Beware of “Hotel California” Contracts

hotel-californiaBeware of what I call “Hotel California” contracts.  These are contracts that may be easy to enter into but difficult to leave (i.e., terminate).

Before you sign a new contract, train yourself to think like a spy entering a hotel lobby, “Where are my exits if things go awry?”

For more on this, please read my article: “Your Right to Terminate: Quite Possibly the Most Important Right in Your Business Contract.”  Relationships change, and some day you may need a clean exit.

‘Relax’ said the night man, ‘We are programmed to receive. You can check out any time you like, But you can never leave!’   – Eagles

How to Create a Simple Cash Bonus Plan to Incentivize and Attract Employees

showmethemoney-Jerry-Maguire-1Your employees, like wide receiver Rod Tidwell (Cuba Gooding Jr.) in the classic movie Jerry McGuire, are valuable commodities.  They will stay with you if offered proper incentives, especially if you “show them the money.”

One of the best ways to do this is to create a simple cash bonus plan.  A cash bonus plan offers employees a financial reward for achievement of corporate, business unit and/or individual goals. The goals can be short-term (e.g., annual or quarterly) or long-term (e.g., three to five years), or both.

The best cash bonus plans are easy for employees to understand and easy for companies to operate. The plan is memorialized in a short written document that is specifically tailored to the company. The company retains the right to amend the plan at any time.

A cash bonus plan can be particularly useful for LLCs and S-corporations that wish to share the economic benefits of ownership with employees without the burdens of issuing Schedule K-1s (with negative tax consequences to employees) or having additional owners with voting and other rights. Cash bonus payments are taxed as ordinary income to employees and subject to standard payroll withholdings and deductions.

A well-crafted plan is a wonderful tool to incentivize and attract high-performing employees.

Here is a summary of the main issues you should cover to create a simple cash bonus plan:

  1. Purpose. The purpose of the plan should be stated clearly so that employees understand its goals, such as “to attract and retain superior employees by providing a competitive bonus program that rewards outstanding performance.”
  2. Eligibility. To be eligible, an employee must typically work at least a minimum number of hours (e.g., 40) as a full-time employee. Employees who have been terminated or who have resigned prior to the bonus payment date are usually ineligible, as are temporary workers. Companies may implement special eligibility requirements as they deem appropriate.
  3. Funding Metrics. The bonus pool can be a percentage of company net income, adjusted net income, earnings before interest, taxes, depreciation and amortization (EBITDA), or any other pool of money that the company identifies. The pool is generally capped as a percentage of the chosen metric.
  4. Performance Goals. Performance goals should clearly describe the metrics that the employee is required to achieve to earn a bonus, and how award determinations are made. Goals should align corporate, business unit and individual performance targets with company interests and encourage teamwork, while retaining incentives for individual performance. Many plans define the maximum target bonus available to each plan participant at the beginning of the performance period if all goals are achieved. Goals may be separated into organizational and individual categories, such as corporate goals to increase earnings and individual goals for productivity, customer satisfaction and client procurement/retention. Goal categories may be weighed (e.g., 50% EBITDA, 50% individual) to encourage one factor over another or equal weight in each category, depending on company objectives. However, the simplest, most easily understsood plans tend to be the most successful.
  5. Bonus Payments. Bonus payments are customarily made within 30-60 days after the end of the performance period (e.g., quarter or year). Bonus payments may be prorated for employees who take approved leave, including maternity or parental leave, and according to date of hire.
  6. Calculation Method. The bonus payable to each employee may be calculated as a percentage or multiple of annual base salary or as a percentage of the bonus pool. Bonuses are often capped at a certain amount.
  7. Non-Assignment. Bonuses should be non-assignable to prevent incentives from being mis-directed. IRS private letter rulings require S-corporations to prohibit assignment of bonus rights to prevent classification of the bonus as a second class of stock.
  8. Withholding. All bonus payments should be subject to applicable deductions and withholdings for federal, state and local taxes, and any other required deductions.

