Mergers and Acquisitions Involving Family-Owned Targets
Family-owned and controlled companies are the backbone of Latin American economies. More than 85 per cent of the companies in the region are family owned, accounting for 60 per cent of the region’s GPD and employing more than 70 per cent of its workforce. In Colombia, for example, as at 2018, 86.5 per cent of operating companies were family owned. Despite recent concerns due to political instability, election cycles and social and economic turmoil, mainly driven by the effects of the global pandemic, 70 per cent of private equity firms plan to invest in the region between now and 2025, and many families in the region are migrating or increasing their investments outside of their countries of origin, either to diversify risk, because they have reached high levels of concentration in their countries, or because of fear of political and social instability that may disproportionately affect them in their own markets. These facts mean that if you work in M&A in Latin America, chances are you will encounter family-owned targets. Therefore, understanding the particularities of these transactions is key for any practitioner involved in M&A in Latin America.
These deals have many of the same characteristics and challenges of any M&A transaction, with the added complexity associated to the family’s strong attachment to the target. Guisser and Gonzalez note that ‘insensitivity on the part of buyers and advisers to particular issues that arise in the context of the family-held company has created real problems in many transactions’. These issues can be grouped in three categories: the (understandable) lack of M&A experience of the family facing what is likely a once-in-a-lifetime transaction; the deep economic entanglement between the family and the company; and the strong emotional bond with the business. The combination of these three variables will determine the complexity of the deal and will permeate the dealmaking process. If they are not properly managed, the dynamics of the deal may become problematic to the point of affecting, delaying or even frustrating signing or closing. However, if the process is well handled, these challenges will be compensated with factors such as the transfer of knowledge of the business and its market as well as the relative ease resulting from not having to comply with capital markets regulations applicable to publicly traded companies.
Within this framework, at the intersection of these three variables, this chapter explores the particularities and complexities of M&A transactions involving family-owned companies. The first section describes the deal dynamics and the main challenges in that respect. The second section focuses on substantive points of negotiation that are relevant and perhaps unique to this type of deal. The third section sets forth certain considerations regarding partial sales, particularly shareholders agreements and exit rights. The fourth section concludes.
Deal dynamics: no two families are alike
Data shows that family-owned businesses generally do not get involved in acquisitions. The aversion to acquisitions may be explained by the fact that families may not want to risk their financial autonomy or are not willing or do not have the financial means to inject into the business large amounts of capital usually required to complete an acquisition. However, this assumption may vary in the coming years. Due to the political uncertainty in the region and the devaluation of Latin American currencies against the US dollar, we have seen more families seeking to diversify their risk and open to investing in other markets.
Even though no two families (and no two transactions) are alike, the following are certain matters to consider when working with families on either side of the equation.
Is the family ready to sell?
Unlike institutional shareholders, families think in terms of years, decades or even generations. Therefore, it is not surprising that M&A deals involving families take a long time to build up. Even when a handshake agreement is in place, execution may lag for months or years. In approaching a family, it is extremely convenient to ask if they are truly ready to sell. This can be a function of some of the following variables. First, succession is critical. If the younger generations are not actively involved in the company, this may be a signal that a sale may be in the horizon. Second, families will typically look at long-term market conditions, with a view to strike the best possible price for their lifetime investment. This equation will probably combine the maturity of the business with good market prospects. Third, country risk in Latin America will play a major role in a family’s decision to exit an investment, especially considering the current political polarisation in the region. Fourth, a family will look at its legacy, seeking to assure that the company they consider their life’s work will endure through time. Failure to understand if a family is ready to sell or not may be frustrating for buyers, and it is, therefore, advisable to fully assess these and other circumstances before putting the pedal down at full speed.
When should counsel be engaged?
The short answer is the sooner the better. Engaging counsel early in the process can help the family understand and organise the process efficiently from the beginning. It may also assist the family in identifying the issues that will be pivotal in the transaction. Even if counsel is not engaged at the very outset of the process, families should reject the temptation of entering into preliminary agreements (see Chapter 14 of this guide on preliminary agreements) without adequate legal advice. A somewhat common challenge that M&A counsel face when they are hired after the execution of a preliminary agreement is finding that it contains agreements on matters that would otherwise be purchase agreement material (typically not precisely in the benefit of the family). These may include procedural terms, such as exclusivity periods, pre-signing covenants, or substantive terms, such as commitments regarding conditions precedent or the indemnity package. In these circumstances, attempts to re-establish the balance at a later point must be carefully proposed because they can affect the trust and credibility of the parties in the process.
Legal advice may also prove useful for the family in the negotiation of mandate agreements with bankers and other advisers.
Identify the decision-makers and potential sources of tension
Whether you are advising the seller or buyer side, you need to understand the dynamics of the family and the decision-making process within it. This knowledge will enable counsel to anticipate possible sources of tension and be prepared to solve them when they arise. Very early in the process you need to understand who will be leading the negotiation and what is the scope of his or her authority, the clusters of family alliances, the generation to which the respective family members belong, and the majority required to approve corporate actions. For instance, the dynamics of the deal are completely different when you are dealing with parents and their siblings, than when you are dealing with the extended family.
