Robbery by Repurchase Rights – A Private Equity Story

“Once you give up integrity, the rest is a piece of cake.” 

– J.R. Ewing, From the TV Series Dallas

ACTUAL CASE HISTORY*: Kurt was intrigued. As a well-known and highly regarded Marketing Consultant to large automotive dealerships, he was presented with what seemed like a grand opportunity: to help build a national network of motorcycle dealerships, with the goal of “taking it public” in five years or so in an Initial Public Offering (“IPO.”) The best part of the opportunity was his becoming an owner of 5% of the company, a potential reward of extraordinary value – perhaps in the many millions of dollars – if things went according to plan.

To come on board, Kurt would have to leave a secure and long-term position with his firm. And, too, to come on board Kurt would have to take a significant cut in income for three or four years. But other things were quite enticing. First, the people putting the deal together were part of a highly experienced and highly regarded Private Equity firm with a proven track record in automotive private equity businesses. Second, the team being put together to run the new company was top-notch, each in his or her own way an expert in one aspect or another of the automotive business. Third, the potential rewards were “in the $5 million to $10 million” range, which would quite literally set Kurt up for life.

The pitch was simple: “Come on board, take a significant pay cut, build a business that is highly profitable, and when we sell it we will all enjoy the sweet fruit of financial success.” Kurt bought in, with his mind, heart and soul. Kurt also invested $10,000 “as a sign of good faith” for the 10,000 shares of the company he was allotted.

And, so, for four years Kurt and his colleagues did everything humanly possible to build the business into a highly profitable machine. That included laying off most of the “old guard,” who were used to doing things “the old way.” That also included eliminating health care contributions, cutting paid vacations in half, and slashing everyone’s compensation. It was “the Private Equity way of doing business.” Prestigious institutional investors joined in to gain greater growth of their endowments, seemingly unaware of (or unconcerned about) the pain the process inflicted on good, hard-working people who saw their long-term efforts and loyalty dismissed, devalued, and dishonored.

Four years later, just six months or so before the company was to be sold to the public in an IPO, Kurt and his colleagues received something they did not understand: a “Notice of Exercise of Repurchase Rights.” Not being able to understand the opaque legal jargon in which it was written, Kurt consulted our firm. We reviewed the papers before us, and gave Kurt the bad news:  his share of the company – soon to be worth perhaps several million dollars – was being purchased back from him for the same $10,000 he had paid for it. The worst part was that Kurt had agreed to just that way back when he was hired.

You see, when Kurt was hired, he purchased his 10,000 shares for $10,000, he signed a 21-page “Executive Shares Agreement,” and on page 17 of that document was a section entitled “Repurchase Rights.” That section provided that, at the Company’s option, at any time, it could repurchase Kurt’s shares for the lesser of (a) the amount he had paid for the shares, and (b) the market value of those shares upon repurchase. Kurt had invested $10,000, and the shares were now worth about $7 million, so the Company had a right to buy them back for just $10,000. Each of Kurt’s colleagues received the same notification.  

Kurt did not understand what “Repurchase Rights” meant when he signed the Executive Shares Agreement, but he will never forget what that meant to him. When he and his colleagues went to the Private Equity owners of the company in dismay and anger, the response they received was icy cold: “Didn’t you have a lawyer read the agreement before you signed?”   

Not a good result for Kurt, or his colleagues. Four years of hard work, at low pay, without benefits, all for a dream that just disappeared. Sadly, in business and especially in the “Private Equity world,” it happens every day, without legal remedy or recourse.

LESSON TO LEARN: Over the years I have reviewed scores of agreements for employees going to work for Private Equity firms. Sometimes provisions regarding “equity” (stock, options, restricted shares, etc.) are found inside Employment Agreements. Sometimes they are in separate agreements called “Share Purchase Agreements” or “Executive Equity Agreements.” In perhaps 90% of these and similarly-entitled agreements I have found “Repurchase Rights” which give the company the right to take back the “grand opportunity” that attracted the employees to come on board in the first place.

Though I have come to expect to find repurchase rights in such agreements, I have never heard a good reason for their being there. If the employee is being offered a “lifetime opportunity,” why in the world should the company have the right to take that “lifetime opportunity” away, especially after the employee has worked for years to earn it? My own view is that repurchase rights are nothing less than a legal way to rob people of what they’ve earned by outwitting the employees by having them sign the “share grant” (or similarly named) agreement containing “repurchase rights.”    

If you are considering working for a company owned (or to be owned) by a Private Equity firm, look carefully for “Repurchase Rights,” a “Repurchase Option,” or words to that effect, and do what you can to get them removed or changed. No matter what the paragraph or section is labeled, if the effect of the words is that you can be forced to sell your equity at a price determined by others, tread most carefully.

