Historically, traditional private equity firms have avoided minority, or non-control, investments. Recently, however, there has been an increase in the number of non-control investment transactions as private equity firms have started to pursue such investments in order to put money to work in an increasingly competitive market. The rise in the number of minority investment transactions is also due to the increasing number of new single and multi-family, family offices that want to deploy capital but lack the desire or capacity to source, diligence and manage control deals. The above trends have placed a renewed focus on the contractual protections that are available to minority investors.
When evaluating a minority investment, it is important to not think of control/non-control as a zero-sum game. Not having a controlling share in a company doesn’t mean the investor has to accept a position of merely being “along for the ride.” There are a number of protections available to minority investors that will allow them to exert influence and have an active role in the investment.
The three most basic of these protections are information rights, preemptive rights, and “tag along” rights.
Information rights require a company to provide investors with certain financial statements (typically annual and monthly) and other material company information. Most information rights also include the opportunity to visit the company’s facilities, inspect its books and discuss matters with management.
Board observation rights also fall into the information rights category. Such rights allow a minority investor (or its designee) to attend board meetings in a non-voting role and, depending on company/board culture, participate in board discussions. Many minority investors prefer board observation rights over having an actual board seat because they have a “seat at the table” when material issues are discussed, but do not have the fiduciary responsibility and potential liability that comes with an actual board seat.
A preemptive right is simply a privilege extended to certain investors that allows them to maintain a proportionate share of the ownership of a company by purchasing a proportionate share of any new equity issuances before they are sold to third-parties.
Minority investors are generally restricted from selling their equity interests, but they commonly are given the right to participate, or “tag along,” in sales of equity interests by the controlling investor who is not similarly restricted. This right provides minority investors an opportunity to share in the control premium that would otherwise only be paid to the controlling investor.
More Protections for Investors with More Leverage
Investors that are acquiring a minority stake in either a start-up enterprise or businesses that have an urgent need for capital may have additional leverage to obtain certain minority protection rights in addition to the basic protections described above. Such additional protections may include: blocking rights; “drag-along” restrictions; and a “put option.”
Blocking rights provide a minority investor with the ability to have a say on certain corporate actions that the minority investor deems to be material. Such blocking rights are typically included in a stockholders’ agreement or the company’s operating agreement and give the minority investor the right to block certain material corporate actions that could negatively impact the minority investor’s investment (e.g., an acquisition by the company of another business or the entry by the company into a different line of business). Depending on an investor’s leverage and desire to be involved in the operation of the business, the blocking rights could be expanded to cover other material decisions of the management team such as the company’s ability to incur debt above certain thresholds, deviations from the annual operating budget or the hiring and firing of key employees.
Most minority investors are subject to a “drag-along” right of the majority owners. A drag-along right allows the majority owners to require a minority investor to participate in any sale of the company that has been approved by the company’s board and a majority of the company’s equity holders. In order to protect the return on his or her investment, a minority investor may require that he or she must receive a minimum return before the drag-along right can be exercised. In limited circumstances, a minority investor may also be provided with a “put option” that allows the minority investor to require the company or the majority owners to purchase his or her equity at a pre-determined value.
Minority investors in private companies must carefully consider a host of issues when evaluating such investments but, armed with the knowledge that protective provisions for minority investors are available, fear of being merely “along for the ride” need not be one of them.