In this context, it is particularly relevant to understand if all the members of the family are aligned in connection with the transaction. If they are not aligned, you must be sure that the family members that are on board with the sale have the majority required to approve it or to transfer control (or the desired stake). Also, although rare, it is crucial to understand if there are rogue family members that may oppose the transaction or may seek to behave opportunistically to extract non-proportional value. In any event, early active discussion with the financial and legal M&A advisers to address any opposition to the transaction is highly recommended. More often than not, opposing family members are better persuaded if they are brought closer to the deal team and actively provided information to build up their trust in the process.
Once the decision-making process has been nailed down, the following tools may be useful to navigate it. When trust among the family members is strong and there is a salient leader, all the family members may grant a proxy to that person and this may be the best way to guarantee deal certainty. Needless to say that the proxy has to be carefully drafted to make sure that it includes all the actions involved in an M&A transaction, such as the transfer of shares, compliance with foreign exchange requirements, negotiation and execution of the transaction documents, and so on. When a proxy is not in the menu, it may be prudent to design an organised approval process involving committees, defined timelines and other internal agreements to make sure that the process advances swiftly. It is also crucial to make sure that all the family members are comfortable with the fact that the M&A advisers are acting on behalf of the entire family, thereby preventing the proverbial last-minute request of a family member to involve his or her own counsel to review the entire transaction (and even provide mark-ups) a few days before signing. Evidently, establishing trust in the deal advisers becomes even more important when different family clusters are acting independently.
Make sure that the family fully understands the proposed transaction
An M&A transaction is a ‘singularity’ for a family. Although they are real experts in their business, they are not necessarily (and do not need to be) familiar with the particularities of an M&A process. From the seller’s perspective, one of the best uses of M&A counsel’s time may be to engage in an M&A ‘masterclass’ with the members of the family or the target that will participate in the transaction. This provides the opportunity to explain to them how the process works, the expectations of the buyer during due diligence, the structuring alternatives, the details and key customary terms of the stock purchase agreement (and in fact what ‘SPA’ and other common M&A jargon means), the dynamics of the negotiation and the timing of each of these steps.
The sellers will likely be nervous about the process as this is a novel experience for them and the stakes cannot be higher. This exercise will help them understand and be prepared for what is coming, mitigate their fears and build trust in their M&A counsel. Throughout the process, it is convenient to regularly ensure that the family fully understands the terms of the transaction.
Working with trusted advisers
Families regularly rely on their traditional lawyers, who may not necessarily be M&A specialists. What they may lack in experience in this field they usually compensate with their knowledge of the business and the trust and report they have built with the family over the years. Some act as real ‘consigliere’, which gives them enormous influence over decision-makers, including as frequent observers in board meetings and crucial company events, and other family celebrations. Therefore, as a matter of loyalty and trust, sellers often hesitate to engage sophisticated M&A lawyers for the transaction. Alternatively and perhaps more frequently, they hire an M&A adviser to team up with their trusted adviser. If you are on the seller’s side, this means that you have to educate your client and work in a coordinated manner with your colleague, combining his or her knowledge of the business and the sensibilities of the family with your M&A expertise. This yields strong synergies and deal advantages for the family.
Every once in a while, perhaps increasingly infrequent as M&A markets mature in the region, buyer’s counsel has to work in a deal where the selling family has not engaged M&A specialists. At first sight, it could appear that this lack of expertise on the sell side will make the deal a ‘piece of cake’. However, reality may often prove to be the opposite. The lack of expertise and the fear of being outperformed or fooled is the perfect cocktail for a nightmare negotiation. A counterparty who does not speak the ‘language of M&A’ may oppose the most standard provisions simply out of unease or lack of expertise. This is why it is wise for buyers to advise the family to engage M&A specialists. If, despite this, the sellers have not hired M&A advisers, buyer’s counsel needs to ensure that the sellers and their advisers properly understand the M&A terms of art and the detailed terms of the transaction documents, so they can trust your expertise and feel comfortable with the reasoning behind your comments and positions with regard to the terms of the transaction.
There are a few good tools to address this issue. A good starting point can be the preliminary agreements, which are shorter but, at the same time, allow the parties to set their expectations in respect of the transaction. From the advisers’ standpoint, these initial agreements provide the opportunity to bring the M&A terms of art to the table and explain their relevance in the transaction. Another useful tool to inspire confidence in the counterparty about the M&A terms of art is to use deal point studies, which are studies that survey, record and portray the market standards in the negotiation of certain sensible topics in M&A deals. For example, these studies can be used to illustrate to the parties the market ranges for caps, baskets, de minimis provisions, survival periods and the like.