Some “Repurchase Rights” provide that the repurchase price payable to the employee is zero. Some provide for a repurchase price of “the lower of the original purchase price or the then-current market value of the shares.” These provisions simply repay the employee for what he or she originally invested, while taking away the now-more-valuable shares. Some provide for a repurchase price at their fair market value as determined – and here’s the trick – “in the sole discretion of the Board of Directors.” No matter what the precise words are, if by the “Repurchase Rights” you may be denied the benefit of your “grand opportunity,” you would be wise to do all you can to stop that from happening.

Every person faced with “Repurchase Rights” should resist them. If you are important enough to your prospective employer, the company will remove the repurchase rights, or agree to other measures to reduce the loss to you. If your prospective employer will not do so, you will be faced with a difficult decision: to take the risk or not to do so.

In business, it is important that you (a) identify risks, (b) assess those risks, and (c) reduce or eliminate those risk. When it comes to repurchase rights, there are steps you can take to do just that, if you are willing to devote the effort to do so.

WHAT YOU CAN DO: Consider taking one or more of these thirteen steps – and any others that may suit your particular facts and circumstances – to address the considerable risk inherent in “Repurchase Rights” in your Private Equity “grand opportunity”:    

1. If you are offered “equity” by an employer, carefully review all agreements before signing. – Believe it or not, in my experience most people who are offered “equity” in their employer do not carefully review the papers they are asked to sign. It may be the excitement of becoming an “owner.” Or maybe it is the view that “I have nothing to lose.” The only thing that can be said for those who do not “look before they leap” is “You have only yourself to blame.” Responsible people act responsibly; it’s that simple. I would recommend that anyone who is expecting to gain financially from a grant or purchase of equity stock should have an attorney review the papers before they are signed.  

2. Though “Repurchase Rights” (sometimes called “Repurchase Option”) is the usual section heading in an agreement, repurchase rights are not always clearly labeled. – It is frequently the case that repurchase rights are labeled clearly, but not always. The section of any “Stock Grant Agreement” (or similarly named document) containing repurchase rights is usually very close to the end of the document, essentially “buried” among other sections with legally-confusing titles. At times, they are found under a section entitled “Miscellaneous” or even “Termination.” To determine whether repurchase rights exist in your stock agreement, there is no substitute for reading the agreement, word for word.

3. Understand that every kind of “equity,” and both “vested” and “unvested” shares, can be lost to repurchase rights. – Some people think that “vested” forms of equity – whether stock shares, options, restricted stock, or other forms of “equity” – cannot be lost or forfeited. They are wrong, The words of an agreement govern the effect of that agreement. I have seen all kinds of equity lost to repurchase rights, and even purportedly “vested” equity, as well.

4. Ask, first, that the repurchase rights be removed. – The most direct approach to take when you are faced with repurchase rights is to say, “I have found that the ultimate reward offered to me can be taken away from me at any time, without any reason. That doesn’t sound right. I’d like the ‘repurchase rights’ provision removed.” If you are perceived as valuable enough to the company, they will remove the section. Many of our clients have been successful in this way. However, others have not. One thing is for sure: you won’t be successful unless you try.

5. Respectfully reject “You can (or should) (or must) trust us.” – “Don’t you trust us?” is the most common response received from Private Equity owners when employees try to resist repurchase rights. It is an unfair and intimidating question, because who can say “I don’t trust you” to someone they are hoping will hire them? I think the best response is “Of course I trust you, but the loss of my ownership opportunity would be a great loss, and I don’t know who will be the owners of the company when this issue may arise. How about we put this in the agreement: So long as your Private Equity firm is involved with the company, the company won’t exercise this option? If you would agree to this, then we can move forward?” 

6. Resist this language:  “The Company will determine, in its sole discretion, the value of your repurchased shares.” – If the company will not remove the repurchase rights section from your agreement, then try to change the language of that section. Quite often, the language of the company’s repurchase right provides that “the company, in its discretion, will determine the value of the shares to be repurchased,” or words to that effect. As you might expect, any price determined by the “sole discretion” of the company will be extraordinarily low. You might ask that the valuation be (a) explained in writing in full detail, (b) be done in accordance with customary valuation techniques, and (c) be subject to review by an independent valuation expert of your choice. You might also ask that an independent valuation be conducted by an independent third party. Try real hard to get “sole discretion” or “absolute discretion” out of any such provision, and substitute in their place “in good faith, in accordance with generally accepted accounting principles.”

7. Resist this language: “ . . . the lower of . . .”  – Quite often, repurchase rights provisions set a price for the repurchased stock as “the lower of (a) what the employee paid, and (b) the current value.” Whenever you see “the lower of” request, instead, “the higher of,” at the very least.

8. Be wary of “at book value.” – Sometimes the amount to be paid for repurchased equity is based on “book value” of the shares. Be wary of that phrase, as it is an accounting term that can be highly manipulated. Resist its use, and suggest, instead, the use of the phrase “based on a fair enterprise value,” which would generally be a higher amount, and incorporates the use of the word “fair,” an advantageous word to get inserted for possible later use in the event of adversarial relations.  

