The Devilish Details of Stock Purchase Agreements

We’ve all heard and said the expression, “The devil is in the details.” This article addresses two types of complexity associated with stock purchase agreements. First, we’ll cover some risks in a contract where the purchase price is contingent upon future business performance. Second, we’ll address some issues regarding related party transactions where the stock purchase is for less than a controlling interest, and the stock purchaser is subject to the control of the majority holders.

Let’s start by clearing the deck of some fundamentals. If stock is purchased in a company, other than on a major exchange, employment contracts with excessive salaries, bonuses, perks or golden parachutes, as well as material company assets being used for personal enjoyment more than business (e.g., the company yacht) or company obligations that have little to do with benefitting shareholders going forward, should not be surprises after the fact. Routine investigations during due diligence typically uncover such obvious items that may or may not impact the decision whether to consummate the transaction. Consequently, such items will not be part of this discussion.

Another topic we will ignore for now is the fact that when stock is purchased from the issuer, the money paid may be allocated for one or more particular uses. That use may be something very specific such as new equipment or debt repayment. Alternatively, the use could be more general, such as working capital. In either case, the purpose of the capital invested is to enhance, strengthen and/or grow the company whose stock is being purchased. On the other hand, when stock is purchased from an existing shareholder, none of the capital used to acquire that stock will go to build or improve the business because it is going into the pocket of the seller. A future topic will discuss alternative uses by the issuer and evaluating the impact on the business and value of the company resulting from the different uses. For now, though, that topic shall be put to the side.

The first situation to consider is when stock is purchased in a company, regardless whether the seller is the issuing company or a shareholder, and the purchase price is tied to some future measure of the issuer’s sales. For example, you, as a seller of stock (personally or on behalf of the issuing company), might have a business that you believe will grow quickly over the next few years. I, as a prospective purchaser of stock in your company, generally believe in its prospects, but I am not so persuaded as to make my investment today at a value based on your enthusiastic forecasts. I prefer to take a somewhat more conservative approach. While I don’t mind rewarding people for the creativity and work they’ve done laying the groundwork for rapid growth, the value based on the reality today may not match the seller’s optimistic future valuation. One way seller and buyer can both feel they are receiving fair consideration is to split the purchase price into multiple parts: the first payment in consideration of today’s value plus some future payment(s) contingent on designated benchmarks of growth. The buyer might offer $X today and $Y for every additional million dollars in sales in each of the next 3 years.

This approach gives the buyer a position in a business that has optimistic forecasts without having to choose between walking away and gambling on a valuation that may never be realized. At the same time, the seller secures an investor who believes in the company and wants to grow with it.   

One risk of such a transaction for the stock seller is the possibility that millions more in sales are generated, entitling the seller to additional investment dollars per the terms of the stock purchase agreement, but when the time comes for the next payment, the buyer says, “I don’t have it right now” or “I changed my mind.”  Obviously, the seller has grounds for a lawsuit; but, litigation entails time and expense with no guarantee that even if the seller wins, the buyer will have the funds to pay. Maybe more importantly, though, the seller may have counted on that extra capital to, in the case of an issuing company seller, support those rapidly growing sales. Instead of looking for back-up investors, the company went about the business of business because it thought the additional capital was already locked up. As a consequence of the defaulted payment, the company might be cash-strapped, unable to purchase inventory or equipment, or do whatever else it had intended with that additional capital — all because the stock purchase agreement didn’t provide for the “what if” the buyer simply doesn’t do what he/she/it was supposed to do.

Here are a few suggestions to consider:

  1. The buyer can put some or all of the additional purchase money into a secure third-party escrow, with the buyer receiving all of the interest so there is not as much lost opportunity cost. As a further inducement for the buyer to deposit the funds into an escrow account, the seller could offer to pay the difference between the escrow interest and some other measure of return the buyer might have received (akin to insurance for both the seller and the buyer) to cover the buyer’s reasonable opportunity cost. If the benchmarks for the additional purchase price are not satisfied, the funds are released back to the buyer; if the benchmarks are met, the seller knows there is some amount of money readily available (even if not 100%) upon providing the requisite proof and notice to the escrow agent.
  2. There can be some measure of liquidated damages. “Liquidated damages” are damages the parties estimate in advance in the stock purchase agreement to cover what both parties reasonably think could be the damage caused by buyer’s failure to perform. Of course, if the buyer can’t make the additional stock purchase payment, who’s to say the buyer can pay the liquidated damages amount? 
  3. The stock purchase agreement could have a provision that seller retains buyer’s shares until fully paid for and if buyer defaults, seller can resell buyer’s position and apply the purchase price to the amount buyer owes.  The problem with this is, unless seller anticipated this situation and has a back-up buyer lined up, the seller will have to divert time, attention and effort to re-selling this interest just when the seller expected to be moving smoothly ahead.