The due diligence process
In April 2021, a panel of 100 senior-level private equity fund managers were asked about the biggest complexities when engaging in a cross-border investment. Fifty per cent responded that the biggest complexity is the due diligence. Regarding the key challenges that they face, 39 per cent of the fund managers referred to insufficient levels of transparency in information supplied during the due diligence process. This is additional evidence that due diligence is not a mere formality but a major driver of the transaction, including for pricing, certainty of closing and growth opportunities.
Due diligence is a very challenging process for a selling family for at least two reasons. First, it carries an important emotional component. A significant hurdle is helping family members understand that disclosure is in fact in their own benefit, since it will enable an adequate risk allocation exercise and will help protect them against a future breach of representations and warranties. Families also need to be advised that it is reasonable and not uncommon that the buyer identifies some contingencies and liabilities. This by itself will not trump a deal; inadequate disclosure may. All of this may sound counterintuitive to some families and may feel like asking proud parents to identify the flaws or weaknesses of their children. Again, the key to managing this emotional hurdle is to educate the family on the importance of due diligence and the benefits of disclosure, while negotiating the best possible deal terms for them.
Second, a due diligence process may be disruptive to day-to-day operations. The process will demand significant resources from the company and will require the involvement of senior management and key employees. M&A counsel should help the family navigate this process. Some key recommendations include tasking investment bankers with the interface with potential buyers, engaging a professional virtual data room provider expert on record keeping tailored to the M&A process and confidentiality and cybersecurity controls (with the exception of very small deals, stay away from Dropbox, Google Drive or other similar cloud-based platforms that do not provide those functionalities), ensuring that the family appoints one key person in the company who will be coordinating all the diligence efforts; designing with management the architecture of the data room (from the overall folder structure to details such as naming the files according to their content); providing advice as to what information is relevant and what information is not (for example, by defining materiality thresholds), etc.
A well-conceived and organised data room will save tons of work and time, send a powerful signal of good management to the buyer and help strengthen trust during the process.
From the buyers’ perspective, the main challenge arises when the sellers do not hire investment bankers or M&A counsel for the process, and they prefer to use their internal resources for the due diligence process. Working on the due diligence directly with the employees of the target is not per se a bad idea; it has its pros and cons. On the one hand, it is very useful for the buyer to have a direct relationship with the individuals that have handled the issues in the target and that really know the particularities of the business. On the other hand, sometimes managers and employees feel a need to minimise existing issues rather than address them objectively, mainly because they are worried the issues may reflect poorly on them personally, and thus may feel challenged and audited by their counterparty (sometimes resulting in fear of losing their jobs as a result of the deal). To benefit from a direct relationship with the target while ensuring an effective diligence process, buyer’s counsel needs to approach the employees respectfully, making them feel comfortable sharing the information and their opinions about the issues under discussion, while explaining the need to be open and candid about the facts of the business. As with everything in life, being respectful is key to success.
In the age of information, protecting the trade secrets and the confidential information of the family business is a crucial aspect of an M&A deal. We suggest considering at least the following aspects. First, if the buyer is a competitor (which is quite usual), the family should be advised that the execution of a standard confidentiality agreement may not be enough, mainly due to hardship proving breach, damages and causality. It is, therefore, prudent to complement it with other practical measures to protect the most sensitive information of the company. For example, the disclosure of price lists, clients, suppliers and other strategic matters may be delayed until an advanced phase of the process, when approaching deal certainty. In addition, logistical protections can be put in place, such as limiting the ability to print or download the information from the virtual data room and password protect certain key documents. Further, when there are antitrust concerns, the buyer may be required to set up a ‘clean team’ to make sure that material non-public information is only accessed by persons that are not engaged in the day-to-day business of the acquiring company.
The second aspect is to consider if the family members need or prefer to keep the deal confidential. In addition to commercial, financial and strategic reasons, anonymity is typically important in our region due to security and privacy concerns. To address this, the transaction documents must include robust confidentiality provisions restricting public disclosure. Of course, buyers may oppose this since they may be interested in announcing the deal for commercial reasons or may be required to do so for legal reasons (for example, securities regulations). When this is the case, the parties may agree on what information may or not be disclosed freely. For example, the family may accept that the transaction be disclosed but may request the buyer to keep the price and the identity of the family members confidential to the maximum extent permitted by law. In these instances, it is also prudent to make sure that the confidentiality agreements with the advisers include express provisions to avoid any undesired disclosure of the transaction.
Finally, the sellers need to determine how to maintain the confidentiality of the transaction during the negotiation process to avoid speculation and anxiety among the company’s main stakeholders. For this purpose, it is advisable to engage a limited number of employees in the process and ask them to sign confidentiality agreements in a personal capacity. Key employees may be offered a success or retention bonus if the transaction is consummated to align interests. They should also be made aware of the adverse effects that any leakage may cause to the process.
