The season finale of the hit reality TV show The Bachelor attracted more than 8 million viewers. My wife and teenage daughters help make up this devoted fan base, and watch every episode. Yet, when I question them about whether the subject of a pre-nup agreement has ever come up on the show, I get eye rolls, and comments like, “Dad, don’t be such a downer.” Assuming that the Bachelor and his new fiancé do make it to the altar, however, the show also does not mention that marriages in the US still have just a 50% chance of lasting despite the continuing decline in the national divorce rate.
Why bring up The Bachelor, marriage and divorce in this Business Divorce Blog? Because, like the enthralled contestants on The Bachelor, private company investors are often too eager to make it to the proverbial altar of a new investment in a private company even when millions of dollars are at stake. As a result, they fail to put a “corporate pre-nup” in place before making their private company investment, and lose the right to ensure that they have the ability to monetize their investment in the future.
Declining to secure a contractual exit strategy before making a large investment is a risky business move. A minority investor who fails to secure a buyout right will often be stuck in the company when he or she desires to cash out of the investment. The only buyer for the minority-held interest is the majority owner, and in the absence of an agreement, the majority owner has no duty to purchase the minority investor’s stake in the company. To make matters worse for minority investors, under current Texas case law, minority owners have no clear legal remedy authorizing a court-ordered buyout of their interest.
Given the importance of a corporate pre-nup to private company investors, this blog post reviews the key elements of a corporate pre-nup, the buy-sell agreement (BSA). This term, BSA, is used to cover the many different types of redemption agreements that can be negotiated and implemented to provide private company investors with a contractual exit strategy.
Why is it critical for business owners to have a buy-sell agreement in place?
At the beginning of a business relationship, business partners may believe that no disagreement between them could become so severe that it would result in a lawsuit. They may therefore decline to spend time and money on attorneys to prepare a BSA, because they do not view it as necessary. But this optimistic view ignores the reality that most business partners do not remain together for their entire career, and one or more of them will exit the business at some point in the future. The BSA is the documented plan that business partners negotiate and adopt to govern the process for their future exit from the company.
What are the key elements of a buy-sell agreement?
There are four elements that all BSA’s agreements should cover: (1) under what circumstances will the BSA apply, (2) who has the right to trigger the BSA, (3) how the business should be valued during a buyout, and (4) the terms under which the purchase price is paid if a buyout takes place.
When does a BSA apply?
It is common for private companies to insist that their minority investors agree to sell their ownership stake in the business back to the company if the investor leaves the business, files for bankruptcy, dies, or gets divorced.
But, on the other side of the table, the minority investor will want the right to require that the company and/or the majority owner purchase the minority owner’s interest in the company upon certain events, such as a specified number of years of ownership, a change in management control, the termination of the investor’s employment, or a potential dilution of the minority owner’s interest in the company.
The BSA must therefore specify the circumstances under which each party can exercise its rights to secure a redemption or buyout of the minority-held interest in the company.
Who can trigger the BSA?
The BSA must specify who can trigger the agreement. A one-sided BSA that only permits the company to trigger a redemption of the minority owner’s interest in the business provides the minority owner with no rights and no protection. The minority investor will therefore want to ensure that the BSA authorizes the investor to trigger the BSA and secure a buyout of his or her interest in the business at the time that he or she is ready to depart from the company.
The minority investor may also want to secure the right to sell some, but not all, of his or her interest in the business. That partial buyout scenario may not be acceptable to the majority owner, who may refuse to permit the minority investor to exit from the company, but retain a continuing ownership interest in the business. Most BSA’s do call for all or nothing sales of the minority investor’s ownership interest, but that does not mean the minority owner should not request the right to make a partial sale.
How will the business be valued if the BSA is triggered?
The manner in which value is determined is just as important to investors as the right to obtain a buyout, and the calculation of value is often the most contentious part of Business Divorces when the minority ownership interest in the company is worth millions of dollars. If the parties decide on the valuation formula that they will use at the time the investment is made, however, this should avoid or limit the scope of the valuation dispute when the BSA is exercised. Including a valuation formula in the BSA may save the investor hundreds of thousands of dollars in legal fees, and also expedite the time frame in which the buyout can be completed.
Many BSA’s specify that the value of the minority ownership interest will be discounted because they interest is not marketable and the minority investor lacks control over the business. For example, if a business is valued at $100 million as a going concern, the majority owner may not be willing to pay the minority investor holding a 25% interest a total of $25 million, because a third-party buyer would not pay full value for this minority interest. By the same token, however, a minority investor may decline to make an investment in the company if his or her interest will be subject to a discount upon exiting the business.
Negotiating the extent to which a minority discount applies will remove all emotion when the BSA is exercised, and permit a calculation of value based strictly on the company’s financial performance.
How will the majority owner’s buyout of the minority interest be structured?
Determining value is a critical part of the BSA, but the agreement must also specify the manner in which the amount will be paid to the investor for purchase of the minority interest, and whether any collateral will be provided to the investor if the purchase involves payment over an extended buyout. Most often, the buyout will be structured to take place over a number of years, but the investor’s ownership in the company will transfer at the time of closing, and the equity interest will serve as collateral for the purchase until the full amount has been paid to the investor.
‘Till Death, Or Disagreement Do Us Part
Negotiating a pre-nup requires couples to make a sober assessment of financial issues before they make a lifelong commitment to each other, which can help them create a foundation upon which to build a strong relationship. BSA’s do the same thing for potential business partners.
Sponsors and viewers of The Bachelor may consider the discussion of a potential pre-nup as both boring and bad for the couple (and the show’s ratings), but a business investment is different. An investor who purchases a multi-million dollar minority stake in a private company and fails to secure a BSA at the time of the investment is asking for serious financial and legal troubles down the road.