Threading the Needle: A Win-Win Buy-Sell Agreement for Private Company Majority Owners and Minority Investors

by Winstead PC
Contact

Winstead PC

Peace is not the absence of conflict, but the ability to cope with conflict by peaceful means.

— President Ronald Reagan, Commencement Address at Eureka College in Illinois, May 9, 1982.

The business relationship between private company majority owners and minority investors does not have to be a zero sum game—there are positives available for both sides in their business dealings.  But, a win-win approach for majority owners and minority investors needs to begin at the outset when they negotiate and adopt a buy-sell agreement at the time the investment is made in the company, which provides terms that will govern the eventual exit of the minority investor from the business.

A buy-sell agreement will not eliminate all conflicts between company owners and investors, but signing off on a “corporate pre-nup,” which carefully balances the rights of both parties should help lessen the potentially contentious nature of the investor’s ultimate departure from the company.  This blog post therefore reviews some of the critical terms that majority owners and minority investors will want to include in their buy-sell agreement to provide for a more peaceful future Business Divorce between them.  Those terms are listed and discussed below:

  • Trigger Rights – Who Can Trigger the Buy-Sell and When
  • Lookback Provision – Payment Applying to Later Sale of Business
  • Structured Buyout – Providing Terms for Repurchase of Minority Interest
  • Minority Discounts – Eliminating or Reducing Minority Discounts

Trigger Rights – Who Can Exercise and When

Majority owners want to secure the right to redeem (repurchase) the ownership interest held by the minority investor, because the investor may become difficult or disruptive to the future growth and/or operations of the business.  By the same token, the minority investor wants to obtain an “exit right” or a “put right,” which provides the investor with the right to demand and secure a buyout of the investor’s interest in the business.  The minority investor does not want to remain stuck in the business holding an illiquid, unmarketable ownership stake with no ability to monetize the interest.

The foregoing rights are known as trigger rights because the majority owner and the investor each want the right to either trigger a repurchase (majority owner) of the minority interest or trigger a sale of the minority interest (investor) in the business.  Even when these rights are included in the buy-sell contract, the parties may also require the exercise of these rights to be delayed for a period of time.  First, the minority owner may want to prevent the majority owner from exercising a right of redemption for 3-5 years until the investor’s ownership interest has appreciated significantly in value.  Second, the majority owner may want to preclude the minority investor from exercising the right to demand a buyout of the minority investor for a period of years so that the majority owner is not required to keep cash on hand to pay for a sudden buyout requested by the minority investor.  Third, both sides may want to require the other party to provide notice of the exercise of the buy/sell far in advance of the actual date—at least six months or a year before the transaction takes place.

Look-Back Provision Applies to Future Sale of the Company

A majority owner who has the right to redeem the minority investor’s interest at any time has the opportunity to exploit this right to an unfair advantage.  Specifically, the majority owner could purchase the minority investor’s interest just before the sale of the entire company for a higher value.  Under these circumstances, the minority investor would be paid a smaller amount than if the investor had been permitted to continue to own his/her ownership stake in the business when the company was sold.  This is the proverbial situation where the minority investor is bought out at one value, and then the company is sold just a week or a month later for a much higher price.

This situation is avoided is by including a “lookback” provision in the buy-sell agreement.  The look-back provision provides for the minority investor to receive an additional payment if the business is sold a short time after the investor’s interest in the business was purchased by the majority owner.  If this term is included in the buy-sell, this additional payment provides the minority investor with the benefit of the increased value of the company the majority owner also received when the business was sold.

The length of time for the lookback provision is negotiable, but it is common for this provision to last for at least a year.  Therefore, if the time period for the lookback provision is one year, the majority owner must pay an additional amount to the minority investor: (i) if the business is sold within a year after the minority owner’s interest was repurchased and (ii) the value paid by a third party for the company is greater than the value the majority owner paid in repurchasing the investor’s ownership interest.

Terms of Structured Buyout Used to Repurchase Minority Interest

The terms under which the majority owner repurchases the minority investor’s interest are subject to negotiation, but virtually all buy-sell agreements permit the majority owner to repurchase the minority interest over a period of years rather than in a lump sum.  The minority investor will often require some form of collateral to ensure repayment, and again, the nature and terms of the collateral will be subject to a negotiation process.  At the end of the day, the majority owner needs some flexibility in purchasing the minority interest in a manner that does not cause financial hardship to the business, but at the same time, the minority investor is entitled to be assured of full payment without a default taking place.

Eliminating or Limiting Minority Discounts

The provision in the buy-sell agreement addressing minority discounts applicable to the value of the minority interest is especially critical for minority investors, because valuation experts typically apply steep discounts to the value of minority interests in private companies, which can reduce the value of the minority interest by 50% or more.  The “bus val” experts apply discounts to the minority interest for lack of marketability (DLOM) and lack of control (DLOC), because minority interests are not viewed as readily marketable and minority investors lack control over the business.   In negotiating the buy-sell terms with the majority owner, the minority investor will want to eliminate these discounts from the valuation of the minority interest, if possible, or at a minimum, limit them, perhaps by removing one of the two discounts from the valuation process.

Conclusion

In most contracts, there are areas of mutual agreement that provide the opportunity for a win-win outcome which is beneficial to both parties.  That is certainly the case in regard to buy-sell agreements in which private company majority owners and minority investors have key points of mutual interest.  While adopting a buy-sell agreement will not guaranty a conflict-free relationship between owners and investors, it is an important first step in the right direction that will benefit both parties when they face the prospect of a future Business Divorce.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Winstead PC | Attorney Advertising

Written by:

Winstead PC
Contact
more
less

Winstead PC on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.