Negotiation of the transaction documents: do not underestimate the seller’s attachment to its ways
When sellers are not used to participating in M&A transactions, there is a natural tension between their pragmatic approach and the standards set by sophisticated investors. Family businesses are usually entirely built by their owners: very successful entrepreneurs that can recall how they started their business from scratch with just a briefcase, a phone and a lot of hard work. Many sellers also believe that they have built their business based on the effectiveness of a reliable handshake and are confident about their approach and instinct for business.
However, M&A practice and standards are clearly not as simple as a handshake. This creates a natural tension between sellers and buyers, especially with institutional buyers who need to meet certain standards for obtaining the approvals of their investment committees. While one side of the table aims for a short agreement, evidence of the wire transfer and a well-earned vacation, the other party needs a comprehensive agreement with robust risk allocation clauses and a detailed disclosure under recognised international standards and best practices.
In this scenario, it is advisable that the M&A specialist take control of the documents and be as efficient as possible. It is not an easy task, but it is necessary to meet the client’s needs and facilitate the decision-making process. Naturally, in that case, counsel should produce balanced documents and avoid departing from customary terms. All the time saved on the drafting of the agreements may be wasted if the counterparties lose trust in the M&A specialist. Finally, provide the counterparty a reasonable time frame to read and understand the agreements, and include contractual provisions that protect the integrity of the agreement by having all parties acknowledge they had the opportunity to hire counsel and receive advice, and no negative inference should be used against the drafting party.
Upon closing the transaction, the family will likely experience a major liquidity event. Counsel can help the family prepare for this by making adequate tax planning and wealth management. The financial advisers of the family may also play a key role in this respect, helping them diversify their investments and setting up the required infrastructure to manage the resulting liquidity.
Substantive points of negotiation
Once we have tackled the deal dynamics, it is time to address the major substantive points that are relevant when the target is a family-owned company. In addition to the standard provisions and the usual hurdles of an asset or share purchase agreement (such as the price adjustment mechanism, the conditions to closing and the indemnity package), the following matters require special attention.
Untangling the family from the business: related party transactions, commingled assets and guarantees.
Regardless of your side on the table, special attention needs to be paid to the entanglement between the affairs of the family members and the affairs of the target.
First, related-party transactions need to be assessed to determine which of them should continue after closing. If members of the family will continue providing services to the acquired target, ensure that such agreements are duly reviewed and, if required, amended and restated to include arm’s-length provisions.
Further, the company may own assets that are unrelated to its core activities and are in fact devoted to the family. This may be the case with respect to real estate, vehicles, etc. The opposite may also be true; certain core assets of the business may be registered under the names of family members. For example, a relevant brand or software, real estate or other asset. Both buyer and seller must be fully aware of this situation to set forth the appropriate contractual provisions to transfer these assets to their rightful owner taking into account the perimeter of the transaction. Counsel should anticipate and to the extent possible minimise or avert delays and adverse tax consequences in connection with the transfer of these assets.
Finally, it is also common that the family members have provided personal guarantees in connection with the business of the company, or vice versa. For example, it is common practice in Latin America that banks require the shareholders to issue personal guarantees to secure the loans to the company. These guarantees need to be replaced on closing or shortly thereafter, and the transaction documents must set clear deadlines and procedures to do so.
From owner to employee
Regardless of whether the transaction is structured as a full or a partial sale, family members may continue to be employed by the company after closing. This may be beneficial for both parties. Sellers may benefit personally, by making sure that they retain a source of income and professional engagement. This may also have important emotional effects on certain family members, making it easier to close a deal and secure a swift transition. Buyers may also benefit greatly from this. The expertise of the family members in the management and the business of the company can be crucial to boost its performance. When this happens, the golden rule is to make sure that the terms of engagement are clear both in paper and in the minds of the persons involved.
Buyer’s counsel should identify the type of engagement that the family members had with the company prior to the transaction. It is not unusual to find that no written agreement exists and, when it does, that its terms are different from those that apply in reality (particularly regarding salary and other benefits). To avoid future liabilities in this regard, it is advisable to consider whether it is necessary to terminate and settle the prior arrangements between the family members and the company and enter into new agreements upon closing. Going forward, the parties must clearly set forth the new rules of engagement, which, in addition to economic benefits, can address issues such as the policy for business travels, the number of hours per week that the family member needs to commit to the business and non-compete matters.
Counsel for the sellers should make sure that the expectations of the family members are properly addressed. Perhaps the most outstanding item in this respect is stability. When the family member intends to retain its position after closing (an item that may be part of the economic rationale of the deal), including in the case of an early exit of the investor or the arrival of new investors, it may be advisable to negotiate a golden parachute (a provision to guarantee a financial compensation to the executives of the target if they are dismissed within a certain period after a merger or a change of control of the target). Also, counsel should guide its client in making sure that other matters are clearly agreed upon, such as extended vacations, performance bonuses, dedication and the possibility to engage in other businesses.
