IN BRIEF
- What factors should practitioners consider when crafting a clawback provision in a sale document?
- By drafting a provision that fits the unique facts of the situation, attorneys can ensure that fair value has been provided to the departed equity owner.
Clawbacks are provisions that assure a former equity owner receives fair, full consideration when it sells its equity. Such provisions enable the former owner to participate in the consideration received in a subsequent sale of the business by the remaining owner or owners.
Whether a buy-sell agreement was previously in place among equity owners or not, a departing business partner wants to be assured that at the time of sale it receives full value for its interest. In many cases, there is concern that shortly after the sale of its interest, the remaining owners will sell their interest for a significantly higher price.
Although federal and state securities laws may protect a departing owner from the remaining owners not disclosing an imminent sale, or that a higher offer has been made for the business, it is prudent for counsel for the departing owner to consider inclusion of a clawback provision in the sale agreement.
A departed shareholder may feel that his or her business efforts, or the critical capital provided, greatly contributed to the company’s growth and that dividends from those efforts will continue for at time after his or her departure. A clawback provision allows a departed owner to share in the proceeds of a later sale as if its shares were not previously sold.
From the remaining owner’s perspective, a clawback may be the final negotiated piece that convinced the departing partner to sell and that does not have an economic cost if there is no subsequent sale. If there is a subsequent sale, the clawback amount is paid by the buyer. Although the funds may come from proceeds otherwise payable to the remaining owner, hopefully the funds actually received from such sale will be sufficient to more than satisfy the owner.
Moreover, whether the sale price was fixed by prior contract or negotiated at the time of the sale, the value received by the departed owner may have been based primarily, if not exclusively, on the value of the business as a going concern with no consideration based on a potential sale. This is a common occurrence when the remaining owner states that he or she desires to continue to run the operation as a family business for the indefinite future and not with the purpose of selling to a competitor or other third party.
If there was a buy-sell provision included from the beginning of the partnership, the remaining equity owners will argue that the absence of a clawback provision in such instrument should be determinative that there should not be one added at a later time. This is not always a persuasive argument if there is no requirement to sell.
Once the decision is made to include a clawback provision in the sale document, there are many factors that should be considered in crafting such a provision.
- Whether the decision to separate the partners, causing the business to divert funds from operations to the buyout, is made by the remaining partner or the departing partner often influences the sale price, as well as determining whether a clawback is appropriate.
- Whether the departing partner was active in management or a passive investor. In the first instance, the departing owner claims his or her efforts contributed to the growth of the business and that the value of the contribution continues for a period post-sale. A passive investor may not be able to make a similar claim.
- Clawbacks may also be useful in the termination of contingent payments that form a part of many pay-out provisions. A future buyer may not want to continue contingent payments to former owners, particularly if such payments can’t be quantified or the terms of which may impact the buyer’s ability to change procedures in the acquired business. A clawback benefits the future buyer by allowing it to end the contingent payments for a fixed amount. The departed equity owner benefits by getting an earlier fixed payment, and the remaining owners have one less difficult issue to negotiate.
- Clawback provisions may last one year after the sale or for several years. I have utilized provisions that last up to 10 years, although ranges of three to five years are more common. An active partner involved for many years in a mature business (i.e., bakery or funeral home) with slow, steady growth will claim the clawback should continue for a longer period than a young, fast-growing business where the future efforts of active managers contribute to the future growth. There is a point where the claim of residual value expenses negates the rationale for a clawback to continue.
- Recognizing that the departed partners’ influence will diminish over time, it is not uncommon for the clawback percentage to decline over time. For example, if the second sale occurs within the first 12 months after the sale of the departed shareholder’s interest, such shareholder will receive the value for its equity as if no original sale had occurred. The percentage may decline to 50 percent of the value in the second and third years after the original sale and only 25 percent in years four and five. To illustrate, if a 30-percent owner of a business received $3 million to sell his or her interest in 2020 (representing a $10 million enterprise value), but less than a year later the business is sold for $15 million, then the former owner would receive an additional $1.5 million, representing 30 percent of the subsequent sale price less the $3 million already received. If the sale occurred in 2024, the former owner would receive only $375,000, or 25 percent of the differential.
By recognizing the value of clawbacks and drafting provisions that fit the unique facts of the situation, attorneys can ensure that fair value has been provided to the departed equity owner and that no additional funds will be expended by the remaining owners if no future sale occurs.