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Most business divorce lawsuits do not end with a dramatic trial and a judge pounding a gavel. Rather, they typically end through a settlement reached between the parties where one party buys out the other party’s equity in the company or the parties agree to rebalance their ownership rights. This article highlights key issues in both types of settlements.

Buyout

A buyout settlement in a business divorce generally refers to the purchase of equity by one owner from the other owner.  Typically, the purchaser in buyout transactions are the ones who either run the company’s day-to-day operations or have access to financing.

In facilitating a buyout, the first step is for the parties to agree on a buyout price.  Common approaches to valuing the seller’s equity include a fixed price per share or unit of equity, retention of a third-party valuation expert to calculate equity valuation, or use of a fixed formula (e.g., a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA) or book value with adjustments).

Once a buyout price is negotiated and agreed upon, the second step is to agree upon the structure of the transaction. Generally, either the purchaser will acquire the seller’s equity directly (owner-to-owner sale) or the company redeems the seller’s equity (redemption transaction).  In an owner-to-owner sale, the company is not a party to the purchase agreement and the interest is conveyed from the seller to the purchaser.  In a redemption transaction, by contrast, the company buys back the seller’s equity, consideration flows from the company to the seller, and, thereafter, the redeemed equity is usually retired.

After finalizing the purchase price and structure of the transaction, the parties must determine how the sale will be financed. This will include whether the payment of the purchase price will be a lump sum or payment over time. If the parties agree the purchase price will be paid over time, the parties must agree on the term, the payment schedule, and whether any interest will accompany the financed amount. Often times, the sale will be secured by the equity so if there is a default under the financing arrangement, the seller can take back its equity.

Additional terms typically involved in a buyout settlement may include: (1) the exchange of releases – to provide finality going forward relating to prior acts; (2) indemnification rights to provide protection from third party claims for which the other party should be responsible; (3) post-transaction restrictive covenants on competing with the company, soliciting employees and clients of the company, and/or using any trade secrets or confidential information resulting from the seller’s ownership of equity in the company; and (4) tail insurance — which allows the seller to participate in price appreciation if the purchaser flips the equity immediately after they purchase it from the seller.

Rebalancing Ownership Rights

Another way a business divorce may be settled is by rebalancing ownership and control so that one party emerges as the controlling owner with more valuable remuneration rights, and the other remains as a minority and more passive owner with less remuneration rights.  The purpose of rebalancing ownership rights is generally to end operational deadlock; remove one owner from day-to-day control; provide greater compensation and incentives to one of the parties; or position the company for a financing or sale that was otherwise blocked by the prior ownership and governance structure.

In rebalancing ownership rights, the parties typically arrange for one owner to purchase a portion (but not all) of the equity from the other owner.  This can be accomplished through a direct purchase and sale of equity between the parties, redemption of some portion of one owner’s equity by the company, a recapitalization (e.g., issuing new voting/non-voting classes, preferred vs. common); or some combination of the above.  Primary financial considerations for the rebalancing of ownership rights involve valuation, tax consequences, and financing. The parties may also negotiate compensation to be paid to the owners going forward, additional benefits (such as insurance, reimbursement for travel and entertainment, use of company resources, and retirement accounts), and bonuses.

Equally as important as negotiating the financial conditions is the negotiation of the control rights and how they will be allocated between the parties.  Generally, the parties must agree on who controls day-to-day decisions (such as hiring and firing of employees, retention of professionals, opening bank accounts, and entering into transactions up to a certain financial threshold) versus major decisions (such as a sale of all or substantially all assets, issuance of new equity or debt beyond set amounts, amendments to the ownership and governance agreements, liquidation/dissolution, and affiliate transactions with the controlling party).  The party given control over the company is typically able to make day-to-day decisions, but must obtain consent or authority to make major decisions.

Additional considerations contemplated in rebalancing of ownership rights include: (1) the issuance of distributions (e.g., tax distributions plus a set % of excess cash); (2) the issuance of additional equity to third parties; and (3) capital contributions.  The parties should also consider under what circumstances they can compel or participate in a sale transaction, including put rights (where the minority can force the company or controlling owner to purchase their interest at a formula price after a certain horizon or upon specified triggers); tag-along rights (if the controller sells a controlling stake, minority can sell a pro-rata portion on the same terms); and drag-along rights (if the controller sells, minority can be compelled to join).

The parties should also discuss the minority owners right to and frequency of which they should receive information such as financial statements (monthly/quarterly/annually); tax returns, K-1s, and relevant workpapers; and generally reasonable inspection rights for books and records.  Clear information rights help reduce suspicion and make it harder to allege concealment or breach later.

Finally, in many business divorces, ownership and employment are intertwined.  Key issues that need to be resolved in this context include employment of the parties, and, if so, role, title, and level of authority; what termination rights the company has (with/without cause); and if there is a termination whether the terminated party is entitled to a mandatory buyout.  Similar to a settlement by buyout, the parties should consider and negotiate non-competition and non-solicitation restrictions, as well as confidentiality and non-disparagement obligations, releases and indemnification rights.