When business owners begin to contemplate a sale of their company, they will often only think in terms of selling 100% of their business, and, in fact, a majority of merger and acquisition transactions have been structured in this very manner. However, there are an increasing number of buyers and sellers that are entering into transactions in which the buyer is purchasing a majority (but not 100%) of the ownership interest in a business, resulting in the sellers retaining a significant minority position. This structure can be very attractive, especially for service sector businesses where the owners of a company are often critical to ongoing operations. This article will focus on the structural and corporate aspects of such a decision. There are also numerous tax issues involved in this decision, discussion of which will be left to another day.
Advantages Of A Controlling Interest Transaction
Aligning the interests of a buyer and seller after the closing is probably the single greatest advantage in structuring a transaction in which the sellers retain control over a portion of the equity of the business. If sellers have a continuing ownership interest in the company, they are much more likely to remain fully engaged and be integrally involved in the day-to-day operations. Particularly in businesses where the sellers either have a unique expertise or are essential to maintaining customer and client relationships, a majority control transaction will afford the buyer with a high degree of comfort that the sellers will continue to operate the business with the same degree of care as they used prior to the acquisition.
If structured properly, a controlling interest transaction allows sellers to take an adequate amount of risk capital off the table (based on the percentage of equity being sold at the company's current valuation), while simultaneously presenting the sellers with an opportunity to participate in the company's future growth based on the equity retained. In essence, if the sellers truly believe that aligning with the buyer is going to result in their company becoming more profitable, a controlling interest transaction gives these sellers two bites at the apple: a first bite which locks in the valuation at the time of the initial sale and a second bite which could allow the sellers to hit a homerun on the balance of their equity if the company's alliance with the buyer yields high levels of growth and profitability.
In instances where sellers believe that they have maximized their ability to grow organically, a controlling interest transaction with a well-matched buyer could potentially provide sellers with the ability to access financing for growth, to capitalize on resources that they do not currently have, and to access additional markets or customers and clients and expand its offered services.
A controlling interest transaction also minimizes the disruptions caused by the announcement of an outright sale. Clients and customers often feel more secure about their future relationship with the company when the owners that they are used to dealing with are remaining with the company as equity holders. Likewise, employees who may otherwise feel apprehensive about the intentions of their bosses may feel more secure with the knowledge that the sellers aren't "cashing out" and leaving the company.
In circumstances in which a selling company has multiple owners with differing opinions as to when they may want to sell, a controlling interest transaction provides a unique ability for certain owners to sell their equity outright, while other owners can retain their equity and continue to stay involved with the business. This is particularly of interest when certain owners are approaching retirement but their partners want to remain actively employed.
From a buyer's perspective, a controlling interest transaction provides a high degree of assurance that the sellers will be actively involved after the closing and will remain interested in growing the business. The continuity of management is especially important for businesses whose sellers are critical to the operation of the company. A buyer in a controlling interest transaction will be more comfortable knowing that the company will continue to be operated by the owners of the business, rather than by employees. Simply put, the buyer achieves peace of mind knowing that someone with a stake in the business is there to turn off the lights at the end of the day.
Disadvantages Of A Controlling Interest Transaction
Although there are a number of advantages to structuring acquisitions as a controlling interest transaction, such deals represent only a small number of merger and acquisition transactions. One of the main reasons is that the complexity of the transaction increases greatly when the owners are selling less than 100% of their business. A controlling interest transaction involves the same complexities of an outright sale, but also requires the parties to negotiate an entirely separate set of agreements in the form of either a stockholders' agreement (for corporations) or an operating agreement (for limited liability companies). These agreements require buyers and sellers to confront an entirely new range of issues. The cost of working through some of these complexities can often negate some of the advantages of this structure. Through these negotiations, the relationship between the parties going forward will need to be clearly set forth. We will examine some of the issues each side should consider later in this article.
For a seller, a controlling interest transaction has its own set of difficulties. Due to the fact they are no longer in control of a majority of the voting interests, the sellers will relinquish the right to manage the company other than as set forth in the stockholders' agreement or operating agreement. Sellers who are used to complete control over their company often find it difficult to comprehend that, after the transaction, the buyer statutorily controls the company. Any protections the sellers want to retain must be fully negotiated beforehand and set forth in the governing agreement.
