Think Carefully Before Giving PE a Majority Shareholding

This is an extract from an email I sent a client who was considering selling 51% of his firm to PE:

"....In a private equity (PE) deal where the PE firm holds 51% of your company, they can force you to sell more of your shares. Drag-along rights?allow a majority shareholder, like the PE firm, to force minority shareholders to sell their shares if the majority decides to sell its stake to a third party. To protect yourself, negotiate conditions under which drag-along rights can be exercised, such as a minimum sale price or a fair market valuation.

Another method is through a?call option on minority shares. This gives PE the right (but not the obligation) to purchase additional shares from you at a predetermined price or valuation formula. This option may be triggered by specific conditions, such as the company not meeting performance targets, a change in control, or after a defined period. This could require you to sell your remaining shares to them at a previously agreed-upon price. To safeguard your interests, you should negotiate the terms that would trigger the call option and aim for a fair market value or premium price for your shares.

Another mechanism is a?put and call option agreement. This type of agreement can give either the PE firm or you the right to compel you to sell or buy shares at a predetermined price following a specific event or date. For example, the PE firm might have a call option to buy more shares after a certain period or under certain conditions, while you might have a put option allowing you to sell your shares to the PE firm under agreed terms. It's essential to clearly define the conditions under which these options can be exercised and to ensure fair valuation mechanisms are included.

A more indirect method is through?dilution via additional capital raises. The PE firm could force a capital raise or issue new shares, requiring you to contribute additional capital to maintain your ownership percentage. If you don't have the capital or choose not to invest more, your ownership percentage will be diluted, effectively reducing your stake. Since the PE firm controls the majority, they can approve these capital raises and potentially increase their ownership. To protect against this, you can negotiate pre-emptive rights that allow you the first right to buy new shares issued, helping you maintain your ownership percentage.

Triggering default provisions?is another way the PE firm could force a sale of your shares. Shareholder agreements often include default provisions that require a forced sale of shares if certain conditions are met, such as breaches of contract, insolvency, or failure to meet performance targets. If these provisions are triggered, the PE firm could have the right to buy your shares at a discounted price or under terms less favorable to you. It's important to carefully review any default provisions and negotiate terms that are fair, reasonable, and specific, ensuring that any performance targets or conditions are achievable and that remedies for defaults are clearly defined.

Lastly, the PE firm could?leverage their control over the board of directors. As the majority owner, the PE firm might use their influence to make strategic decisions that put pressure on you to sell more shares. For example, the board might decide to take actions that reduce the value of your stake or make it less attractive to remain a minority shareholder, such as restructuring the company, changing dividend policies, or pursuing specific financial strategies. To protect yourself, you could negotiate for a seat on the board, veto rights over key decisions, or other governance rights that provide some protection against being pressured into selling.

To safeguard your interests, it's crucial to?negotiate clear terms?in the shareholder agreement that define the circumstances under which any forced sale of shares could occur and at what valuation. Obtaining?minority protection rights, such as veto rights on significant transactions, anti-dilution provisions, and fair treatment clauses, can also help protect your position. Additionally, ensuring that any exit provisions, such as drag-along rights or call options, are?clearly defined with fair terms and conditions,?including pricing mechanisms that reflect market value, will help ensure a more balanced and fair partnership with the PE firm....".