Despite Dante’s Warning (Abandon Hope), There is Hope for Minority Investors Who Failed to Obtain a Buy-Sell Agreement Before Acquiring Their Interest

Life is all a about second chances.   In the business world, minority investors may feel that they are trapped if they failed to obtain a buy-sell agreement before investing and have no contractual right to exit the company.  This situation is common in family businesses when the minority owners did not request their grandparents, parents or other family members to provide a buy-out right at the time the company was formed.  Fortunately, all hope is not lost for minority investors who did not obtain a buy-sell agreement before they obtained their stake in the company.  This post explores ways minority investors may secure a buy-sell agreement with majority owners even after the investors acquired their minority ownership interest in the business.

Most Things are Negotiable – Especially in Private Companies.

Minority investors who do not have a contractual right to exit the business, must understand their bargaining position – and the potential stalemate that exists with the majority owner.  When no buy-sell agreement is in place, the minority investor cannot contractually require the majority owner to purchase the investor’s interest in the business. Similarly, the majority owner cannot require the investor to sell his or her minority stake.  This is the stalemate, because the lack of a contract precludes the minority investor from compelling a purchase and, by the same token, the majority owner cannot require a sale.  Thus, in the absence of a buy-sell agreement, the majority owner and minority investor will remain co-owners of the company unless they can work out the terms of a mutually acceptable buyout.

It is this impasse when both sides are blocked from obtaining their goal, which opens the door to a potential renegotiation of the parties’ business arrangements.

Potential to Secure a Post-Ownership, Buy-Sell Agreement

The situation described above presents the minority investor with a potential opportunity to secure a buy-sell agreement from the majority owner after-the-fact.  This opportunity may arise when the majority owner wants to remove the minority investor from the business, but there is no contractual means to do so.  In that scenario, the minority investor can start to negotiate with the majority owner in an effort to enable both of them to reach their business goals – to achieve a true win-win scenario. 

The negotiation typically starts with an offer by the minority investor to give the majority owner what he/she wants.  Specifically, the minority investor will agree to provide the majority owner with a “redemption right” – the contractual right to redeem (purchase) the minority investor’s ownership interest, effectively, requiring a forced sale of the minority interest.    In exchange for the minority investor’s grant of this redemption right to the majority owner, the investor will want to secure some important rights of his/her own in the resulting agreement.

Key Terms for Minority Investor to Include in Buy-Sell Agreement

The minority investor’s grant of a redemption right permits the majority owner to remove the investor as an owner in the company through a mandatory sale.  By providing that redemption right, the minority investor should be in a position to negotiate for inclusion of the following terms in the new buy-sell agreement.

  • The Right to Trigger a Buyout – After a Waiting Period
  • A Favorable Valuation Formula – No Minority Discounts
  • Tag-Along Rights – In Event of Sale by Majority Owner
  • A Look-Back Right Regarding Sale Price

The Triggering of a Buy-Out Right

The minority investor’s chief goal under a buy-sell agreement is to secure the ability to exit the business — to monetize his/her stake in the company.  The first step in this process is to determine when, or under what circumstances, the investor can exercise the right to a buy-out.

 The majority owner may be willing to grant this buyout right to the minority investor, provided that the investor cannot immediately exercise that right.  Specifically, the majority owner may require that the buy-sell agreement include a holding period, which does not permit the buyout to be triggered for some period of years. Further, the majority owner will also likely require that when the buyout is triggered, it will apply to the full interest held by the minority investor and preclude a piecemeal exit from the business.  The minority investor may agree that the benefit of securing the buyout right is worth the trade-off of accepting a waiting period and being required to sell his/her full ownership interest.

A Favorable Valuation Formula that Excludes Minority Discounts

When valuing a minority-held interest in a private company, valuation experts will often apply substantial discounts, because third-party buyers typically will not agree to pay full value for a minority-held interest.  This is due to the fact that a minority interest in a private company is not readily marketable and minority investors lack control over the business.  As a result, the minority investor should insist that the valuation formula that is used in the buy-sell agreement exclude all minority discounts, or at least negotiate the amount of the discount. This is a critical point, because a minority investor who secures a buyout right from the majority owner only to find that the buyout price is subject to steep discounts has won a pyrrhic victory.

Tag-Along Rights to Protect Minority In Event of Sale

The majority owner always has the right to sell out to a third party and leave the minority owner behind unless there are restrictions in the governing documents that prevent him/her from doing so. The majority owner can therefore choose to cash out, and leave the minority owner on the sideline receiving no benefit from the appreciated value of the business. The way to prevent this is to require the majority owner to include a “tag along” right in the buy-sell agreement. This gives the minority investor the option to “tag along” when any transfer of the majority owner’s interest takes place, and grants the minority investor the right to be included in the transaction for the same price/value that is received by the majority owner.

Look Back Rights – To Protect Investor in Event of Quick Sale

If there are no restrictions on the majority owner’s right of redemption, the majority owner could buy out the minority owner for a low valuation and sell the business to a third party one month later to a third party for a much higher valuation. This situation can be prevented by including a “look back” provision in the buy-sell agreement, which requires the majority owner to commit to pay additional amounts to the minority investor depending upon the results of a later transaction by the company following the purchase of the minority investor’s interest in the business.

Under a look back provision, if the company engages in a transaction within a specified period after the minority investor’s interest was purchased and which would have provided a higher sale price to the investor, the majority owner will be required to pay the increased amount to the investor. The length of time that this type of look back provision will remain in place to protect the minority investor is negotiable, but it is typically in force for at least one full year.

Don’t Wait to Start the Negotiation Process.

Despite Dante’s warning, minority investors have reasonable cause for hope when starting the negotiation of a buy-sell agreement with the majority owner even after acquiring an ownership interest in the business.  Minority investors should start this negotiation process without delay, however, and before tensions arise. Once the investor begins having conflicts with the majority owner, there is little chance that the owner will be open to negotiating and adopting a balanced form of a buy-sell agreement.