of the coin, the minority investor does not want to be required to exit the business before the company appreciates in value. The investor may therefore insist that the BSA prevents the majority owner from triggering a buyout of the minority interest less than three to five years after the investment is made. In addition, and importantly, the minority investor will also want to insist that a look-back provision be part of the BSA, which ensures that the minority investor will not receive a below market value if the majority owner buys the investor’s interest and then promptly sells the company (or a share of the company) for a higher value than used to pay the investor for its interest. If the majority owner redeems/purchases the investor’s interest and then sells the business (or a substantial stake in it) in a fairly short period of time for a higher value, the look-back provision will require the majority owner to make a “true up” payment to the investor based on the increase in value. The length of the look-back provision is negotiable, but it is often in place for a full year after the majority owner buys the investor’s interest.

Finally, while the minority investor may want to be able to demand a buyout whenever the investor desires to exit the business, the majority owner is unlikely to agree to permit the investor to pull the plug shortly after investing in the company. The majority owner may therefore insist that the minority investor cannot exercise a redemption right for at least three to four years (or longer) after the investment is made. This gives the majority owner a set period of time before the investor can withdraw its investment. The majority owner may also require that all of the investor’s stake in the company be redeemed at one time to preclude multiple exercises of buyout rights. 

Determine How to Value the Redeemed Interest

There are guidelines for valuing a private company, yet highly regarded valuation experts frequently reach different opinions about the value of the business and the value of the investor’s interest in the company. Given the importance of the purchase price to be paid to the departing partner, the co-owners should focus on how they want to determine the value of the company and purchase price when a business divorce takes place. It is often helpful to retain a business valuation expert to help draft the valuation provision and how the process will take place.

The major elements that the parties will need to consider in determining the value of the redeemed interest include:

  • What is the valuation date (should it be the date the buyout is triggered, or a specific day of the year, e.g., December 31, regardless of the trigger date)?
  • Should the value be based on a single date/point in time, or should it reflect a composite/average of the company’s value over the past two to three years?
  • After the value of the business has been determined, should minority discounts be applied in calculating the value of the interest held by the minority investor, which are discounts based on the lack of marketability and the lack of control that are often applied when valuing minority held interests in a private company?
  • Should the value of the company be based on a specific formula applied to the company’s financial performance (e.g., a multiple of the company’s revenues or earnings), or should the value be determined by business valuation experts who will rely on several different valuation methods? If so, how is the expert selected, and how are disagreements with the expert’s opinion resolved?

Further, agreeing to retain a business valuation expert to determine the value of the redeemed interest will not suffice to address all questions about the valuation process. The expert needs to be instructed by the parties whether or not to apply minority discounts to the company’s value, what the date of valuation is, whether a single valuation date is being used or whether the value determination should be based on an average of the company’s performance over a set period of years, and finally, whether the company’s value should include or omit retained earnings and/or working capital. All these issues need to be spelled out in the BSA.

The BSA will also provide the payment terms after the value of the redeemed interest has been determined. In most cases, the purchase price will be paid over a period of years after an initial payment is made. Therefore, the partners will need to document in the BSA (1) the rate of interest to be paid on the balance of the purchase price; (2) whether the majority owner will provide any collateral in the event of a default in payment; and (3) what rights/remedies the minority investor will have in the event of a default in payment by the majority owner.

Select a Prompt, Efficient Conflict Resolution Process

The final element of the BSA is the dispute resolution mechanism. It is not uncommon for partners to have conflicts over the value of the redemption price even when the BSA details how the value will be determined. Rather than allowing these conflicts to become the subject of protracted, expensive litigation that is carried out publicly in the courts, the parties can agree to make their disputes subject to a mandatory arbitration provision.

Arbitration is a matter of contract, and the parties can structure the arbitration to meet their needs by limiting scope, duration and timing of the arbitration proceeding. For example, in the BSA’s arbitration provision the parties can choose just one arbitrator or a panel of three; they can limit the scope of discovery permitted before the final hearing; they can require the final hearing to take place in just 60-90 days after the arbitrator (or panel) is appointed; and they can eliminate any potential award for lost profits or punitive damages by the arbitrator(s). This type of a fast-track arbitration allows the parties to agree to conduct a prompt, cost-effective and private resolution of their disputes without a public airing of grievances, which may hold significant appeal to family members who are in business together. 

Conclusion

Family dysfunction is the subject of countless books and movies, and those conflicts exist in family businesses, as well. One way to avoid or at least narrow the scope of the conflicts when family members enter into business together, however, is for them to adopt a BSA at the outset.  The BSA provides for a defined partner exit, which the parties can carefully negotiate to protect their interests as majority owners or minority investors if a business divorce becomes necessary. While no agreement can eliminate all conflicts, spending time on the BSA to pre-plan how a future business divorce will take place will help limit the issues that may be disputed in the future. Further, including a fast-track arbitration provision in the BSA will enable the parties to reach a prompt and cost-effective resolution of any future conflicts that do arise.