Obviously, choosing a buyer is a critical consideration. If the buyer is struggling with the initial purchase price, chances are he/she/it will struggle with the additional payments; seller should anticipate that issue and plan for it.

But, we digress. Back to the “details” that can emerge as issues when future value is related to sales. The example is that the issuing company (“ABC”) is selling stock for $X and the buyer has agreed to pay $500,000 for each additional $2 mil in sales per year. For the sake of this discussion, we will assume it’s a calendar year and, on January 15th, ABC has happily sent buyer a letter with an accompanying income statement showing sales for the year just ended were $4 mil more than the previous year, meaning buyer owes $1 mil in additional purchase price.   

Not to say ABC would do anything larcenous, but it would certainly be in ABC’s interest for that sales figure to be as high as it possibly could be. Upon receipt of that income statement, it might be in buyer’s interest to ask — or even better — it might have been in the interests of both buyer and seller to have agreed in the stock purchase agreement as to some of the following:

Were sales accounted for on a cash or accrual basis? While sales accounted for on a cash basis are sales for which ABC has been paid, sales accounted for on an accrual basis include sales for which ABC is still owed money and which ABC might not ever collect. It would certainly be possible for ABC to “sell” $100,000 worth of widgets on December 31st to a purchaser who ABC knows cannot afford them and either will not pay for them or will return them. Depending on the definition of “sales,” that return may or may not reduce sales in the next year; while a write-down of a receivable probably would result in an additional selling, general and administrative expense (allowance for bad debts) but not result in a reduction of sales. Right now, though, the stock purchaser is being asked for $1 mil based on a $4 mil increase in sales. The buyer could make an issue of it or just figure it will balance out in another year. The reality is that such a sale of widgets made by ABC, while having a reasonably solid expectation of the outcome, poses several potential problems for a buyer of ABC’s stock: (a) an artificially higher price today, (b) lower net income next year due to either an offset in sales or a higher allowance for bad debts and (c) the company into which he/she invested – ABC – just committed a fraud upon the buyer, raising the additional question whether this is the only fraud or are there/will there be others?

While generally accepted accounting principles (gaap) require the accrual method be used where inventory is involved, ABC’s business may be selling services rather than goods and/or ABC may simply not follow gaap. It’s also possible that the stock purchase agreement can provide that “sales” for the financial statements be calculated on an accrual basis but “sales” for purposes of determining the additional purchase price in the stock purchase agreement be calculated using the cash basis for expressly the reasons described above.

