For decades, buyers of privately held companies have required that the sellers appoint a representative of the former shareholders to speak on their behalf with respect to certain matters that may arise following closing. In private equity transactions the lead investor frequently elects to assume the role of shareholder representative. They are often most familiar with the day-to-day operations and working capital calculations of the selling company and they often own the majority share of the money at risk during the post-closing period and therefore want to maintain control over the post-closing process. However, there are significant risks and costs associated with the role. These risks and costs can, and should, be outsourced.
The Problems with Doing It Yourself
Serving as the representative creates significant risks for the person or entity serving in that role. Those risks can come from two directions. First, the representative has duties to the other shareholders and could be sued by them. Second, the representative has risks related to the transaction and could be sued by the buyer.
Risk regarding other shareholders comes from the duties imposed by courts on any shareholder representative. The representative is an agent of all of the former shareholders and has a legal obligation to ensure their best interests are adequately represented. This agency relationship means that the shareholder representative owes the former shareholders duties of due care, loyalty, good faith and fair dealing. In Delaware, the agent’s duties have been compared to, and described in the context of, those of corporate directors.
This creates a risk of personal liability for the representative if he or she is found to have failed to meet the duty of care or to have been negligent or grossly negligent in the performance of duties. Further, because the duties of the shareholder representative are analogous to those of a director, it is easier to accuse the shareholder representative of failing to protect other former shareholders if the representative has financial interests that may diverge from other shareholders or if the representative has an acrimonious relationship with other shareholders (such as former founders).1
Even if not challenged by other shareholders, the primary purpose of having a shareholder representative is to serve as agent in conflicts with the buyer or third parties. As a result, shareholder representative is one of the few roles a person can assume in which there is a material risk of doing nothing wrong but nevertheless becoming personally targeted in litigation. Being named as a party to a lawsuit can adversely affect the fund or person serving as representative through the obvious distraction and cost of litigation; potential negative impact on an ability to get a loan or insurance; and undesired disclosure requirements to limited partners or potential new investors when fundraising. Additionally, most funds would strongly prefer avoiding a public fight with a buyer they may see again on future deals.
These risks can be significantly reduced by simply not serving as the representative. Usually there is no need for shareholders to be named defendants, and if the buyer attempts to add them anyway, the shareholder representative can have the court dismiss them from the case.2
Forming a New Company to be the Representative is Not a Solution
On some deals, selling shareholders decide to form a new company (typically a limited liability company) to serve as the representative on the theory that any personal liability associated with serving as the representative will be largely eliminated because such liability will be limited to the new entity. There are several pitfalls with this strategy. First, is time-consuming and expensive to draft, review, edit, finalize and file with the applicable state agencies all the paperwork that must be completed to form a new entity, appoint its managers, designate its owners, and specify all applicable rights, obligations and privileges of the various parties. The total cost can be tens of thousands of dollars. Second, it is questionable whether the new entity would actually eliminate personal liability. If the new entity is merely a shell that is not well capitalized and does not follow formal corporate procedures, there is significant risk that a court could “pierce the corporate veil” and find the owners or managers personally liable in the event the new entity is sued. Finally, even if there is incremental mitigation of risk, the individual managing the entity still retains the same administrative burdens that require a commitment of time and effort to properly perform.
Retaining Control Without Serving as the Representative
Avoiding the above issues is obviously beneficial, but what about the uncertainty of ceding control to a third-party representative? Investors want to ensure that they can manage their investment post-closing just like they did previously. Fortunately, hiring an independent shareholder representative does not reduce control—only hassle.
When retaining a shareholder representative, the shareholders can specifically define in an engagement agreement what the representative must do, what communications it is required to convey to the fund or the shareholders generally, and what consents are required before it takes certain actions. The agreement can specify that the fund or a shareholder committee must be included in certain matters following closing, such as purchase price adjustments. The communication requirements can include both monthly updates and immediate notification in the event of a claim or other material matter. The result is that the fund and the other shareholders are able to contractually retain the desired level of control while shedding the burdensome aspects of the job. This is no longer an unproven concept and has been employed on hundreds of deals.
While private equity fund managers have for decades defaulted to the assumption that they can and should serve as the shareholder representative after the sale of a portfolio company, recent developments in case law and the emergence of low-cost solutions should cause them to reconsider whether assuming the role is really their best course of action on each deal. On some transactions, there may be no alternative. But on most, ample evidence demonstrates that it is neither the best use of their time nor a risk worth assuming.
1 See In re Trados Inc. Shareholder Litig., 73 A.3d 17, 41-42 (Del. Ch. 2013) (stating that deference given to directors under the business judgment rule might not be available when economic interests differ).
2 See Mercury Systems, Inc. v. Shareholder Representative Services LLC, No. 13-11962-RGS, 2014 WL 591218 (D. Mass. Feb.14, 2014) (“the common practice of appointing a shareholder representative is a helpful mechanism for resolving post-closing disputes efficiently and quickly.”).