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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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In a real-life case of adding insult to financial injury, companies harmed by the disloyal actions of their former partners, officers, managers or employees (the “former insiders”) may also have to pay their legal fees when the company sues them to recover for their misconduct. In this situation, if the company’s governance documents (and specific indemnity provisions) have not been carefully drafted, the company may have to pay the legal fees the insiders incur when they defend claims filed against them by the company. 

This situation arises because almost all corporate bylaws, company agreements for LLCs, and partnership agreements for limited partnerships contain indemnity provisions protecting current or former insiders if they are named in a lawsuit because of their position with the company. Frequently, the governing documents will provide these insiders with the right to receive current payment of their legal fees during the litigation and before the lawsuit is ever resolved. And in some instances, the governing documents grant these rights to every company employee rather than to just partners, officers, directors and managers of the company.

Companies include these indemnity provisions in their governance documents because they encourage business leaders to serve in management roles without fear of sustaining personal loss from lawsuits, regulatory actions, or other legal proceedings related to their services for the company. These assurances also support sound decision-making and responsible risk taking by managing leaders that benefit the company. But, as noted, if the indemnity provisions in the company’s governing documents are not carefully drafted, these often-overlooked terms can result in some costly unintended consequences for the company. More specifically, the company could be forced to fund the legal fees incurred by both sides of the company’s lawsuit against a disloyal former insider. This post provides an overview of well-drafted indemnification and advancement rights and how they should be used by companies to achieve their best effect.

Indemnification and Advancement Defined

Typically, a company’s obligation to indemnify will arise from a contract (i.e., a company agreement), a statute, or a combination of the two. When a company provides indemnity, it usually covers legal fees, settlements, and judgments that are incurred or entered against an individual who was sued because of his or her services for the company. Generally, a company’s indemnity obligation will either indemnify insiders against liabilities or damages, or indemnify them against both liabilities and damages. When a company indemnifies against liabilities, the indemnification is owed when the liabilities become “fixed and certain,” such as when a judgment becomes final. But when a company indemnifies against damages, the indemnity becomes due when the indemnitee is compelled to pay the judgment or debt.

Although the right to indemnification and advancement are related, they are separate and distinct rights with notable differences. When a company provides the right of advancement, this enables the insider to receive advance payment of the legal expenses the insider incurs in defending against any claims that relate to that person’s services for the company. In other words, the advancement provision provides insiders with immediate interim relief from the burden of paying for the defense of a claim rather than waiting until the point at which the litigation concludes. Further, because the right to receive advanced payment of legal fees is not dependent on the right to receive indemnification, whether the company insider actually engaged in the misconduct alleged in the lawsuit is irrelevant to the insider’s right to receive advancement of legal fees.

The Scope of the Indemnity Provision Is Critical to Understand

Majority business owners who direct their companies to file suit against disloyal former insiders often assume that their company won’t be required to indemnify or advance legal expenses for the insider’s egregious or even blatant misconduct — regardless of what the company’s governing documents may say. But if the company is an LLC or GP, that assumption can be both incorrect and very costly.

This common misunderstanding may stem from the statutory scheme for indemnification and advancement for corporations. Specifically, the Texas Business Organizations Code (TBOC) codifies certain “default” rules applicable to corporations (and other Texas entities other than LLCs and GPs). For example, the TBOC specifies the circumstances under which a Texas corporation is required to indemnify a governing person, permitted to indemnify a governing person, and prohibited from indemnifying a governing person:

  • Mandatory Indemnification – First, Texas corporations are required to indemnify their current or former governing persons if they are wholly successful in defending a lawsuit to which they were a defendant because of their position in the company.
  • Permissive Indemnification – Second, a corporation is permitted, without the necessity of any enabling provision in its governing documents, to indemnify a governing person who meets certain standards. In civil proceedings, this standard requires that the governing person (1) acted in good faith and (2) reasonably believed the conduct was in the best interest of the corporation (or was not opposed to the corporation’s best interest if the conduct was outside the person’s official capacity).
  • Prohibited Indemnification – And third, corporations are statutorily prohibited from providing indemnification to a person “in relation to a proceeding in which the person has been liable for (A) [willful] or intentional misconduct in the performance of the person’s duty to the enterprise; (B) breach of the person’s duty of loyalty owed to the enterprise; or (C) an act or omission not committed in good faith that constitutes a breach of a duty owed by the person to the enterprise.”

