/>iIn 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:
- Death – Death of the minority investor
- Disability – Permanent incapacity of the minority investor
- Departure – Resignation or retirement of the investor from the business
- 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.
