[This article was written by Bob Holmen for Fortis Advisors. Additional articles may be found at Fortis News.]
M&A transactions present a wide range of situations where conflicts of interest can arise. As a leading post-closing shareholder representative on private M&A transactions, we have faced these issues many times on behalf of selling shareholders. Effectively dealing with these issues requires more than just being a neutral party relative to the shareholders. Understanding disparate interests and their relative priorities, as well as being able to effectively communicate with and align interests, are critical factors necessary to achieve results.
The interests in an M&A transaction go beyond the buying company and selling company, extending to the shareholders (and the subsets of preferred, common, option and warrant holders), the management team, the other employees, third party lenders and third party vendors. In a recent transaction where Fortis was served as shareholder representative, a number of difficult conflict issues arose based on the disparate interests of the constituents.
A buyer agreed to acquire a selling company for $150 million in cash and a potential $30 million earn-out based on post-closing sales of the seller’s products. The cash at closing was sufficient to pay back the preferred (mostly venture capital) investors. If earned, the earn-out would allow the common stock holders and option holders to receive an equivalent amount per share as the preferred investors.
At closing, the buyer required that $15 million of the closing cash be placed in escrow to secure the seller’s indemnity obligations under the purchase agreement. The shareholders set aside a $500,000 expense fund to engage counsel and other professionals in the event of claims against the escrow or issues involving the earn-out (with any unspent funds eventually returned to the preferred shareholders).
When Fortis was engaged to serve as shareholder representative, we understood that our constituents were not similarly situated, and thus may not be aligned on all issues. Our group included preferred holders, who had already received 90% of their capital and had only an interest in the escrow/expense funds, common holders whose primary interest was in the earn-out, and option holders who were former seller employees (including seller’s CEO) that had been hired by buyer, with potential divided loyalties between their interests as a selling shareholder and as a buyer employee.
One year post-closing, the buyer provided notice that the earn-out would not be paid, claiming sales of seller’s products were insufficient to trigger payment. We communicated buyer’s position to the selling shareholders, and began investigating buyer’s claim. In speaking with different shareholders, it was not surprising that the views on how to proceed varied.
Common shareholders who had no continuing relationship with the buyer were adamant that the buyer must have acted in bad faith. In their view, the sales targets were easily achievable had the buyer continued to market and sell the products in good faith. Those shareholders were ready to file a lawsuit, with costs paid out of the expense fund, to go after the $30 million earn-out.
Preferred shareholders were generally sympathetic to the common shareholders; however, they were less enthusiastic about the expense fund being used to pay the costs of a lawsuit for the sole benefit of the common shareholders. First, the preferred shareholders wanted to preserve the expense fund for use in defending against any claim related to the $15 million escrow. Second, since the preferred holders were entitled to any unspent portion of the $500,000 expense fund, they weren’t inclined to expend it on a matter in which they had no financial interest.
The former option holders, who were now working for the buyer (led by the CEO), had mixed motives. They were interested in maximizing recovery on their holdings in the seller, but did not want to be part of a litigation against their current employer. They especially did not want to end up in a position where they had to testify in a lawsuit against the buyer.
Fortis, serving as shareholder representative on the deal, recognized and understood all of the conflicts described above and acted swiftly and efficiently to come to a resolution with all parties involved. A crucial element of this was the fact that Fortis was able to proceed in a neutral manner on behalf of all constituents since Fortis had no economic interest in the matter—Fortis’ focus was the shareholders’ collective interest. If any seller securityholder had agreed to serve as shareholder representative, not only would that individual holder have had to deal with the conflicts among all the constituents, the holder also would have had a personal interest in the matter that could be in conflict with other holders depending on the category to which it belonged: preferred holder, common holder or option holder/current buyer employee.
So how did we resolve these issues? Fortis engaged in a series of good faith negotiations with buyer around the earn-out, focusing on the buyer’s efforts to achieve the earn-out, what was required under the merger agreement, whether principles of good faith and fair dealing applied, and the likely results and impacts on the business and employees of various paths from paying the earn-out to getting involved in protracted litigation.
Ultimately, the parties settled the matter through a partial payment of the $30 million earn-out. We believe it would have been difficult for any one securityholder serving as shareholder representative to have achieved this result. Invariably, even the mere appearance of impropriety based on a shareholder’s self-interest can hinder resolution.