Minority investors take a substantial risk when they take an equity position in a closely held company. They have limited control over the management of the company and don’t have a liquid market to sell their equity should things go wrong. For this reason, before investing, a minority investor will typically ask for substantial protections to go along with their investment. The following are the ten most typical protections we see requested by minority investors.
1. Board Participation
Although a minority investor may not be able to control the board, they will typically expect some level of board participation and might even negotiate for the majority of the board be independent. As a minority board member, they will most likely insist on protections such as appropriate D&O insurance, approval of significant transactions as well as the requirement of regular meetings.
2. Information Rights
Minority investors will expect to have access to financial information related to the company. This will include the right to review the company’s books and records and to receive financial statements and the operating budget on a periodic basis. Advance approval by the board of an annual operating budget may be required.
3. Right of First Refusal
Prior to selling shares, a shareholder who is subject to a right of first refusal must first offer shares to existing shareholders who hold a right of refusal. This gives the minority shareholder an opportunity to increase its position if they so desire, especially if they would prefer not to be in business with the proposed third party purchaser.
4. Company Call for Departed Employees’ Shares
If a founder or employee shareholder leaves the company, whether voluntarily or involuntarily, the company typically has the right to repurchase shares held by the departing party. Often if the employee has been fired, or has left voluntarily within a specified initial period, the purchase price will reflect a discount. If a minority investor is the first shareholder who is not also a founder or employee, the minority investor may need to ensure that this call right is provided for.
5. Pre-Emptive Rights
In order to prevent their ownership interest from being diluted by future issuances of shares, investors will typically require that they be given the right to participate in any subsequent offering of shares, options, warrants or other securities.
6. Tag Along Rights
Simple co-sale or “tag along” rights afford minority investors the right to participate in the sale of equity on the same terms and conditions as the selling shareholder. If the investor does not wish to remain a co-owner with the new shareholder, the minority investor can sell its shares, proportionately, along with the other selling shareholder(s). A more sophisticated tag-along provision can be drafted to cover a broader array of transactions, providing greater protection to a minority investor.
7. Drag Along Payment Rights
Majority shareholders will typically provide for drag along rights requiring the minority investor to participate in a sale of the company or a sale of a controlling equity stake. In this case, minority shareholders might also insist that if they be dragged into a transaction, the sale proceeds be allocated proportionate to equity percentages and be paid in cash or marketable securities, or at least that any other private securities to be issued will provide for certain minimum investor rights.
Anti-dilution provisions are designed to ensure an investor’s interest is not diluted through the issuance of new equity at a lower price. Usually this entails the issue of additional shares to the investor to reduce its effective average purchase price.
9. Supermajority Voting/Consent Rights
In order for minority shareholders to have a say in major changes in the company, the minority shareholder may expect consent rights or supermajority voting for significant matters. Although not an exhaustive list, it would not be unusual to see consent rights or supermajority voting with regard to:
a. Equity transactions such as sale of a particular class of equity, the reclassification or change in the rights of any such class of equity or the issuance or sale of options or other convertible securities for such class of equity;
b. Sale of the company (by asset sale, stock sale, merger, liquidation or other corporate transaction);
c. Acquisition by the company of the stock, assets or business of another entity;
d. Investment by the company in another entity;
e. The incurrence of debt, sometimes subject to a materiality threshold;
f. Amendment or modification of the company’s organizational documents in material respects;
g. Entering into, modifying, terminating or renewing any real property lease or any other material agreement;
h. Entering into affiliated transactions;
i. Material deviation from the approved annual operating budget or capital expenditure budget;
j. Relocation of the company’s primary offices;
k. Hiring or firing of any key employee or the material change in salary or bonus compensation of any key employee.
10. Put Right/Shotgun Clause
Because there is no liquid market for minority shares of a closely held corporation, an investor may want a way to exit if things do not go according to plan. A put option would require either the company or other shareholders to buy out the minority investor in specific situations such as a failure to meet milestones or key personnel leaving. A close cousin to the put right, a shotgun clause gives the minority investor the right to buy or sell shares to another shareholder or the company if specific issues cannot be resolved.
While a Company seeking funding can expect to be asked for some if not all of these concessions, whether or not the investor successfully obtains these protections will vary from transaction to transaction, depending on the relative leverage of each of the parties and the risks associated with the particular deal. Regardless of the outcome, negotiation of these issues often paves the way to a complete understanding between the parties which in turn helps to promote a more positive partnership moving forward.