If you are interested in creating a simple cash bonus plan for your company, please contact me at john@jmdorsey.com.

Photo credit: ‘Show me the money!’: Tom Cruise as Jerry Maguire

The Top 8 Issues in Sponsorship Sales/Strategy Consulting Agreements

Maximizing sponsorship revenue for an event or brand often requires greater resources than those available within a rights-holder’s internal organization.  Fortunately, there are several reputable consulting companies that provide sponsorship sales and strategy consulting to bridge the gap. The consultants, which range from big players such as IEG/ESP Properties and Legends to boutiques like Caravel Marketing, provide a range of sponsorship-related services, including valuation, packaging, content creation, branding, analytics, activation strategies, customer engagement and sales representation.

I have helped clients negotiate successful arrangements with sponsorship consultants and I have also represented consultants in deals with sponsorship properties.  This article discusses the most heavily negotiated terms based on my experience:

  1. Scope of Services.  The scope of services will vary depending on the needs of the rights-holder.  A recurring event with a substantial operations team may require only sponsorship sales consulting to help boost revenue, while a well-established organization seeking to develop a comprehensive sponsorship platform for the first time may need a full strategy, valuation and execution package in addition to sponsorship sales consulting.  The key here is to be clear about each party’s expectations of the other. Consultants should make sure they have, among other things, full access to their client’s sponsorship assets and activation opportunities, and assured responsiveness to requests for approvals and information.  Rights-holders should make sure the agreement answers their main questions regarding services to be provided, such as:
    • What are the consultant’s specific duties and deliverables?
    • What strategy services will be provided (e.g., ideas, content creation, packaging, presentation development, valuation, digital, analytics, customer/fan engagement, etc.?)
    • Will regular reports about meetings, presentations, pitches, introductions, prospects contacted, etc. be provided?  How often and in what level of detail?
    • Will the consultant permit a representative of the rights-holder to attend sponsor/prospect meetings?
    • Will the consultant help negotiate sponsorship agreements?
    • Is the consultant expected to be available for meetings to travel for the benefit of the rights- holder?
  2. Exclusive vs. Non-exclusive.
    • Exclusive Relationships. Sponsorship consultants will almost invariably seek an exclusive relationship with the rights holder to fully incentivize the consultant to secure deals and freely market and sell the rights across its relationship portfolio without competitor interference.  Exclusivity can also be beneficial to the rights-holder because it mitigates against the risk of duplicative sales efforts by multiple consultants, which would demonstrate organizational mismanagement by the rights-holder and possibly diminish sponsorship revenue.
    • Non-exclusive Relationships.  Notwithstanding the above-mentioned benefits of exclusivity to both parties, non-exclusive deals are possible.  I have successfully crafted non-exclusive sponsorship sales consulting arrangements for larger clients with care to avoid overlapping marketing efforts. Non-exclusive arrangements should (i) clearly identify the prospects to be solicited in a mutually agreed joint prospect list and (ii) require ongoing open communication and reporting regarding any changes to that list.
  3. Compensation.
    • Sales Consulting. Market rate compensation for sponsorship sales consultants is typically (i) a monthly retainer plus (ii) a commission based on a percentage of gross sponsorship revenue received (including both cash and in-kind value).  Commissions on in-kind value are typically paid only to the extent such value relieves budgeted line items of the sponsorship property.  (Note that the value attributed to in-kind benefits can be heavily negotiated, ranging from fair market value to wholesale value to some other value, often depending on whether the property must put forth additional effort or resources to use the in-kind contributions.)  I have seen sponsorship sales commissions ranging from 10%-20%, with customary commissions being from 10%-15% when a retainer is paid.  Sometimes commissions are laddered, such as a commission of 15% on the first $X of sponsorship revenue and 10% on amounts above $X.  In certain cases, the rights-holder may negotiate recoupment of a portion of the monthly retainer (I have seen up to 50% recoupment) by deduction from the commissions payable.
    • Strategy Consulting. Compensation for strategy work is often project-based or charged on an hourly basis.  If strategy consulting is combined with sales consulting, then the fees will be a combination of the above.