Finally, it is worth making sure that all family members that continue to be engaged by the company fully digest that their role will change dramatically, from that of owner to that of employee.
Non-compete provisions are especially important and challenging in connection with family-owned companies. Buyers usually look forward for broad non-compete provisions as part of the bargained-for benefit flowing from the acquisition. A former owner engaging in a competing business shortly after the transaction has the potential to significantly detract from the value of the business and its projections as factored in by buyers in their financial models. This is a real concern in this setting since family members possess deep knowledge of the market and a strong network. On the other hand, families may be particularly sensitive to non-compete restrictions, since they have spent all their life in a particular business, and they do not want to completely give up opportunities that may arise in their area of expertise. Also, the discussion of non-compete provisions and adequate compensation thereof may be a source of tension among family members because the family members that actually work in the relevant business will be disproportionately impacted by the non-compete. The counsel’s job here is to strike the right balance, making sure that the buyer can take the benefit of an interference-free business for a reasonable period, while the family can continue to engage in certain permitted activities.
The drafting of a non-compete provision is a subtle art, but broadly speaking, it gravitates around the following questions:
- Who will be bound by the non-compete? Yes, the family members. But all of them? What about spouses? What about family members who sell a small stake (e.g., 5 per cent)?
- What is the scope of the restriction? In this respect, in addition to defining the restricted activities, it is possible (and quite common) to define specific exclusions or exceptions to make sure that the family can continue developing existing non-core businesses or lines of business in the pipeline that may fall in a grey area.
- What is the duration? Two to three years appears to be on the safe side and five years seems to be approaching the outer limit of enforceability in most jurisdictions.
- What is the territory within which the sellers cannot compete? Typically, this should match the current geographical scope of the business. As portrayed, there are rules of thumb for each of these questions, but in the end it will be the counsel’s specific task to adjust these variables to come up with a construct that is agreeable to both parties and tailored to the particular circumstances.
From a more technical perspective, the buyer’s counsel should make sure that the agreement is enforceable in the respective jurisdictions, particularly in light of antitrust rules. Matters seem to be converging in the region in this respect, with the authorities enforcing reasonable non-compete provisions in the context of M&A transactions. In Colombia, for example, non-compete provisions were considered per se anticompetitive until 2010. However, this changed with the increase of M&A activity. That year, the Colombian competition authority indicated that non-compete provisions are enforceable if they (1) do not constitute the main purpose of the contract, but rather a secondary obligation of a broader deal (such as an M&A deal); (2) are reasonable in both geographic scope and term; and (3) are necessary to maintain the value of the broader deal.
Another issue to consider is whether a non-compete is enforceable vis-à-vis an individual (as opposed to a company). In certain jurisdictions, an individual may successfully challenge a non-compete provision based on constitutional grounds (e.g., the individual’s constitutional rights to freely choose its occupation or the right to employment). In these cases, the purpose of the non-compete could be satisfied by means of other commercial agreements in aid of the non-compete clause, such as provisions seeking to limit the possibility to use the know-how of the target (e.g., with strict confidentiality agreements) or requiring the individual to invite the buyer to participate in new competing businesses.
Negotiating the security package to protect the family’s patrimony
Many M&A practitioners will agree that the indemnity package tends to be the one of the elements of the purchase agreement on which the parties focus much of their attention. This may be even more relevant when families are involved because post-closing indemnification payments directly affect their personal wealth (unlike large publicly traded corporations or investment funds).
A poorly balanced indemnity package may expose the family’s patrimony and lifetime’s work, eroding the benefits of the transaction as well as imposing long-term organisational, administrative, accounting and liquidity requirements. The following are some of the salient challenges in this respect when dealing with a family-owned company.
No recourse or an ‘as is where is’ standard is not common in private M&A transactions. A good indicator of this is the fact that deal points studies generally do not address the percentage of deals without indemnification provisions. However, selling families sometimes express that they do not want to be held liable for any loss after the closing of the transaction and they often don’t appreciate the fact that such expectation, if it can be met at all, would likely come with a significant discount on the price tag or a reduction in the number of parties interested in acquiring the business. M&A practitioners need to be prepared for this discussion to show the family the pros and cons of agreeing to certain indemnification obligations.
From the seller’s side, counsel must pay extra attention to the elements of the indemnity package and discuss thoroughly with the family the terms thereof. The overall exposure will mainly be a variable of the amounts assigned to the cap, the survival period, the basket, and the de minimis provision. Different sellers may have different preferences and company dynamics may warrant different treatment from deal to deal. Some may prefer to have a higher cap but a shorter survival period, while others may prefer the opposite. Some may prefer a high tipping basket, others may prefer a lower deductible basket. These examples are an oversimplification, since the above-mentioned elements may be combined through multiple permutations, but they show the importance of working closely with the family to explore what works best for them.