9. Request “In no event will I be paid less than what my shares are actually worth.” – If you are not successful in your request to eliminate the repurchase rights section, and you are also unsuccessful in changing language as indicated above, consider requesting “In no event will I be paid less than what my shares are worth.” That is a “catch-all” phrase that your employer should have a hard time arguing with. It may encourage a more honest valuation of your equity, and could also serve as the basis of a legal claim later on that you did not, in fact, get paid what you should have for your repurchased equity.

You might want to review our related article entitled “Offered a Position and Ownership Interests? 10 Traps in the Legal Papers and How to Cure Them.” Just click [here.]

10. Request “only if all employees’ stock is also repurchased at that time and price.” – Another “fallback” request would be to make sure that, at the very least, your equity will be repurchased (a) only in the event that all employees’ equity is repurchased, and (b) at the same price. In my experience it is rather unlikely that all employees would lose their equity by means of the exercise of a repurchase option, as losing your equity is often a reason to quit, and at least some of the company’s employees would likely be needed to continue to run the company. 

11. Request “Look Back Rights.” – A rather audacious request, but one that does sometimes work, is a “look back right.” This means that, if it turns out that, say, 12 months later the company is sold, and your share of the company ends up being worth 10 times what you were paid for it in the repurchase transaction, then you should be given the additional monies you would have earned. Frankly, this is rarely granted, but it does often serve to motivate employers to be more flexible in other requests you may make, noted above.

Offered “Employee-Ownership Interests?” Consider our “Model Memo and Addendum Responding to an Offer of Employee Ownership from a New or Young Company.” A unique and sophisticated model to gain significant protections to both your employment and your equity. “What To Say, and How to Say It.”™ To get your copy just [click here.] Delivered by Email – Instantly!

12. Be wary of later amendments to the stock equity agreement. – Sometimes repurchase rights are incorporated into a later version of a stock grant agreement (or equity purchase agreement) by means of a later amendment, I have seen several instances of amendments being sent around to the staff of a private equity-owned company for prompt signature, without any real opportunity for review, consideration or legal analysis. Don’t be rushed; it’s too important.

13. If you are a present employee, and are being asked to remain and “sign on,” consider group action. – Sometimes Private Equity firms purchase an existing business, and ask existing employees to remain, and to “sign on” to remain, enticed by the vision of a “grand opportunity.” In these circumstances, if one employee objects to repurchase rights, he or she can be seen as an individual “trouble maker,” and asked to leave. However, if two, three, four or more band together, and each make the same request, perhaps even doing it together or with one attorney, the chances are much higher that the repurchase rights will be either removed, or modified, as the Private Equity firm will be reluctant to lose most or all of the experienced employees they’ve just “purchased.” Joint requests, and joint legal representation, have their own issues, headaches, and possible conflicts of interest, but it should be considered.   

Over the past several years, Private Equity firms have come to purchase and own more and more businesses. A quite common mode of these firms is to buy (hopefully at a low price), hold for five years, and then sell (hopefully at a higher price.) A critical part of the common game plan is to cut employee compensation and benefits severely, but at the same time to promise “grand opportunities” as owners. Sadly, just before the companies are sold, these “grand opportunities” often disappear by means of “repurchase rights.” It’s important that you do your best not to lose out to repurchase rights, and these 13 ways are the best ways to do so.   

P.S.: If you would like to speak with me directly about this (or other workplace-related subjects), I am available for 30-minute, 60-minute, or 120-minute telephone consultations. Just [click here.] Evenings and weekends can be accommodated.

SkloverWorkingWisdom™ emphasizes smart negotiating – and navigating – for yourself at work. Negotiation and navigation of work and career issues requires that you think “out of the box,” and avoid risks at every point in your career. Knowing ways to lower and eliminate risks give you  a distinct advantage in navigating workplace life. Knowing ways to avoid disputes is even more advantageous. Learning the “in’s and out’s” of doing so is what we are here for. Now it’s up to you.       

Always be proactive.  Always be creative.  Always be persistent.  Always be vigilant. And always do what you can to achieve for yourself, your family, and your career. Take all available steps to increase and secure employment “rewards” and eliminate or reduce employment “risks.” That’s what SkloverWorkingWisdom™is all about.

*A note about our Actual Case Histories: In order to preserve client confidences, and protect client identities, we alter certain facts, including the name, age, gender, position, date, geographical location, and industry of our clients. The essential facts, the point illustrated and the lesson to be learned, remain actual.    

Please Note: This Newsletter is not legal advice, but only an effort to provide generalized information about important topics related to employment and the law. Legal advice can only be rendered after formal retention of counsel, and must take into account the facts and circumstances of a particular case. Those in need of legal advice, counsel or representation should retain competent legal counsel licensed to practice law in their locale. 

© 2011, Alan L. SkloverAll Rights Reserved. Commercial Use Prohibited.

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