    • Expense Reimbursement.  The consultant will require reimbursement for its travel and other out-of-pocket expenses, including graphic printing costs or other special project costs.  Usually the rights-holder has a pre-approval right over all reimbursable expenses or reimbursables in excess of an agreed cap.
  4. Commission Carve-Outs.  The rights-holder may reasonably seek to exclude from commissions sponsorship dollars received from companies or brands (i) with which the rights-holder has a bona fide pre-existing sponsorship relationship and (ii) it finds objectionable on moral, business or other grounds.  In addition, to prevent conflicts of interest, the rights-holder may wish to prohibit the consultant from receiving commissions on sponsorships from any organization in which the consultant owns an interest or would receive remuneration (e.g., a kickback) without full disclosure to and prior written consent of the rights-holder.  The consultant should freely disclose any possible “double-dipping” opportunities from affiliate relationships from the beginning, and any permitted affiliate deals should be stated in the contract to avoid later disputes.
  5. Commissions on Renewals (“Tail”). Sales consultants will usually seek commissions on sponsorship renewals after the term expires if they arose from relationships the consultant originated during the term. The rationale for this is that, without the consultant’s origination efforts, there would be no renewal.  It is reasonable to allow these “tail” commissions for a limited time period after the term, although in certain instances I have seen the rights-holder negotiate up to a 50% reduced commission on sponsorship renewals (e.g., if the origination commission is 10%, the renewal commission is 5%).  The obligatory term for payment of renewal commissions is negotiable and varies depending on the type of rights at issue.  I have seen renewal commissions payable for terms ranging from 6 months to 3 years after expiration of the original agreement term.  If the consultant is terminated for breaching the contract, the tail commissions should terminate.
  6. Services to Competitors.  Especially in sponsorship sales arrangements, the rights-holder may wish to prevent the consultant from providing similar services to direct competitors if the services are likely to conflict with the services provided to the rights-holder or otherwise put the rights-holder at a competitive disadvantage.  For example, if a music festival retains a consultant to sell sponsorships for a June 2018 event, the festival may require the consultant not to provide services to any other music festival within a within 300 square miles of the event during the 90-day period immediately before or after the event. This is often a fair request if the clause is narrowly tailored, but for large consultants with substantial worldwide customer portfolios it may be unrealistic.
  7. Work Product.  If the consultant is creating specific deliverables for a sponsorship property, then the property should typically own the intellectual property rights in those deliverables since it is paying value for them.  The consultant should, however, be permitted to retain ownership of any underlying or pre-existing IP used to create the deliverables and should grant the rights-holder an irrevocable, worldwide, royalty-free license to use that underlying IP to the extent it is incorporated into the deliverables.
  8. Term.  The agreement term is customarily a period of time necessary to complete the project or obtain sponsorships for the event or brand.  Each party is usually permitted to terminate the agreement (i) at any time for uncured material breach by the other party and (ii) for convenience upon advance written notice.  Often the consultant will negotiate a minimum fixed term of the agreement and/or a minimum fee payable by the rights-holder even if the agreement is terminated early, as long as the consultant is not in breach. This is generally a reasonable request because it justifies the consultant’s investment of time and energy into the project, which can be substantial during the initial ramp-up period.  I have seen agreements giving the rights-holder a termination right if $X in sponsorship revenue is not generated by Y date, but those are unusual.

I hope this article is helpful for both consultants and sponsorship properties.  If you have any experiences in the sponsorship consulting market you would like to share, please write them in the comments below or send me an email at john@jmdorsey.com.

 

Sponsorship Agreements: Rights of First Negotiation (ROFNs) and Rights of Last Refusal (ROLR)

In a previous article, I discussed Rights of First Offer (ROFOs) and Why You Need Them in your sponsorship agreement if you are a sponsor.  But if you are not the sponsor and instead you are the event or other sponsorship rights-holder, the ROFO will limit competitive bidding for your valuable sponsorship rights and may therefore decrease your sponsorship revenue.