From the buyer’s perspective, the indemnification obligations may only be as good as the collateral backing them. For good reasons, creditworthiness going forward is a significant concern of buyers when sellers are individuals instead of operating companies. The most typical mechanism to secure indemnity payments is to deposit in escrow a percentage of the purchase price or to hold back such amount for an agreed period (see Chapter 16 of this guide). Escrow or holdback provisions may also benefit the family when several of its members are acting as sellers. Indeed, it may alleviate the debate between joint and several liability, it may act as a reserve for the family to attend for future liabilities and it may reduce coordination costs in case of litigation.
Representation and warranty insurance is slowly becoming another option to address these problems. Although it is common practice in the United States, this type of insurance is just taking off in Latin America and currently it is costly and not always easy to obtain, especially for medium- and small-sized transactions. However, we expect that these products will gain more traction in the market considering their effectiveness in protecting the interests of the buyer and releasing the seller from post-closing indemnification obligations.
Earn-outs in the 'Age of Uncertainty'
After the social and economic impact of the covid-19 pandemic, Latin America has continued to see political instability and social tension that has been fuelled by the rise of far-left governments in Chile, Peru, Mexico and Colombia; the war in Ukraine and its worldwide impact in food supply and energy; inflation and interest rates reaching all-time highs; and a global recession around the corner.
Uncertainty affects business valuations. Sellers argue that their business should be valued based on their proved performance, their resilience and the market's outlook, while buyers argue that they cannot attribute such value due to the uncertainty. Against this background, earn-outs have become a useful tool to bridge valuation gaps. This comes as no surprise. As a historical reference, earn-outs and other contingent value rights were also highly used in the aftermath of the 2008 financial crisis. Earn-outs are contractual provisions whereby the buyer agrees to pay an additional consideration that is contingent on future facts or circumstances, such as the achievement of certain performance targets.
From the legal advisors’ perspective, the drafting of an earn-out is a challenging task. First, the earn-out refers to events that will occur in the future, therefore the earn-out targets may become outdated or inappropriate. Second, the new management of the company may affect the satisfaction of the conditions that trigger the payment of the earn-out or, if the sellers continue to be involved in the management of the target, they might face a conflict of interest. Finally, trying to anticipate all the potential interpretative issues and the potential to negatively impact the likelihood of achievement of the relevant metrics makes the earn-outs time-consuming to negotiate and an easy target for future dispute.
For these reasons, a good set of questions, including the following, could be useful to facilitate the drafting efforts and to help the parties to be clear about the scope of the earn-out:
- Upon what basis will the earn-out be measured (e.g., earnings, revenues, cash flows)?
- Will the measurement have exclusions (e.g., transaction expenses, revenues from unrelated businesses, interests)?
- What is the specific formula to determine the contingent payments, and what is the basis to determine the contingent payment (e.g., a flat amount, a percentage, a multiple)?
- Will the seller have the right to participate in the management of the target post-closing? And if the answer is yes and the seller has fiduciary duties (e.g., the appointment of independent members of the board or audit committees), do the parties need to negotiate a mechanism to address potential conflicts of interest?
- Will the buyer be subject to post-closing covenants with respect to the operation of the business (e.g., will they operate in the ordinary course of business or consistent with past practices)?
- Will the earn-out payment, if applicable, accrue interest?
- Is the buyer’s payment obligation secured by an escrow, letter of credit or some other guarantee?
Considering that earn-out provisions are included in the main transaction documents described in this chapter, all the challenges related to the particularities of negotiation with family members (e.g., working with trusted advisers of the family, or the seller's attachment to its practices and procedures) are applicable and worth considering.
Special considerations regarding partial sales
One of the most relevant questions when a family is considering a sale is whether to sell less than 100 per cent of the target. This decision will determine the structure of the transaction, the terms of the transaction documents, the type of relationship with the prospective buyer, the future relationship with the company, etc. The following are some relevant issues to consider in this respect.
The rationale for a partial sale
Family-owned businesses are attractive for strategic or private equity investors because, in addition to their profitability and position in their markets, they are diamonds in the rough with much room for improvement. It is not unusual that buyers (especially private equity funds) prefer partial acquisitions as they look to create synergies with the deep market knowledge and robust network of the family.
From the seller’s perspective, it is not uncommon either for the family to opt for a partial divestment. If it wants to retain control, institutional investors may bring fresh funds to boost the performance of the company or to develop the projects that the current shareholders have not been able to fund. On the other hand, if the family prefers to keep a minority stake, they can profit from the results of the new management of the company without having to put all their wealth at risk.
Both sellers and buyers may also seek for two-step acquisition structures in which either party has the right to buy or sell, as the case may be, the stake retained by the family at a future time (for example, three or five years later). A buyer may be attracted by this structure since it permits the buyer to implement an organised, phased-in takeover of the operations and to fully capture the know-how of the family. This structure may also allow the family to benefit from the upside resulting from the buyer’s injection of capital or managerial assets into the company by selling the retained stake at a better price in the future.