  1. What if sales are returnable? What’s the average return rate? Was there anything unusual about the end of year sales, such as a spike unlike previous years’ sales that might suggest some manner of manipulation? And, does the buyer again assume it will even out after year 2?
  2. Gross sales or net sales? Is the “sales” figure to be used as the measure of the increase in determining the additional payment to be “gross sales” or “net sales”? On one hand, gross sales is the total amount of revenue attributed to the business during a period of time. The problem can be that some of that revenue may not be real, may not be a true indication of the success of the business (relating to the “Quality of Earnings”), or may even not be the property of ABC. For example, gross sales may include sales tax which, technically, is not the property of ABC but rather the property of the state and, maybe, local governments on whose behalf ABC collected it and then must remit to the appropriate owner. Other adjustments from gross sales may be products that are returned and, while there was a sale at some point, ABC took it back and refunded or agreed to refund some portion of that sale. In dealing with a dissatisfied customer, instead of taking the product back, ABC may have given the customer a credit or an “allowance.” Revenue sharing agreements may be in place where ABC is obligated to share with another company; so, while a sale may have been $100, half or some other portion comes right off the top to another party. How much, if any, of the sales were based on barter?  These are transfers of goods or services in exchange for, in part or in total, other goods and services, or credits applicable to other goods and services. Which is the true “sales” of the subject business?
  3. Does the seller book “trials” as sales? Since products sold on “trial” do not give rise to an obligation of the purchaser until the trial period ends and the purchaser is satisfied, ABC should not, therefore, show it as a sale. Still, sales on trial may be included and it would be worthwhile for the buyer to ask.
  4. Does ABC, if it does a significant amount of business internationally, include currency exchange gains in sales? Currency exchange losses? Such gains and losses should be separated out and, unless the company is in the business of currency exchange, probably shouldn’t be included in considering “sales” for purposes of valuing the company.
  5. While probably not a major factor in wholesale sales of products as it is in hospitality, such as hotels or restaurants, what is the factor of comps? Goods or services that are provided on a complimentary (no charge) basis are called “comps.” Many hotels and restaurants, for example, may comp or give goods or services to guests because, for a variety of reasons, doing so is good for the respective business. In the nightclub business, comps included in sales can run as high as 20% of gross revenues. To reflect the fact that the business does not get paid for comps included in sales, some businesses include an offset for comp’d goods and services to arrive at a “net sales” figure, while other establishments include comps in sales with an offsetting marketing expense; and still others don’t include comps in sales, at all, but simply record the cost of goods sold as the value of the comp. In any of these cases, is the stock purchaser paying a value based on a significant amount of comps? It’s something the buyer should know because comps are an easy way for a business to artificially inflate sales.

These are just a few examples of many details which can be easily overlooked when negotiating a stock purchase agreement. Working with the right team of business and legal advisors can significantly reduce your deal risk and maximize return.

The other scenario we’re covering in this article is “related party transactions” where the stock purchase is for less than a controlling interest. 

When one party obtains control of a company, he/she/it can generally set or change the rules everyone plays by. If there’s an unfavorable contract, the company may be able to renegotiate it, cancel it or buy it out. When acquiring a minority interest, however, the acquiring party is subject to the conditions made by others. Sometimes, those conditions are apparent, as in the express terms of an employment agreement – salary, benefits, severance benefits, etc. What will likely not be so apparent are transactions by and between related parties that benefit the majority holders and/or key employees, but not the minority holders.

For example, imagine the buyer of a minority stock interest. Through due diligence, the buyer examined the employment contract of the president, who also happens to be the majority shareholder. It was learned that the president is entitled to a salary of $500,000 per year, 4 weeks paid vacation, first class travel and a luxury car. What might not be apparent from looking at the documents and financials is that the president is a significant shareholder in one of the company’s major suppliers which benefits greatly from the company’s business, especially since the prices charged are above market. 

Another situation is where related companies are doing business with one another across international borders. For example, ABC is a US company that manufactures widgets in Texas for $1 and sells them throughout the US for a normal markup at $2. After deducting expenses, ABC pays its fair share of income taxes and the balance is distributed as dividends to the shareholders. But, what if the majority owners of ABC set up a manufacturing plant in a country where there are little or no taxes? ABC might pay the foreign company $1.50 instead of $1, still charging $2 but making little or no net income in the US on which to pay tax, and having nothing to distribute as dividends. Owing to their common ownership of the two companies, the majority owners benefit by shifting their profit to the offshore company that they wholly own. But, what about the people who have only an interest in the US company?

A purchaser of stock may not have discovered that several of the company’s customers have retained the president’s brother as a consultant. Is that consulting fee in addition to a fair and reasonable price being paid to the company or has the price paid to the company been reduced so as to reallocate some of those revenues directly to and for the benefit of the brother of the president? Is the brother of the president rendering a real service or is it just camouflage for money being diverted to or for the benefit of the president?

As a minority owner, what control do you have to prevent the acquisition of an asset that is arguably for the personal benefit of a small group of people (of which the minority holder may not be a part), such as a boat or a plane? Once acquired, does the party using the asset differentiate between business and personal use, and reimburse the company for the reasonable value and costs associated with such personal use? If not, the minority owner who gets no benefit or use from the asset is subsidizing the personal benefits obtained by the parties who do use the asset. Maybe that’s fair and maybe it’s not; but it’s something that should be known.