For this reason, if a sponsor seeks to include a ROFO in a sponsorship agreement, the event or other rights-holder should usually either (i) reject the ROFO or (ii) change it to a Right of First Negotiation (ROFN) or Right of Negotiation (RON).  The ROFN is the common middle road approach used in sponsorship agreements.

Below I discuss both the ROFN and the RON, as well as the Right of Last Refusal (ROLR), which is sometimes used in conjunction with the ROFN/RON.

  • Right of First Negotiation (ROFN).  The ROFN requires the grantor to first and exclusively negotiate with the sponsor for a thing (e.g., renewal of the sponsorship or new rights) for a defined time period before negotiating for the thing with any third party. The ROFN is only triggered if the grantor makes the thing available.  For example, if there is no event or no new sponsorship rights are made available during the ROFN period, then the ROFN does not come into effect and expires. The only obligation the ROFN typically imposes on the parties is to negotiate in good faith.  If the sponsor and the grantor fail to reach an agreement for the thing within the defined period, then the grantor is free to negotiate and enter into an agreement for the thing with any third party, assuming the sponsor does not have a Right of Last Refusal (ROLR) (described below).  Here is a sample sponsor-friendly ROFN clause that is derived from a deal I worked on:

“If the Company or any of its affiliates organizes an Event at any time in any part of the world during the 2-year period following the 2017 Event (the “Future Event“), Sponsor shall have the exclusive right of first negotiation to purchase the same rights granted under this Agreement for the Future Event. On the date that the Company makes the final decision to hold the Future Event, the Company shall give written notice to Sponsor that it will hold the Future Event. Beginning on the date that Sponsor receives such notice and ending sixty (60) days thereafter, the parties shall negotiate in good faith to enter into a definitive agreement for the Future Event.  If the negotiations do not result in an agreement during the negotiation period for Sponsor to sponsor the Future Event, the Company may enter into negotiations with third parties with respect to the purchase of such sponsorship rights, or any other rights, and may proceed, in its sole discretion and without further obligation to Sponsor, with the sale of such sponsorship rights, or any other rights, to any third party.”

  •  Right of Negotiation (RON).  The RON is the same as the ROFN except the RON is not exclusive and does not give the sponsor a first priority in negotiation. Since the RON is nearly the functional equivalent of negotiating for the thing on the open market, it has little economic value and is not customarily used.
  • Right of Last Refusal (ROLR).  The ROLR is sometimes implemented in connection with a ROFN or RON.  If the sponsor and the grantor do not reach a deal for the thing during the ROFN/RON period and the grantor subsequently receives an offer from a third party for the thing, the ROLR gives the sponsor the right to match the third party offer during a defined time period.  A potential drawback of the ROLR for the grantor is that may discourage third parties from negotiating with the grantor for the thing since they know they may be outbid.  On the other hand, if there is significant interest among third parties and the ROLR holder, the grantor may be able to use the third party bids as a stalking horse to increase the price payable by the ROLR holder.  That said, ROLRs are not customarily found in sponsorship agreements, and in most cases the sponsorship recipients should avoid them because (i) they are more likely reduce third party interest in sponsorship assets than to increase the price of those assets and, (ii) perhaps more important, they complicate sponsorship negotiations for management.

Portions of this article were inspired by the article, Rights of First Negotiation, Offer and Refusal by PracticalLaw, a tool I use in my law practice.

Sponsorship Agreements: ROFOs and Why You Need Them

Imagine that last year you sponsored a wonderful event with a return on investment that exceeded expectations. The sponsorship agreement has now expired by its terms, and you have learned that the event is seeking alternative sponsors for your former rights, as well as partners for new properties, including digital and internet-of-things partners (See, e.g., SAP digital tools).
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You would have loved to have the first seat at the table in negotiating a renewal and for the new opportunities, but you must now negotiate new terms with the event in full competition with other sponsors.

