Considerations for Minority Equity Interest Owners

CON SIDERATIO NS For Minor ity

Equity InterByes t Evan D. Weiner and Owners Randall H. Lee

Investors with a minority equity dard protections, often called interest in closely held companies “minority protections,“ as well as require a variety of legal protections several methods of equity redemp - relating to the general operations of tion, these investors should consider the business. These owners typically as potential exit strategies. have limited control over the man - Minority Protections agement of the company, as they often do not have enough voting There are several ways minority in - power to influence actions the com - vestors in closely held companies can pany may take. ensure that they are able to participate In addition, these investors most in overseeing the material operations likely will not have a real market in of the business and have a voice in which to sell their equity, and accord - making other significant business de -

here are mIany ways minority investors in closely held firms can ensure that they can participate in overseeing material operations of the business and have a voice in making other significant decisions.

ingly, should provide themselves cisions. Typically, a minority owner with an adequate exit strategy upon may ask for a board seat or board ob -

the occurrence of certain events or server rights, which would give the S after a certain amount of time has investor significant participation in the E U

passed to ensure some return on operations of the business. S S

their investment. However, simply having a seat on I

While there are many areas of the board usually will not allow a L protection that minority interest minority investor to obtain sufficient A G

investors should consider, the fol - control to influence the decision- E lowing will focus on several stan - making process. As a result, these L www.financialexecutives.org july/august 2009 | financial executive 1 major acquisition or disposition by vestors should demand certain in- the company or any other transaction formation rights, such as the right to relating to corporate structure if the review the company’s books and If they want additional minority investor believes that such a records and to receive financial state - protections, minority transaction would not be in the best ments and the operating budget on a interest of the company. periodic basis. Miscellaneous Protections. investors should insist that In addition, consent of minority in - Final - certain actions require their vestors can be required in connection ly, there are various other actions for with the issuance or sale of any senior which minority investors may also pari passu consent. or class of equity, the reclas - want consent rights. sification or change in the rights of any These include: amending or modi - For example, they such class of equity or the issuance or fying the company’s organizational sale of options or other convertible se - documents; changing the company’s Pari may want consent rights curities for such class of equity. ( name; entering into modifying, termi - passu when the company refers to a series of equity that nating or renewing any real property will have the same rights and privi - lease or any other material agree - decides to borrow money leges as another series of equity.) ment; and entering into any affiliated or relocate the firm’s Minority investors should request transactions including making loans this approval right to maintain an to employees or amending or modi - primary offices. ownership position without fear of di - fying the company’s employee bene - lution and to prevent the creation of fits and compensation arrangements. pari passu more senior or equity. Significant Management Protec - Exit Strategies tions. In most cases, minority Investments made in securities of a investors do not have the ability to private company may have a very make general management decisions, limited market through which a investors will often demand language including decisions relating to per - minority investor can sell its equity. in the company’s operating agree - sonnel and business strategy. Absent Despite limited channels to sell such ment or shareholders agreement that a board seat or certain pre-negotiated equity, investors in private compa - requires approval by the minority contractual protections, a minority nies often desire to further restrict investor before the majority owner or owner essentially has very limited any sale or transfer through contrac - the company can take certain materi - control over the material operations tual obligations. al actions. of the business. Transfer restrictions help maintain These protections are generally Though minority investors may the same group of investors and pre - designed to protect against the com - have certain statutory protections serve any existing goodwill or inter- pany incurring significant liabilities that protect stockholders generally, relationships among them, which may or other major transactions without a most significant actions of the compa - have a meaningful impact on the com - minority investor’s consent. These ny require only board approval or — pany’s ultimate success and the mi - provisions can also help protect at most — approval by a majority of nority owner’s continued investment. against poor business management the equityholders. For example, in a strategic invest - decisions, and may result in preserv - Therefore, if they desire addition - ment, a minority investor may want ing the value of the minority owner’s al protections, minority investors to prohibit transfers to a competitor investment. must insist that certain actions of the company. Thus, in light of Transaction Protections. Minority require their consent. They may want these contractual transfer restrictions investors may want approval rights consent rights regarding the incur - and lack of a public market for sale, relating to material transactions of rence of debt for borrowed money, it’s important to negotiate an exit the company. These transactions deviation from the approved annual strategy before acquiring a minority could include: a sale of the company operating budget or capital expendi - interest in a private company. Right of First Offer. (by asset sale, stock sale, merger, liq - ture budget or relocation of the com - Owners of uidation or other corporate transac - pany’s primary offices. minority equity interests in a closely tion); any acquisition by the company In addition, minority investors held company often negotiate trans - of the stock, assets or business of may want consent rights for the hir - fer restrictions subject to a right of another entity; any investment by the ing or firing of any key employee or first offer. Right of first offers can be company in another entity; or the for - the change in salary or bonus com - structured to require the majority mation of any subsidiaries. pensation of any key employee. owner — in the event it desires to sell Such protective provisions allow Also, to maintain their ability to its equity — to first offer the equity to the minority investor to prevent any oversee its investment, minority in- the minority investor on certain

