By the mid-1960s, Ferdinand Porsche’s relatively young car company was looking for an opportunity to attract more buyers to its admittedly quirky brand of sports cars. A marketing axiom in the auto industry at the time was “race on Sunday, sell on Monday”, and Porsche was hoping to enter a variation of its popular 911 Carrera in the GT, or grand-touring, class. GT racing worked well for sports car marketing because the vehicles were so similar to those sold for regular driving, even though the race cars were limited-run, purpose-built vehicles. The GT class was dominated, at the time, by Italian automakers like Ferrari with large displacement, twelve cylinder engines mounted in the front of the car. Porsche had a lot to prove, as at the time the concept of a flat six-cylinder, rear-engine sports car was considered pretty eccentric. Porsche’s big racing advantage was not huge power so much as huge brakes, which, combined with its light weight, made the car faster in the corners.
Porsche’s 1967 entry in the GT races, the 911R shown above, looked like a regular 911, but was otherwise different in every respect, with a larger displacement motor generating an extra 50 horsepower, a fiberglass body which shaved several hundred pounds off the car’s weight, and fewer creature comforts (no rear seats, no radio, no air conditioning). Everything on the car was focused on racing, and it was successful – winning the Tour of France and the Tour of Corsica in 1969. But the car wasn’t good for much else, (like driving to work), and when Porsche studied the economics of trying to sell the 500 units required to qualify for this class of racing, they decided to drop out.
I was thinking about the 911R recently while reviewing a client’s buy-sell agreement. Buy-sell agreements are peculiar contracts between shareholders with a very specific purpose: to provide for the transition of ownership and liquidity in a business, usually in case of a specific event. Outside of a particular event, buy-sell agreements usually sit on a file server or in a desk drawer, and no one thinks about them, until a need arises to pull out the agreement – at which point no one can think about anything else.
We’ve written much about buy-sell agreements at Mercer Capital, probably because we’ve seen so many of them become the centerpiece of huge disputes. Often the dispute is focused on matters of valuation, so while we’re not lawyers drafting these agreements, we have often been presented with shareholder agreements and asked to “interpret” them by providing a valuation of a company or an interest therein subject to the terms of the contract. Often, those terms are unclear as they pertain to valuation.
And while Mercer Capital serves clients across a broad range of industries, we’ve had as much experience with the ambiguities and subsequent pitfalls regarding buy-sell agreements in RIAs as anywhere. The investment management community is perhaps uniquely suited to having problems with buy-sell agreements, because
- There are so many RIAs (over 11,000 at last count).
- Few asset managers are family businesses (most owners operate professionally at arms’ length from day one).
- So many investment management firms are highly valuable (such that there’s a lot to fight over when the issue arises).
Lots of asset managers don’t like to think about practice management any more than they have to, but spending some time reviewing your buy-sell agreement is probably one of the best price-to-value uses of time you will find. “Fixing” issues with buy-sell agreements is fairly inexpensive and painless – but only when there is no immediate need to actually use the agreement for a transaction. Left unattended, an inadequate buy-sell agreement (and most are inadequate in some way) can lead to a multi-million dollar dispute over the value of an interest which can lead to a multi-million dollar expenditure of fees to handle the dispute. This is not hyperbole.
So, while Mercer Capital has written generally about the topic of buy-sell agreements, we’re going to spend the next five or six blog posts on the topic of these agreements specifically as they pertain to RIAs. While we are obviously not attorneys, we will review what we think are important valuation topics to cover in shareholder agreements, how to cover them, and where we have seen expensive disputes break out.
At our firm, we help clients with structuring buy-sell agreements, do regular valuation analyses to set transaction pricing for the purpose of buy-sell agreements, and offer dispute resolution services when things run off the road. The goal of this blog series is to help our readership manage their ownership more efficiently and more predictably to serve the operations of the business. While dispute resolution work can be very good work for us, we’re not too concerned about ownership disputes drying up in the investment management community. Our blog readership isn’t quite that loyal, yet.
Next chance you get, pull out your shareholder agreement and read it. Is it perfectly clear what will happen if, say, someone dies unexpectedly and the buy-sell provision is triggered? Can you tell how the interest will be valued, know roughly what the value will be, identify the buyer, and know how the obligation to purchase can be funded?
Like the 911R, your buy-sell agreement is purpose built, but is presently sitting – maybe in the dark, unused. But unlike the 911R, your agreement’s “racing days” are not over, and it’s not a museum piece. Instead, it’s more likely than not that you’ll have to roll it out one day and find out if your buy-sell functions as it’s supposed to. We’re recommending a test drive. More next week.