TBOC also permits corporations to advance legal fees and other litigation-related expenses to individuals, either through their governing documents or on a case-by-case basis, as long as the individual provides the company with (1) a written affirmation that they believe they have met the standard of conduct necessary for indemnification, and (2) an undertaking, which is a promise to repay the amount advanced if there is a final determination that the person has not met the standard for indemnification.

But LLCs and GPs enjoy significantly more leeway than corporations in permitting the owners to grant or completely omit indemnification and advancement rights for managers and others. That is because, in contrast to corporations, TBOC’s indemnification and advancement provisions are not applicable to LLCs and general partnerships by default. Instead, as it relates to indemnification and advancement, the owners of LLCs and GPs may either expressly adopt the Texas statute applicable to corporations or “may contain other provisions, which will be enforceable.” In most cases, LLCs and general partnerships will choose the second option, which restricts the company’s advancement and indemnification obligations solely to those that are listed in the governing documents. If these standards and restrictions are broad (e.g., any proceeding that the individual is made a party to because of his or her employment), then the company will likely be required to indemnify and advance expenses to a former employee, regardless of how wrongful the former insider’s conduct may have been. 

In sum, owners of LLCs and general partnerships need to decide whether the indemnity provisions that protect insiders in their governance documents will protect them solely from third-party claims brought by third parties or whether they will also apply to first-party claims that are brought against them by the company. In almost all cases, the owner will want to limit the scope and protection of indemnity provisions solely to third-party claims that are filed against former insiders. 

Conclusion

Companies need to provide indemnification and advancement rights to attract and retain talented managers and employees, but the company’s governance documents need to set forth these rights in a manner that is no more expansive than the company intended. In almost all cases, the scope of the indemnity protection should be limited solely to claims made by third parties; these are claims filed against company insiders by third parties based solely on the fact that the insiders are affiliated with the company. If the company’s governance documents properly limit the scope of the indemnity provision, then, in any future suit by the company against disloyal former insiders, they will not be able to obtain any indemnity protection or advancement of their legal fees from the company. This careful drafting of indemnity provisions avoids a situation where the company is required to foot the fees for legal counsel on both sides of the lawsuit. 

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As private companies grow, they need to secure capital to support their efforts to provide more (and/or better) products and services to their clients. The need for emerging companies to obtain growth capital often leads the majority owner to consider accepting an investment in the business by a private equity (PE) firm. In this post, we share a cautionary note: Business owners need to be wary in their dealings with PE firms. If the majority owner does not thoroughly vet the PE firm, the owner may soon discover after the investment that the PE firm is imposing and carrying out a new set of business objectives, which may conflict with the majority owner’s vision for the business.

Determining Whether Business Goals Align

A potential tension exists between company owners and PE firms because their goals may diverge. While the majority owner/operator is typically focused on growing the company to achieve significant appreciation in value over a lengthy timeline of 10 years or longer, PE firms more often focus on achieving a tighter window for return on investment (ROI) to provide robust returns to their investors, usually within five to seven years. The key takeaway here is that the majority owner should determine at the outset whether common ground can be reached with the PE firm on both the goals of the investment and the firm’s stated timetable for achieving those goals.

If the majority owner and the PE firm are not aligned, the PE firm may require the business to adopt timelines that accelerate the ROI, but that fundamentally alter the culture and character of the business. As just a few examples, PE firms may require the company to adopt aggressive cost-cutting measures, to expand rapidly into new markets, and to implement other operational changes with the goal of achieving short-term profitability rather than the long-term growth model the majority owner was building. The owner may value investments in the company’s culture, employee development, or in setting the stage for customer relationships, but the PE firm may view these items as inefficiencies that must be jettisoned to meet the PE firm’s financial performance targets.

For a majority owner to avoid a situation where the PE firm takes the company in an unexpected and undesired direction after investing, the owner needs to investigate the track record and method of operation of the PE firm. Specifically, the owner needs to dig in to find out how the PE firm managed previous investments in other portfolio companies to determine whether the PE firm’s approach aligns with the owner’s vision. The majority owner should be asking these questions: (i) Did the PE firm work in concert with the company’s existing management; (ii) did the PE firm exert its power to redirect the company’s operations in unexpected ways; and (iii) did the PE firm essentially treat the company as a turnaround situation to rebrand and remodel its approach or did the PE firm enhance the company’s performance without rewriting the entire script? 

