In some situations, partners in a deal involving an asset- or relationship-specific investment can foresee the possibility that no third party will buy the interest of either partner if one chooses to exit – at least not at a price that reflects the value of the partner’s interest. This means the partners will have only each other as potential buyers, as in the case of the Inquirer. In this scenario, the partners need to consider how much assurance each can give the other that a buyout will occur, and how the price of a departing partner’s interest will be set. There are a few contractual mechanisms that address these issues, but with any of them, the solvency and liquidity of the parties at the time of a sale will influence their effectiveness.
One approach to an interparty sale is simply to provide in a contract that, if one party wants to sell its interest to the other, the parties will “negotiate in good faith” or “consider an offer in good faith.” When the time comes for a sale, however, the parties may well have different views regarding what constitutes good faith – and different views on how much value should be placed on each other’s interest in the company. If one side rejects the other’s offer, they may have to litigate both these questions, and the outcome of that litigation will be uncertain. A party contemplating exit under a good-faith standard, therefore, would have little assurance of a sale to its partner and little certainty, if a sale did occur, of receiving what it considered to be the right price.
A few years ago, the Carlyle Group, a private equity firm, bought the water system of Missoula, Montana. Carlyle’s purchase of Missoula’s water system was an asset-specific investment: its value depended on the city’s cooperation in facilitating its residents’ purchase of water. Missoula, at the same time, was dependent on Carlyle as the supplier of its water. The city would have liked to own the water system itself but had insufficient cash on hand to make an offer to buy the system from its then-owner, a private individual. The city did, however, obtain an agreement from Carlyle that Carlyle would “consider any offer in good faith” if the city wished to make an offer in the future.
Mayor John Engen told the press that he wanted a stronger commitment, but the agreement to “consider in good faith” was the best he could get. And from Carlyle’s perspective, a “consider in good faith” commitment was a cheap give – indeed, why wouldn’t Carlyle consider in good faith any offer that Missoula (or any other prospective buyer) made? Private equity firms are always sellers, at the right price. This was an interesting twist on the exit scenario in that it was a means by which the city could induce an exit as opposed to one in which Carlyle would initiate an exit. Nonetheless, the underlying issues were the same. How much assurance would the city have that it could buy out Carlyle at a price it could accept?
A few years later, when Missoula indeed made Carlyle an offer to buy the water system, Carlyle hired outside advisors to evaluate it and ultimately sent a letter to Mayor Engen documenting why it declined to accept the city’s offer. The fact that, shortly thereafter, Carlyle sold the water system to a third party for approximately 50 per cent more than Missoula’s offer confirmed that the city’s offer had been low. Missoula nevertheless took Carlyle to arbitration, arguing that Carlyle had not considered its offer in good faith – hoping to benefit from the vagueness of the term. The arbitrator had no trouble concluding that Carlyle had satisfied its obligation to “consider in good faith” any offer from the city; both because the obligation was minimal at best, and because Carlyle had engaged in a significant process to consider the offer
As the Missoula-Carlyle deal illustrates, the use of a vague standard in an exit mechanism, as opposed to a hard rule, can be problematic. It does little to reduce uncertainties around the possibility of exit and it creates the potential for costly litigation. Faced with such uncertainties, the parties will have less incentive to make asset-specific investments while working together, or to enter into a deal in the first place. Exit mechanisms that are rule-based avoid these disincentives – but as we will see next, they come with problems of their own.
A relatively simple process that avoids the uncertainty of a mere good faith negotiation commitment is an agreement that, if a party wants to exit, the business will be appraised by a professional appraiser and sold to its counterparty. The parties could further agree to a mandatory sale at the appraised price. Alternatively, the contract could state that the sale would only proceed subject to the agreement of both parties, but this, of course, would not assure the possibility of exit.
Under some circumstances, an appraisal may not be as simple as it appears. Let’s say the exiting partner had been contributing important skills, and its exit will reduce the value of the company. In that case, it is unclear what that partner should receive. If ownership had been 50-50, should the buyout price be half the company’s pre-exit value, or should the price reflect the disproportionate contribution of the exiting party? There is no right answer to this question. Ideally, the parties would negotiate this and specify an approach to valuation at the outset or during the course of their relationship, keeping in mind that they want to encourage each other to make optimal investments while they work together.
Reliance on a professional appraisal also raises the issue of how the parties will select the appraiser. How can they be assured of an appraiser’s competence and lack of bias? One approach is to provide that the parties will work together to select an appraiser from a reputable firm that knows their industry. Or, if there is an accounting firm or an investment bank that both parties trust, the agreement can provide that the appraisal will be done by someone from that firm who has had no prior contact with either party. This approach can still result in the parties disagreeing, and failing to select an appraiser, finding themselves in litigation, but it is commonly used.
Another approach is for the parties to agree that each will select an appraiser, and that those two appraisers will then select a third. Their agreement might further provide that the selling price would be the average of the three appraisals or would match the one in the middle. Hiring three appraisers is, of course, more expensive than hiring one, but if the value of the business is large enough, the expense can be justified by the reduced risk of an errant valuation.
Yet another approach is for both parties to perform their own valuations and give them to a mutually trusted appraiser to judge which is most accurate. If the appraiser must make a choice between only the two options provided, there will be an incentive for each party to be reasonable in its valuation. This method is a variation of baseball-style arbitration, so named because an arbitrator in a professional baseball salary dispute must choose between the two offers proposed by the team and the player.
Excerpted with permission from Deals: The Economic Structure of Business Transactions, Michael Klausner and Guhan Subramanian, Harvard University Press.