2 financial executive | july/august 2009 www.financialexecutives.org terms and conditions. able exit strategy for minority The investor may elect to pur - investors in closely held companies. chase the offered equity and, in Such an option allows the minority effect, has the ability to prevent the investor to require the company or Minority investors may majority owner from selling its equi - the majority owner to purchase its want a prearranged exit ty to a third-party. If the minority equity upon certain terms and condi - investor does not elect to purchase tions. A typical put option is general - if the company fails to the equity offered for sale, the majori - ly not exercisable until a period of reach certain financial ty investor would be allowed to sell time has lapsed or until certain mile - to the third-party, subject to certain stones are achieved to give the com - thresholds or in the event terms and conditions. pany an opportunity to grow and Tag-Along Rights/Drag-Along a founder or other key mature its business before a mean - Rights. executive leaves the firm. Minority investors should ingful value can be attributed to it. strongly consider requiring the oper - This factor would ultimately affect ating agreement or shareholders’ the put option purchase price, The investors also may agreement to include a “tag-along” because typically the purchase price provision. Such a provision can be is calculated based on a formula that want the ability to sell structured to afford minority takes into account a designated equity back to the majority investors the right to participate in a financial measure such as net income, sale of equity by the majority investor revenue, EBITDA [earnings before owner if the company’s on the same terms and conditions. interest, tax, depreciation and amorti - performance falls below This allows minority investors to zation] or revenue growth rate, or a certain level. decide whether they want to remain other operational metrics (such as the an owner of the company in the number and strength of the clients, event a majority of the equity build-out phases or Web analytics). changes hands. If the investor is not In addition, a multiple (a variable willing to remain a co-owner with number depending on the growth rate the company, the same trigger events the proposed third-party purchaser, of the business) may be applied to could be structured to give rise to the the minority investor can elect to such financial measures. Alternatively, investor’s right to buy out the majori - exercise its tag-along right and par - if the minority investor has a strategic ty investor at a discounted price. ticipate in the sale to the third-party. interest to fully own the company, a It is important for investors own - Often a majority investor requires a call option can be structured whereby ing a minority interest in a closely “drag-along” provision, which would the minority investor would have the held company to obtain contractual require the minority investor to par - right to purchase the equity owned by protective rights to maintain a certain ticipate in a sale of the company. A the majority investor. level of control over the operations of Other Trigger Events. majority investor will desire to secure Minority the business. In many instances, these this right, because it does not want a investors may desire a prearranged protections afford minority investors minority investor to be able to pre - exit if the company fails to achieve their only ability to influence man - vent a sale . certain financial thresholds or in agement and prevent the company To protect itself from being the event a founder or key execu - from incurring significant liabilities “dragged” into a less-than-ideal sale tive of the company were to leave or entering into major transactions. transaction, the minority investor the business. In addition, these investors must should make the “drag-along” provi - The minority investor may want be aware of certain methods to pro - sion effective only upon approval by a the ability to sell back its equity to vide beneficial exit strategies. Minori - supermajority of stockholders or, per - the majority owner if the business’ ty investors should consider various haps, only if the net proceeds of such performance falls below a certain lev - exit strategies and transfer restrictions sale will exceed a predetermined el or its success is impaired because that will allow them to be adequately threshold amount. certain critical personnel are no protected while preserving the right In addition, the minority investor longer involved in the day-to-day to divest the investment under favor - could ask for a “right to first negoti - affairs. This right may not be appro - able terms and conditions. ate,“ pursuant to which the company priate for a passive investor, because ([email protected]) is a would be required to exclusively a passive investor is likely to be EVAN D. W EINER partner and (rlee@dglaw negotiate a sale of the company with required to bear some risk of failure. RANDALL H. L EE .com) is an associate in the Corporate De - the minority investor prior to any But in a strategic alliance or joint partment of New York-based law firm Davis negotiations with third parties. venture, this right may be warranted. Put Option. & Gilbert LLP. In certain circum - Alternatively, if the minority investor stances, a put option may be a suit - has a strategic interest to fully own

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