In our prior post, we identified 8 common means used to protect minority investors’ stakes in start-ups. In addition to considering those, minority investors should be aware of their ability to exit their investments. Typically, investments in privately held companies are illiquid. This can be either positive or negative to a minority investor, depending on the context. In a positive light, such restrictions help maintain the same investors and the majority investor may have been a reason the minority investor bought into the venture. However, if the minority investor desires to sell its interests in the venture, it may find it exceedingly difficult to exit.
Minority investors often try to negotiate for some of the following exit rights:
- Put Options:
A put option requires the venture or other shareholders in the venture to buy out a minority investor if specified circumstances occur – typically if an exit has not occurred within a stated number of years. The specific circumstances would need to be negotiated, but failures to meet milestones and breaches of certain covenants are a couple examples that a minority investor may deem desirable and worth negotiating for.
- Tag-Along Rights:
Tag-along rights provide that a minority investor must be allowed to participate on a pro rata basis if the majority owners (usually the founders) sell some of their equity to a third party.
- Drag Along Payment Rights:
A drag along right requires a minority investor to participate in the sale of the venture (or sale of a controlling stake in the venture) and is typically requested by a majority holder. If such provision is proposed or demanded by the majority investor, a minority investor may want to consider requesting that the sale proceeds be allocated according to equity percentages and paid in cash, or another agreeable form.
Keep in mind that the list of minority protections and exit strategies above is not exhaustive and even some mentioned here are not always appropriate depending on the context. The rights a minority investor should focus on is immensely situational, based on a variety of factors including the strength of their negotiating leverage, the relationship with the majority investor and the minority investor’s desire to be closely involved in the venture’s dealings. Start-ups need to understand minority investor’s motivations and think ahead about where their ventures are headed when evaluating proposals from minority investors.