The starring role of the shareholders’ agreement
In any situation in which the family is retaining an interest in the company, a shareholders’ agreement becomes a critical tool of the new alliance. If the family is selling control, there is even more pressure to enter into a shareholders’ agreement that adequately protects its interests after losing the ability to guide the business and take corporate decisions. Shareholders agreements go beyond organisational matters; they become long-term operational rules. They help facilitate the adjustment process that family members must undergo after closing a partial sale, including adjustments related to (1) the loss of some or all of the power to take the decisions of the target at their own discretion, (2) the loss of social clout associated with the business and (3) the loss of control over the finances of the target and the need to separate them from their own finances.
It is difficult for family members having to report and be accountable to third parties, to be forced into imposed schedules and be required to discuss and reach agreements with buyer-appointed individuals with whom they have not yet built relationships and who have different approaches to the business. It is particularly challenging to realise that they cannot spend or invest the money of the target at their own discretion. There is no pre-established formula to facilitate the process of detachment that the family members must go through, but a strong and robust shareholders agreement and clarity during negotiations help avoid unnecessary conflicts. Among others, the shareholders’ agreement must help resolve the following questions:
- How are relevant decisions taken and what will be the role of the family in this respect?
- How will the board be appointed and how many members will the family nominate?
- Who will be manage the company on a day-to-day basis?
- What happens if the family and the investor have a major disagreement regarding the future of the company?
- When and under what conditions will the family have a right to sell its remaining interest?
The shareholders agreement is a highly fact-sensitive document, which needs to be tailored to the specific circumstances at hand, including in connection with the ownership structure of the company and shareholder groups thereunder, the type of business and the industry and jurisdictions in which it operates, among other things. Latin American M&A practice has largely drawn from US practice (mostly New York and Delaware) with respect to the structure, drafting approach and subject matters covered in a typical shareholders agreement. However, M&A practitioners have tailored these instruments to make them compliant with local law and with local business culture. In this context, regardless of the applicable law of the transaction documents, M&A practitioners need to be wary of unchecked use of forms that have been designed with a US or other foreign perspective in mind to enure that they are suitable for the local context.
Veto rights are extremely important for the minority shareholder (quite often the family). In the absence of contractual veto rights, it is possible that corporate law affords little to no power to the minority shareholder to object major (or any) decisions at the shareholder level. That is certainly the case in Colombia. Therefore, if the family has transferred control, it should seek to retain a reasonable set of veto rights. The extent and strength of these rights will depend on the size of the stake retained and the bargaining power of the parties. There is no clear objective threshold, but the list of veto rights will undoubtedly look different if the family holds, for instance, 20 per cent instead of 49 per cent. In the first case, a minority shareholder will typically only retain protective rights, which are aimed at protecting the economic investment of the shareholder. Some customary vetoes in this respect include anti-dilution rights, vetoes with respect to related-party transactions, vetoes with respect to major changes in the capital structure (reacquisition of shares, stock splits, etc.) and vetoes regarding major decisions, such as mergers, reorganisations, the disposition of all or substantially all of the assets, liquidation, etc. In the second case, a minority shareholder will likely be able to ask, in addition, for participation rights, which will allow that shareholder to actively participate in the business. These will include veto rights regarding the business plan, the annual budget, the appointment or removal of certain officers, the execution of certain agreements, etc. ‘Sunset’ provisions, pursuant to which a party may lose all or part of its veto rights if its participation dilutes below a specific threshold, are common in this type of agreements.
Exit rights and transfer restrictions
Exit rights constitute another crucial component of shareholders’ agreements. Exit rights are particularly relevant for professional investors, such as private equity funds, who need to liquidate their positions within a defined investment period. Families also typically look forward to securing exit rights as part of their longer-term strategy and as a safe harbour if things do not work out as expected. This is particularly important in two-step acquisitions as described above.
The parties usually agree to detailed private market alternatives on exit provisions such as drag along and tag along rights, or put options, especially since the general rule in the region, with certain notable exceptions in Brazil and perhaps Mexico, is that IPOs are rare as an exit option. Some such alternatives provide a certain exit, such as put options, other mechanisms simply increase liquidity, such as drag-along rights, and others are mainly designed to protect minority shareholders from changes in ownership and to allow them to share in control premiums, such as such as tag-along rights. In any event, the main challenge in this respect is to make sure that these provisions are bullet-proof and that, when the time comes, they will be self-enforceable even against the will of one of the parties. This explains why these provisions are so detailed and may dwell on every aspect of a future transaction and everything that may potentially go wrong. How is the purchase price determined? Should there be a minimum price? Is notice required and, if so, what information must be included? Is non-cash consideration permissible? These are just a few examples of questions that will come up with respect to any exit mechanism.