If you had a ROFO, or Right of First Offer, you could have improved your lot. The ROFO gives the sponsor the opportunity to “stay in the game” when the agreement terminates or when new sponsorship opportunities are made available.

The ROFO is important because the sponsorship agreement, particularly in the eyes of the sponsor, has two significant limitations:

  1. It will expire after a defined term, such as conclusion of the event or a period of years; and
  2. It will not cover all potential sponsorship opportunities, such as new properties or rights that are not fully established or contemplated when the deal is first papered.

The ROFO requires the grantor (in this case, the event) to offer to the sponsor the right to purchase a thing before making or soliciting an offer for that thing from any third party. The thing, in the context of a sponsorship agreement, is customarily a renewal of the sponsorship or new/additional rights that were not previously available.

If the sponsor rejects the grantor’s offer, the grantor is free to negotiate a deal for the thing with third parties. But the ROFO prohibits the grantor from making a third-party deal unless the terms are at least as favorable (or materially more favorable) to the grantor as the terms offered to the sponsor.

For example, if ACME Rental Car enters into an agreement to become the exclusive official rental car sponsor of the 2018 Indianapolis 500 for $5 million cash plus additional benefits, ACME could include a provision in the agreement giving ACME a ROFO for the same rights for the 2019 event (and possibly for subsequently available sponsorship properties, categories, or territories).

The ROFO would provide that the Indy 500 could not offer any third party the right to be the official rental car sponsor (or similar category sponsor) of the 2019 event without first making an offer to ACME. If ACME refused the offer, only then could the Indy 500 seek third party rental car sponsors. However, the Indy 500 could not enter into an agreement with a third-party sponsor unless the deal was at least as favorable (or materially more favorable) to the Indy 500 as the offer made to ACME.

For instance, assume that under the ROFO the Indy 500 offers ACME a 2019 sponsorship package for $6 million cash plus additional benefits. ACME rejects the offer. The Indy 500 could enter into the same deal ACME rejected with Jalopy Car Rental Car, but it could not do a deal with Jalopy for $5.5 million unless it first made that offer to ACME and ACME rejected it.

Now, if you are not the sponsor but instead you are the event or other sponsorship recipient, the ROFO is not necessarily favorable to you because it limits the market of potential sponsors, which can reduce your fees. What to do? The event or other recipient can either (i) decline to include the ROFO in the sponsorship agreement or (ii) change it to a Right of Negotiation (RON) or a Right of First Negotiation (ROFN), both of which I discuss here.

Term Sheets: Five Legal Tricks To Make Them Work For You

One of my first questions when asked to draft the agreement for a client’s new business deal is whether a term sheet (also known as a letter of intent or summary of terms) has been prepared.

A term sheet is a short and sweet document that sets out the parties’ mutual understanding of the main terms they will agree on in a later definitive agreement. The key word is mutual: while you and your counterpart may have agreed a deal over a nice wine dinner, your individual perceptions of the main terms may actually be different than you believe. To the rescue comes the term sheet to crystallize the basic terms on which both parties agree and serve as a road map for drafting the definitive agreement. The act of preparing the term sheet also allows you the contemplative time to assess opportunities or risks you may not have previously considered.

In this way, the term sheet helps prevents misunderstandings at an early stage and saves valuable time and attorney’s fees when drafting the definitive agreement. Once complete, the term sheet symbolically bolsters the parties’ commitment to the deal and focuses negotiations.

Term sheets are commonly used for M&A and financing transactions, as well as commercial deals, such as joint ventures, IP licenses, sales of goods and services, and executive employment agreements. Of course, if your deal is simple, you can skip the term sheet and draft the definitive agreement. If not or if there is any doubt, then use a term sheet.