Getting answers to these questions will require the majority owner to obtain specific references from the PE firm to current and former clients and the right to speak freely with them about their experiences with the PE firm. In addition, the owner should ask whether the PE firm has been involved in litigation with any former clients, and if so, it is advisable to understand what transpired regarding that dispute, i.e., what claims were made by the former client against the PE firm. Finally, the owner should ask detailed questions about what the former clients experienced in their business dealings with the PE firm, as noted above, in regard to operational changes, new timetables, and exercise of control. This type of due diligence will yield key insights about what the majority owner can expect if the courtship turns into an actual investment in the company by the PE firm.

Majority Owner Contract Protections – Preserving Control and Exit Rights

Many PE firms will not agree to make a non-controlling investment in a private company and will require the majority owner to accept being diluted to a position of holding less than a 50% ownership stake in the company.  The PE firm will insist on becoming the company’s majority owner, thereby securing the right to direct and control the business. But even if the majority owner accepts the required dilution and becomes a minority partner in the business, the owner should still insist on preserving some important rights in the investment agreement discussed below.

First, the majority owner should attempt to retain veto power over fundamental decisions that would dramatically alter the nature of the business. These are “protected decisions” that would require the PE firm to obtain the majority owner’s consent and may include the following: the sale of the company or key assets; large increases in the amount of the debt carried by the company; the addition of new investors in the business that dilute the ownership percentages of existing owners; expansion of the board/managers; large changes to executive compensation; or major operational changes such as opening an office in another state, shutting down an office or territory, or adding a stock option plan for executives. Unless the majority owner retains these veto rights, the PE firm can make whatever changes it may desire to the company without any constraints or restrictions.

Second, if the PE firm drives a hard bargain, the majority owner may permit the PE firm to override the owner’s veto and/or remove the owner from management. But if the PE firm elects to exercise these rights, the majority owner needs to secure a “put right” that the owner can trigger to demand that the PE firm purchase some or all of the majority owner’s interest in the company at that time based on a pre-determined valuation process or valuation formula. Thus, the PE firm will have the right to overrule the majority owner or even oust the owner from the company, but not without giving the owner the right to obtain a buyout at the time of exit. In short, this “put right” ensures that if the PE firm engages in actions that conflict with the majority owner’s voting rights or ownership in the company, the owner can monetize the value of its interest in the business at that point.

When to Walk Away – Red Flags Showing That Love Is Not in Bloom

The majority owner needs to approach a potential PE investment with the mindset of being willing to walk away if the PE firm’s financial goals for the investment are unrealistic, if the firm is rigid in its approach to the business, or if there are red flags that crop up during the due diligence process. Not every PE firm will be a good, collaborative partner, and for the majority owner, waiting to grow the business until the right partner comes along is a far better alternative than bringing into the fold an unyielding partner that exercises complete control over the company in a manner that defeats the majority owner’s own vision. 

Some red flags may include PE firms (i) that insist the company can meet aggressive growth and revenue projections well above industry norms; (ii) that demand the company meet unrealistic timelines; or (iii) that reduce capital expenditures and insist on making sharp spending cuts and requiring immediate and substantial employee layoffs, which are not tailored to minimize the impact on the company’s culture. A final red flag is a PE firm that declines to explain how setbacks will be handled if the company misses a deadline, fails to meet a revenue projection, or has other problems. If the PE firm cannot engage in a problem-solving exercise before issues arise that is a major concern, because challenges are inevitable and business partners need to be able to work together in an effective manner to meet and overcome them.

Conclusion

Successful private companies need capital as fuel to power their growth. But majority owners need to engage in the process of securing capital from PE firms with care if they want to avoid becoming roadkill the PE firm churns through without slowing down. This requires a majority owner to assess whether the PE firm’s goals, approach to the business, and timetable closely align with the owner’s long-term vision.

At the outset, the majority owner needs to develop a clear, specific statement of the owner’s own goals, to conduct detailed due diligence on the PE firm’s track record, and to adopt contract terms that protect the owner’s ongoing rights to ensure that the company will continue to operate in a manner that aligns with the owner’s vision. The majority owner must also maintain discipline, if necessary, to end discussions with PE firms when that alignment does not exist or when the PE firm insists on contract terms that give the firm the right to kick the owner to the curb with no recourse after investing. Sometimes the right response for the majority owner to the PE firm is to “Just Say No.”