There is also the situation of a key person of one company who has, or someone that key person cares about has, an interest in a competitor; and the key person at the company for which the stock is being purchased has the opportunity and ability to direct which company an order or customer goes to. Since there will rarely be a document or email from the person saying, “You should go to XYZ Company instead of ours,” such an occurrence is difficult to prove absent an admission by the person within your company or a declaration by the customer referred.

The stock purchaser may have examined the employment contracts that existed prior to and as of the date the stock interest was acquired; but, is there any restriction on what the company can do after the stock purchase is consummated? Can the company give some very large employment contracts or bonuses that, had they been disclosed prior to consummation of the stock purchase, the buyer might have decided not to conclude the transaction? The stock purchaser may be able to insert some restrictive covenants in a stock purchase agreement directly with the issuing company; but there is little power in this regard when purchasing from an existing shareholder (unless it’s a controlling shareholder who can change the rules or cause a change in the rules).

With respect to stock purchases directly from the issuing company, are there any limitations in the stock purchase agreement as to what the company can do with the money? Can the board declare a special dividend and distribute some of that money right back to the majority shareholders? Or, are there some specific provisions on how the funds can be used?

Beyond the employment contracts and contractual obligations that exist on or before the date the stock is purchased, is there anything in the by-laws that prevents loans to employees? Or, requires that loans to key employees have terms that are fair or reasonable? Do such loans require approval by a supermajority of shareholders? What authority is required to forgive such loans? This could be relevant in the event the capital provided through the stock purchase with the issuing company goes right out in the form of a loan to a majority holder or key person for improvement of his or her home. Maybe the stock purchaser feels confident enough in the company that the purchaser’s sole goal was to acquire the percentage specified in the stock purchase agreement (subject to the issues regarding dilution described below). But, if the capital was supposed to be used to help the company and/or do something specific, the disposition of the capital could be an issue that could have been addressed in the stock purchase agreement.

One provision that is present in many stock purchase and shareholder agreements but, for some reason, not given the requisite attention are “call provisions” — the right of the issuing company to require existing shareholders to contribute additional capital at the peril of not maintaining their respective proportionate ownership. Some people assume (and, in most cases, correctly) that such a provision would be used for the benefit of the company only when needed. Other people somehow assume it will never happen and are surprised when they are asked to send in more money. A problem arises when the majority holders use it as a weapon to squeeze out minority partners by initiating capital calls simply because they can, and in amounts the minority holders may be incapable of paying; at which point the majority shareholders put in the additional capital, receive the additional stock which increases their proportionate interest while reducing the minority holder’s interest. Initiating a capital call to squeeze the minority holders is not common, but the fact that it’s not common may be the reason so few people take the risk of its abuse seriously.

How can one guard against the potential problem of offensive or malicious capital calls? There are several possible avenues to eliminate or minimize the risk of such calls where an issuing company is the stock seller: (1) The stock purchaser could negotiate the removal of the call provision. (2) The stock purchaser could add some conditions to the use of the call provision, such as “This call provision may be initiated only in the event net working capital is less than X% and the Company is profitable.” (3) The stock purchaser could leave it in and put a cap on the degree of dilution. For example: “Interests of shareholders who do not contribute their proportionate share of the amount stated in the capital call shall be diluted proportionately but to not less than X% of the percentage of the total immediately prior to the capital call.” This provision is effective but still subject to repeated dilution from successive capital calls while “…but to not less than X% of the percentage of the total as of a specific date” puts a finite cap on the dilution that can be sustained.

I’ve highlighted a number of issues in this article not to deter you from doing any specific stock purchase agreement, because there are wonderful opportunities out there. Some issues are simply a matter of the point-of-view from which each party sees the stock purchase agreement and can be addressed easily and quickly while others (such as restricting the board’s ability to enter into expensive employment agreements or initiating capital calls) are more involved. Other issues relate to people who may not be quite as honorable as you would prefer to deal with. 

Either way, knowing which rocks to turn over and, more specifically, what questions to ask, could save a stock purchaser considerable angst and money.

RETURN TO INSIGHTS