Here are five tricks of the trade to help you draft term sheets to your advantage:

  1. Prepare the First Draft. There is no convention as to which party prepares the first draft of a term sheet, but I advise my clients to prepare the first offer because it can become the anchor for negotiation (as demonstrated in compelling psychological studies). Also, if your adversary later seeks to change your terms, you can argue, “Well…I gave up X from my first draft, so I will need Y” in the next draft. Often “X” will be a slight reach, so “Y” may not be the fallback it appears. To use the first draft to your advantage, however, your term sheet should be a reasonable first shot at crafting the basic deal terms (i.e., no excessive overreaching, which may erode your credibility and associated negotiating leverage).
  2. Make it Non-Binding (Usually). The general rule is that the term sheet should not be legally binding. There are exceptions to this rule, such as binding obligations of exclusivity or confidentiality included in acquisition transactions or other special cases in which a party will intentionally seek to bind the other party in furtherance of its goals. The key is to avoid unintentionally binding obligations. Courts review several factors to determine whether a term sheet is binding, such as the language used, the definitiveness of the terms (e.g., are there remaining terms to be negotiated?), and the context of negotiations. If there are binding provisions, both binding and non-binding provisions should be clearly identified. Non-binding term sheets should not be signed and should also include non-binding boilerplate, such as: “This term sheet is for discussion purposes only and is not intended to be construed as a binding agreement. The parties do not intend to be bound until they enter into definitive agreements regarding the subject matter of this term sheet.”
  3. Focus on the Big Issues. The term sheet should cover only the main deal points. It should not include every potential contract detail. Remember that this is a short and simple document, preferably one- or two pages maximum. The idea is to agree on the big picture items and defer the details to the definitive agreement. For example, in a minority investment in an LLC, the big issues might be the purchase price, pre-money valuation and number/percentage of outstanding shares to be acquired, director/manager appointment rights, other minority investor rights, pre-closing conditions, and the projected closing date.
  4. Use Catch-Alls and Conditions to Cover Future Needs. You should use catch-all phrases in the term sheet to preserve your right to include additional terms in the definitive agreement to cover anticipated and unanticipated issues. For example, in a term sheet for a licensing deal, you could say: “The definitive agreement will include additional terms and conditions customarily included in comprehensive [insert type] license agreements.” This sentence gives you the flexibility to include a variety of additional terms in the definitive agreement while staying within the symbolic boundaries of the term sheet. Similarly, if you need to conduct more diligence or obtain financing, then you could say: “The possible transaction is subject to additional due diligence by [buyer] to [buyer’s] satisfaction, as well as [buyer] being able to obtain financing necessary to complete the transaction.” Without these catch-all and conditions provisions, your counterpart may argue that terms you later request should not be included in the definitive agreement because they were not mentioned in the term sheet.
  5. Use Assumptions to Protect Against Unknowns. At the term sheet stage, the parties have typically not conducted substantial due diligence and open questions remain regarding known unknowns and possibly unknown unknowns.  You should use assumptions in the term sheet to hedge against this uncertainty. For example, if your willingness to pay a price for a target company is based on certain assets being transferred to the company at closing, then state the assumption in the term sheet so you have the ability to change the price without disrupting the deal if the assumption proves false.

By using these five tricks of the trade (and the advice of a good lawyer), you should be able to prepare a simple term sheet that serves as a foundation for the successful negotiation and drafting of the definitive agreement for even the most complex of your business deals.

Your Right to Terminate: Quite Possibly the Most Important Right In Your Business Contract

It’s almost inevitable. At least three or four times a year, the phone will ring or an email will arrive with the client saying something like this:

“John, it’s not going as we had hoped. We need to know how to get out of this deal, and the consequences. How soon can you review the contract?

Rewind 6-12 months prior to this message, when the sky was blue, the birds were singing, and this was going to be the best deal in history. Indeed, the parties’ unbridled enthusiasm to work together on a new transaction is one of my favorite things about being a deal lawyer. This enthusiasm provides the foundation momentum to swiftly negotiate and close the transaction.

In an acquisition, the seller is happy to cash out and the buyer is eager to add new assets to its portfolio. In a joint venture, the parties are keen to make a whole greater than the sum of its parts. In the hiring of a new employee or consultant, the company appreciates adding human capital and the employee or consultant relishes the new opportunity.

