How to Maximize Your Minority Rights in Small-Scale Private Equity Investments

Even if you consider yourself a small-scale investor in private companies relative to today’s private equity giants, you should seek certain basic minority rights to protect your investment and enhance your exit opportunities.  In fact, most minority protections that a small-scale investor should seek are exactly the same as those that any larger PE fund would require.

Among my clients, these small-scale private equity investments generally range from $100,000-$3,000,000 for purchases of 10%-30% of a company’s outstanding equity.  They may be investments in corporations or limited liability companies (LLCs).

Here is an overview of rights you should consider:

  1. Preferred Equity.  The preferred stock (corporation) or preferred membership interests (LLC) may have any or all of three elements to help compensate you for placing your capital at risk:
    • A preferred right to dividends or distributions, which should be coupled with a tax distribution clause in an LLC;
    • A liquidation preference, giving you the right to be paid prior to other investors upon a dissolution or sale of the company or its assets; and
    • a right to convert into common equity if the common’s value would be higher than the value of the preferred in a change in control transaction.
  2. Preemptive Rights; Anti-Dilution Protection. A preemptive right is the right to acquire your pro rata share of any new securities issued after the date of your investment, which is self-help protection against dilution.  Preemptive rights may also be coupled with anti-dilution protection, allowing you to receive additional equity if securities are issued below the per unit price you paid for your equity.
  3. Board Appointment. The right to appoint a member of the board of directors (corporation) or board of managers (LLC) gives you a seat at the table at board meetings and the right to vote on board matters.  If board appointment rights cannot be negotiated, you could seek to appoint a non-voting board observer to attend meetings.  Your director/manager should receive at least the same indemnification benefits as other directors.
  4. Veto on Material Transactions.  You should seek a veto over company actions that could materially and adversely affect your investment, such as:
    • Bankruptcy or other liquidation or winding-up;
    • Acquisitions of equity or debt securities or assets;
    • Mergers, consolidations, conversions, or reorganizations of the company;
    • Sales of substantially all of the company’s assets;
    • Formation of subsidiaries;
    • Amendments to governing documents;
    • Transactions with affiliates;
    • Incurrence of debt or expenditures above a certain limit;
    • Termination of key employees; and
    • Changes in board size or composition.
  5. Financial Reports. Quarterly and annual financial reporting may be required, as well as audited financials in certain cases. If the investment is in an LLC, annual tax reports should also be provided to enable you to timely file Form 1065 K-1.
  6. Warrant/Option Rights. The warrant or option is a useful tool for mitigating risk while retaining upside opportunity.  Depending on the terms, a warrant or option can allow you to increase your investment incrementally during an agreed exercise period at the same price and the same valuation associated with the original investment.  This reduces your downside risk if the company fails to perform as anticipated and helps preserve your upside.
  7. Right of First Offer (ROFO).  A ROFO requires an equity holder who receives a third party offer for the purchase of his units to first offer to the other equity holders the right to purchase their pro rata portion of the seller’s units on the same terms as those offered by the third party.  The ROFO can enable you to increase your equity ownership by purchasing the equity of others, which is particularly beneficial if the company’s prospects are favorable and you are able to capitalize on distressed sales by other equity holders.
  8. Exit Rights.  There are several different types of valuable exit rights, a few of which are described below:
    • Tag-Along.  The corollary to the right of first offer is the tag-along right, which gives you the right to “tag-along” on a unit sale by a selling equity holder to a third party on the same terms as those given to the selling equity holder.
    • Drag-Along.  The drag-along right allows a group of equity holders (usually a supermajority) to require all equity holders to participate in a sale of company equity or assets.  If you, as the minority investor, do not wish to be made subject to the tyranny of the supermajority in a drag-along provision, you could negotiate for an appraisal mechanism requiring determination of the fair market value of the equity proposed to be transferred as a condition to the supermajority’s exercise of its drag-along rights. If the appraisal determines that the actual fair market value is greater than the proposed drag-along sale value, you would have the right to retain your equity.
    • Right to Cause a Liquidity Event. You may wish to negotiate the right to obligate the board and shareholders to pursue a sale of company equity or assets the company fails to achieve certain pre-determined milestones.

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