In the fifth part of our series on selling your business (see M&A Basics: Do you want to sell your company? Part 5 - What to Look Out for in a Sale and Purchase Agreement), we covered what a seller should focus on in a Sale and Purchase Agreement (SPA). In this post, for a change, we'll look at some of the points that tend to be stumbling blocks in a Shareholders' Heads of Agreement (SHA).
If the investor has only bought a portion of the shares from you, it is imperative that you and the investor agree on how the company will operate after the transaction closes. This is what is known as an SHA, or Shareholders/Stockholders Agreement. The investor who buys out the majority shareholding will want to have control over the management of the company. However, the management itself may be left to the sellers, especially if the sellers have previously managed the company and know the company's business best. Very often, sellers who remain managers of the company after the transaction closes are motivated by a deferred portion of the purchase price, or a management bonus, or a "put option" to sell the remainder of their interest in the company. On the face of it, an ideal situation.
However, the balance of investor-seller relationships can be very fragile. It is a good idea to set up management and control in such a way that the day-to-day operations are not paralysed (e.g. by overly formal approval of routine actions), but at the same time neither party can 'burst out'. From the vendor's perspective, it should also be borne in mind that the majority shareholder is likely to have the ability to remove the vendor's nominated statutory officers, which will result in a reversal of the operational-control relationship. However, while the seller's nominees are at the helm, they must have the means to achieve the objectives to which the SPA says the additional purchase price payments or management bonuses are tied.
Another key point to be addressed in the SHA is additional financing for the company, particularly if the target company intends to expand or make substantial investments. Pre-emptive rights to commit to a new contribution (or to subscribe for new shares) tend to be commonplace, but if the additional financing is to be provided by way of non-capital additions or shareholder loans, it is important that the SHA addresses (i) the terms on which the additional financing will take place (in particular, the purpose of the financing and the manner in which the additional financing will be reconciled), and (ii) whether and how the interests of the shareholders/stockholders who do not participate in the additional financing will be diluted. The key is that the investor cannot squeeze you out on purpose.
An important point in the SHA (if not directly in the SPA) is also the non-compete. Investors often require sellers not to continue to do business in the industry in which the target company is doing business, not only for the duration of their participation in the company, but also after their paths have diverged. The investor's legal advisers will naturally seek to define the scope of the competing activity as broadly as possible and to limit the scope of persons restricted by this prohibition. Your legal counsel's role will be to negotiate meaningful boundaries so that you cannot be sanctioned for violations that you do not intentionally commit yourself (either directly or through third parties). On the subject of competition, the other side of the coin is sometimes forgotten, namely the competitive conduct of the investor group. You probably don't want to just hand over know-how to an investor that will be developed elsewhere and without you.
A big chapter in SHA tends to be the exit from the company, whether individual or joint. When an investor enters a company, the parties often have clear visions of a joint lucrative sale of the company to a third party, but the visions and the reality may not always coincide. From the seller's perspective, it is particularly important that it has an effective exit opportunity on the same terms as the investor and that it has the option to buy out the investor's stake itself or protect itself in some other way in the event of a speculative offer. A separate chapter is dealing with deadlocks, i.e. where the parties are unable to reach a consensus on issues that they must necessarily decide together. Exit provisions tend to be so complex that a more detailed description of them requires a separate article.
If all goes according to plan, no one will even remember the SHA. However, in case of unexpected developments, it is a good idea to have a contract on hand that will reliably protect you.