But after the deal is signed and the honeymoon period fades, assets may be prove defective or deficient, personalities may clash, performance may falter, and other unexpected challenges may arise.

When this happens, the most important contractual term is not the price you negotiated, the assets you have the right to buy, or the services or other items you are supposed to receive. Instead, the most important term is your right to terminate the deal, including the ability to cut your losses (or increase your gains) and return to the status quo (or enhance your position).

Without the right to terminate, you could be forced to return to the negotiating table for settlement discussions on a termination agreement. This may involve an expensive settlement payment plus attorneys’ fees, in addition to the cost of your valuable time and emotional capital. In the worst case, it could mean mediation, arbitration, or litigation. Meantime, you may need to continue to honor burdensome obligations under the existing contract, ratcheting the pressure on an already tense situation.

Conversely, if you have strong termination rights, you may be able to leverage a termination situation to your advantage. Your leverage may allow you to end the agreement unilaterally, but it may also enable you to re-negotiate the deal to achieve better terms or to salvage a challenging relationship by changing expectations.

The termination clause and its related provisions are so important that when I negotiate deals for my clients, I read them and re-read them several times as we iterate and revise drafts. When negotiating complex deals, I often lie awake in at night weaving the termination and post-termination rights provisions in my mind, making sure they fit and function in my client’s best interests.

While we all hope that each business deal is a success, when negotiating your agreements it is important to take a moment to envision your rights and remedies if the relationship does not evolve as favorably as anticipated. Your lawyer should help you craft deals that enhance your upside but also protect you from downside risks, which include the right to terminate the deal when things go awry.

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.

Top 9 Warning Signs in a Business Deal

One of the benefits of being a corporate lawyer is the opportunity to participate in a variety of interesting deals.  In these, you encounter a motley crew of characters.  You witness a range of negotiating styles and tactics, and learn which are effective and which are not. You see some ventures succeed and many others fail.

In the great theatre of the deal, there are rare moments in which something may not feel right to the lawyer or the client about a proposed business transaction or partner.  The thing amiss may only be verifiable by circumstantial evidence.  To paraphrase the Delaware Chancery Court, it may be that the circumstances surrounding the person or transaction stink bad enough that they simply do not pass the “smell test“.

Questions may arise following diligence on the target (which should minimally include Google and litigation searches), from a person’s conduct in negotiation or from other third party sources.  There will not typically be any proverbial smoking gun, so your judgment and careful diligence will be your guiding light.

In my years as a deal lawyer, the appearance of any of these nine elements (not in any order of priority) has been a fairly reliable harbinger of difficulty, dishonesty or even fraud in proposed business deals.  If any of these elements arise in your dealings, you should consider diving deeper into diligence to determine if there is genuine cause for concern or possibly re-negotiate or abandon the deal altogether.