The exit strategy of the sellers concerning the remaining portion of their equity in the company is also severely curtailed. Transaction documents often limit the sellers' ability to sell their remaining equity to a third party, meaning that in order to complete their exit strategy, the sellers are often forced to sell their remaining shares without the benefit of soliciting third party offers. In many instances sellers may be required to maintain their ownership interest for a certain period of time, which delays their ultimate exit from ownership.
Sellers involved in a controlling interest transaction must also perform much more extensive due diligence on the buyer than they would in a 100% control transaction. Often, when the sellers are selling 100% of a company and the buyers are paying for the company at the closing, little due diligence is necessary (other than making sure the check clears). When a controlling interest transaction is being contemplated, the sellers must recognize that they are now business partners with the buyer. Does the buyer have the financial wherewithal to grow the company in the appropriate manner? How difficult will it be to make decisions in the new structure? How has the buyer treated other companies in similar circumstances? These questions need to be fully investigated by the sellers prior to contemplating a controlling interest transaction.
For the buyer, a controlling interest transaction raises some difficulties as well, such as the buyer's inability to act unilaterally in matters affecting the company. In virtually all controlling interest transactions, the sellers are likely to negotiate various levels of control and/or approval rights for certain decisions. The buyer will also want to negotiate a mechanism to acquire the balance of the equity. This final purchase price is often formulaic, and can be quite complicated. The buyer and the sellers will need to determine whether the purchase price for the balance of the equity should be fixed or vary, depending on a number of factors, such as the overall profitability of the company after the initial closing, as well as the continued employment of the sellers.
Complexities Of A Controlling Interest Transaction
As indicated above, there are many additional complications involved in negotiating a successful controlling interest transaction. One of the more significant and potentially contentious issues is that of "control." When a buyer acquires a controlling interest, absent any specific language in the shareholders agreement or operating agreement, the buyer controls the company. Accordingly, sellers who retain a significant minority position in the company will want to insure that the buyer cannot act unilaterally on a host of decisions. In general, the sellers will want to make sure that they will have the authority to run the day-to-day operations of the company on a going-forward basis, and that the buyer will not force the company to undergo certain fundamental changes without the seller's consent. The amount of control each side cedes to the other is often a potential source of difficult negotiations.
Another item that is typically negotiated and specifically set forth in the shareholders agreement or operating agreement is the amount and frequency of profit distributions. Should the buyer be able to make decisions on distributions in its sole discretion or with the approval of the sellers? How should the company make decisions if the sellers and the buyer disagree on the proper use of funds? Should there be a preset formula for distributions? At a minimum, sellers will want to make sure that distributions will be made to cover taxes.
There is often a significant amount of attention and detail paid to the issues surrounding restrictions on transfer of the seller's remaining equity in the company. Buyers in controlling interest transactions will want a contractual right to acquire such remaining equity from the seller, and, by the same token, sellers will want a contractual right to force the buyer to acquire its remaining equity. When should this buy/sell right occur? Should it be triggered on the occurrence of an event (such as termination of employment) or upon the passage of time? Should the price for the remaining equity be based on a formula ( i.e. , a multiple of EBIT or fair market value), or should it be fixed at the initial closing? All of these questions will need to be addressed and specifically set forth in the operative agreement. The documents need to ensure that no gaming of time periods or measurement periods would give the other side an unfair advantage on pricing of this purchase event.
Although not addressed in this article, there are a number of other issues that should be agreed upon in connection with controlling interest transactions. What is the impact of this structure on the tax and estate planning of the sellers? What if the buyer is unable to fund the company appropriately or live up to its commitments? Can the structure be unwound? Will all the sellers have the same objectives going forward?
In the end, the decision on whether to engage in a controlling interest transaction must be factually driven by the circumstances of the buyer, the sellers and the company. There are definitely times when such a structure may make sense for all parties involved. When used, however, such a structure is sure to add a certain level of complexity to both the negotiation of the transaction and the management of the company after the closing.
Brad J. Schwartzberg is a Partner in and Co-Chair of the Corporate Department of the New York-based firm of Davis & Gilbert LLP. He may be reached at (212) 468-4966. Alexander Barry , an Associate in the Corporate Deparment. may be reached at (212) 468-4978.