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in the spotlight Proactive Structuring of Investment Agreements By John M. Toth Mikael Damkier/iStockphoto Whether private equity and venture capital funds invest in smaller-sized growth companies, or multinational corporations are joint venture co-investors, the structure of the parties’ investment agreement determines the success of the transaction. Terms of management control, methods of dispute resolution, strategies for growth and standards for valuation should all be settled and documented upfront in the shareholders’ agreement. Charles F. Hertlein Jr. and James A. Marx, partners in corporate practice at Dinsmore & Shohl LLP, believe that these issues involve many of the same considerations regardless of the size of the transaction or the partners involved. “Any of these concerns are fertile ground for controversy in an investment transaction,” Marx asserts, “unless the parties clearly define and agree upon eventualities at the start.” Where to Begin A smaller company seeking growth through private equity or venture capital investment should begin a successful transaction by clearly defining the organizational and management structure. Most such businesses choose the limited liability company form because of its tax advantages, but in any entity structure, the most important consideration is determining which management members have active responsibility for control. “The analogy is to a football coach who is most effective when he has responsibility for both developing strategy and securing players,” Marx says. “Even if the control is equally divided among venture partners, there needs to be a clear voice on valuation and buy/sell rights.” “Even if the control is equally divided among venture partners, there needs to be a clear voice on valuation and buy/sell rights.” This is particularly important in private equity and venture deals, where investors generally have a five-year time frame. Deciding the investors’ exit vehicle is essential and Hertlein notes that, in today’s securities regulation climate, put rights to buy out an investment partner are becoming more attractive than registration rights to force a public equity offering. “This also raises business planning issues for company management,” he adds, “because they must secure capital to replace the original investors once they cash out.” The Nuclear Option Control ultimately manifests itself in the board of directors structure. Majority owners will have a majority of the board; equal partners with equal board representation should add a neutral third-party member whose vote can break deadlocks. Either way, avoid requiring unanimous consent to approve the sale of the company. What Hertlein calls a “nuclear option” could be a provision to force one party to buy out the other if they cannot agree on sale terms. Another option, which Marx identifies as 26 www.martindale.com
“Russian roulette,” allows each side to define in the investment agreement those preconditions of price and valuation under which it would be a buyer or seller. Provisions for binding mediation or arbitration would be a third possibility. The last resort for either side is a courtmandated dissolution of the venture. Most private equity and venture investment models currently use either “drag-along” or “tag-along” rights. In the former, the investors can require company management to participate when they find a buyer for their stake; in the latter, if a buyer is found for a certain percentage of the investment, both sides can sell that percentage of their ownership stakes. Because such opportunities can arise suddenly, Marx urges boards to commission an annual company valuation by an outside accounting firm. “Most A Meeting of Equals When large corporate equals create a joint venture investment, many of these same control and valuation issues should be addressed initially. “Both parties contribute something to such a venture,” Hertlein observes, “and establishing issues of fair value and depreciation upfront is essential to a successful transaction, particularly if the contribution of assets is not equal.” If the venture is not administratively selfsufficient, one or both sides must provide management services and value them appropriately. Intellectual property rights are frequently central to large company ventures. The parties must decide from the start whether technology is given or licensed to the venture, and either option has significant implications for IP ownership. To address the issue of who Technology Ventures: The Need for Flexibility As lead counsel in many software manufacturing business combinations, Charles F. Hertlein Jr. urges clients to build maximum flexibility into transaction documentation because the industry changes so rapidly. “Technology ventures often evolve in unexpected directions, and either partner may find that the fully developed venture is significantly different than they anticipated,” he explains. “Once that happens, it is extremely difficult to renegotiate venture terms.” In one example, an engineering design company had created a new category of workflow management software. Because software was not its core business, the company entered a joint venture with another industry participant to develop the product. Five years later, the software had become a significant growth business, and the company could only bring it back in-house by engaging Hertlein to negotiate a new agreement with significantly higher valuation—which could have been avoided by clear growth and control definitions in the original agreement. companies do a single valuation at the start of a venture and never update it, which often creates valuation disputes later,” he says. “An annual valuation brings issues such as underfunded pension plans to the surface, so they can be resolved before they become due diligence problems when selling an investment stake.” gets control of intellectual property developed by the venture itself, Hertlein and Marx suggest that the parties agree to license technology from the venture, with clear definition of ownership expiration rights. Particularly if the joint venture owners are public companies, there should be clear agreement on what and how much each party can consolidate from the venture into its own financial results. That includes the extent to which either side can derive tax benefit from losses and depreciation. Financial agreement should also include agreement on the extent to which either side may buy back its own or the other side’s investment stake. “In all these considerations, it is essential that the parties anticipate and resolve negative eventualities beforehand,” Hertlein warns. “If a dispute arises, it is harder to force an exact division of asset ownership in a joint venture than it is in a marital divorce.” The Fundamental Rule Hertlein and Marx agree that one fundamental rule applies to all investment agreements, no matter what the size of the parties or the nature of their business relationship: Make every effort during negotiations to anticipate future disputes. “The eagerness to get a deal done creates the temptation to minimize the likelihood of problems,” Hertlein warns. “Thinking through negative eventualities and how to address them is one of the surest ways to avoid them.” Dinsmore & Shohl LLP is a full-service law firm with more than 300 attorneys practicing in nine offices. For the past 99 years, Dinsmore & Shohl has provided a broad range of integrated services to meet the needs of both large and small businesses as well as institutions, associations, governments, professional firms and individuals. Article Participants: Charles F. Hertlein Jr. Partner, Corporate chuck.hertlein@dinslaw.com Peer Review Rated James A. Marx Partner, Corporate james.marx@dinslaw.com JULY 2007 27
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