  1. The demanding long-winded negotiator of trivial things.  Excessive demands for non-substantive or patently unreasonable changes to the initial non-binding deal document, such as the term sheet or letter of intent, may foreshadow protracted and possibly agonizing negotiation of the definitive agreements and a challenging ongoing business relationship.  If the demands are coupled with the party’s long-winded or repetitive arguments why he is right and you are wrong (or other ridiculous anectdotes), they may suggest personality issues.  In my experience, character defects are not easily remedied and often worsen with time. The unreasonable negotiator should distinguished from the tough savvy negotiator, who requests substantive deal points but is often reasonable and a good business partner after the deal is papered.
  2. The deal requires urgent participation and won’t be available after “X” occurs.  This is the classic illusion of scarcity tactic.  If your prospective business partner claims that if you fail to act now, (i) a large investment from Mrs. “Y” will soon be received and the price of the investment will increase or (ii) the deal will not be available for “Z” reason, the claim may be a red herring and should be carefully scrutinized.  Fictional future money is sometimes characterized as coming from abroad or from some well-known person with whom the partner purports to have a close relationship.
  3. The secrets that cannot be revealed.  If the target’s founder or your prospective partner is unwilling to reveal certain fundamental aspects of the business or how it expects to make money, the company may not have a business plan.  You have a right to know the company’s business model and growth strategy, with the understanding that the model will likely evolve over time. In one startup deal I reviewed for a client, the founder made repeated excuses why he could not provide information about critical company inventions and provisional patent applications.  Later diligence revealed that the company had no inventions and its business plan was impracticable. After spending the other investors’ money, the founder abandoned the company and the U.S.  This is akin to Bernie Madoff’s “black box” investment strategy that was “so good” that it could not be understood or replicated by any reputable investor.
  4. The anonymous “big money” partner.  Any person who must remain anonymous is often a red flag, particularly if this mystery man is a primary financing source.  A client once instructed me to prepare the draft documents for a “big investment by a Chinese investor who needs to remain anonymous.”  A third party had informed the client that the Chinese wanted this, that, and the other, and I prepared several draft iterations at the client’s request.  The Chinese investment never materialized and the client wasted money on legal fees. Some celebrities and others have genuine reasons to protect their privacy, but if you are doing a deal with someone (including a celebrity), you have a right to know their identity and to size them up.  Always insist upon lifting the veil of anyone who says they must remain anonymous.
  5. The shell company spider web.  Domestic and offshore entities are often formed to execute lawful business strategies, including liability and tax mitigation, particularly for companies with substantial non-U.S. source income.  But as the Panama Papers confirmed, offshore shells with limited assets may also be created for tax evasion and other corrupt purposes.  Before doing any deal with a company that owns or operates affiliates, especially offshore shell entities, you should fully understand the organization chart and confirm that each entity exists for lawful and legitimate purposes.
  6. The paperless office.  It is fine if your partner keeps a clean desk and operates in the cloud, but a lack of paperwork memorializing a business’s structure, assets and operations is almost invariably a red flag.  You should have access to reasonable diligence paperwork and you should be able to freely ask questions and to have them answered.
  7. No skin in the game.  If the deal does not require your business partner to put money or something else of value into the deal, your interests may be de-aligned from the beginning.  In the startup context, this could be the situation where a founder’s shares are fully vested from day one and he has no invested capital or other hook to prevent him from walking away when the going gets tough or he receives a better offer.  In a joint venture, it could be the ability of a party to enrich himself at the expense of the venture.  De-alignment can usually be remedied by careful drafting of the legal incentives in the deal documents.
  8. The promise of abnormally high or guaranteed returns. This trick is as old as prostitution: returns above market rates or guaranteed returns on invested capital are often signs of a Ponzi scheme, where the prompter lures you to invest to pay his prior investors rather than to make bona fide investments with you money. You should always determine the source of returns and whether that source is capable of generating the projected payout.  Most financial projections are exactly that, and vary dramatically from actual results.  There is no such thing as a guaranteed return.
  9. It sounds too good to be true.  This is a corollary of abnormally high returns.  As the adage goes, if what you are to receive in exchange for your participation sounds too good to be true, then it probably is.  In most of these cases, you should run away from these deal absent a reasonable and verifiable justification for its sweetness.

 

Don’t Pay Commissions on Sales to People You Already Know in Your Commission Sales Agreements

Commission-based sales contracts require the payment of a commission to a sales representative when a sale is made.  These contracts are commonly used in the sale of goods and services and real estate.

If you are the seller (i.e., commission payor), you should should try not to pay a commission on sales made to third parties with which you have an existing relationship.  The rationale is that the sales representative earns the commission only on those sales to customers that the representative introduced to the seller by the representative’s efforts.  The representative will generally agree to the carve-out as long as it is limited to the seller’s bona-fide pre-existing relationships, such as those customers to which the seller already sells on a regular basis.  If the representative is savvy, it will ask that an itemized list of excluded persons be set forth in the contract.

A simple carve-out to a commission sales obligation could be drafted as follows:

Unless [SELLER] otherwise agrees in writing, [SELLER] will not pay a commission on any [purchase orders from] [sale[s] made to] [NAMES OF EXISTING RELATIONSHIPS].