Provisions involving dealings with a third party, such as drag along or tag along rights, pose additional challenges. Is the exit triggered on an ‘all or nothing’ or on a proportional basis? Does the dragged or tagging party have to give representations and warranties and grant indemnity? Does it have to become a party to the escrow agreement if there is one? Does it have the right to comment the purchase agreement? What type of ancillary or related dealings should be deemed consideration for purposes of determining equal price, terms and conditions? Can the dragged or tagging party audit the transaction and consideration received therefor? What happens if the proposed consideration is not cash, or a mix of cash and other type of consideration?
Of course, the ideal scenario (and indeed a quite common one) is that both parties work jointly towards a joint sale; however well negotiated and drafted, exit rights serve as an incentive to promote this type of cooperation, and every once in a while, they may see their day in court.
While exit mechanisms provide liquidity, transfer restrictions such as rights of first offer, rights of first refusal and lock-ups, are designed to provide the shareholders some control over the ownership composition of the company, the terms in which the shares are sold in the market and the type of investors allowed into the company, among others. In recent times in which the region has been shaken by corruption scandals and increased anti-corruption and anti-money laundering regulations, it is more common to see transfer restrictions prohibiting sales to investors that do not fit a certain profile or standards, such as investors that have been convicted or are under investigation for corruption, money laundering and other criminal offences. For similar reasons, the parties may agree to put options or other exit mechanisms that will be triggered if the other party becomes subject to any of these measures to quickly unwind the partnership and avoid or mitigate a contamination risk.
Finally, it is important to assess to what extent these exit mechanisms and transfer restrictions are enforceable in the respective jurisdiction and, most relevantly, to understand what remedies are available in the case of breach. In Colombia, for example, this will vary depending on the type of company and the observance of specific requirements. At the risk of overgeneralisation, in a stock corporation (sociedad anónima) and under certain circumstances, a party may only be able to claim damages if a party breaches one of these agreements, while he or she may be able to obtain specific performance in a simplified stock corporation (sociedad por acciones simplificada).
Takeaways and conclusions
Family-owned businesses are crucial participants in the Latin American market and therefore predominant targets of M&A activity in the region. When working in M&A deals with families (on either side of the equation), it is worth keeping in mind that the family may be unfamiliar with M&A practice, may be deeply entangled with the company from an economic perspective and may have a strong emotional bond with it. These factors will affect the deal dynamics in a way that is not necessarily present in other deals, making it important to understand and respect the internal decision-making process, ensure the family is fully advised regarding the terms of the transaction and their implications and work closely with trusted advisers. These factors will also impact the substantive terms of the negotiation, which need to be tailored to meet the family’s expectations and circumstances, including disentangling the family affairs from the company affairs, protecting the expectation of family members to continue working with the company, striking well-balanced non-compete provisions to preserve the value of the sold business while not unduly limiting the family members’ actions and negotiating reasonable indemnity packages and bridging the valuation gap between sellers and buyers with M&A tools such as earn-outs. Finally, it is important to keep in mind that many families prefer to opt for a partial sale, which leads to joint ownership creating a whole set of additional concerns. Both buyer’ and seller’s counsel would do well understanding these dynamics and tensions in order to provide more value-added advice and help the parties close a successful deal with full understanding of their commitments and risks.
 Sergio Michelsen and Darío Laguado are partners, and Ángela García is director at Brigard Urrutia.
 IFC (2018), IFC Family Business Governance Handbook, 2018.
 Confecamaras (2018) and Empresas Familiares en Colombia: un legado que transciende. PwC (2019) pp. 6.
 Latin America’s Growing Appetite for Alternative Assets’. Published on 24 March by Prequin. Auxadi (2021) pp. 6.
 Gisser, M.V. and Gonzalez, E.E. (1993). ‘Family businesses: a breed apart in crafting deals’. Mergers & Acquisitions. Vol. 27, No. 5, pp. 39–44.
 For a review of matters relating to publicly traded targets, see Chapter 8 of this guide, 'Public M&As, Hostile Takeovers and Shareholder Activism'.
 See Chapter 14 of this guide, ‘Preliminary Legal Documents in M&A Transactions’.
 See Chapter 15 of this guide, ‘Due Diligence: A Practical Guide to Deals Involving Latin American Targets’.
 Recovery to Rediscovery: Capitalising on a Change Private Equity Landscape. Auxadi. 2021.
 Counsel should be mindful of potential conflicts of interest depending on the party that contractually retained them. Counsel may be hired by the target itself, by one seller or by all the sellers. Counsel’s duties are owed to the specific retaining parties.
 Supeintendencia de Industria y Comercio. Resolution 46325 of 2010.
 A new approach to no-recourse deals has been evolving in the region, especially in cases where there are many sellers or the asset is distressed.
 Deal points addresses very comprehensive matters related to indemnity provisions, such as: types of indemnities, pro and anti-sandbagging provisions, survival periods and exclusions. But usually no reference is made to ‘as is where is’ transactions. (SRS Acquiom, Inc. 2020 M&A Deal Terms Study.)
 Foreign Affairs magazine named the September/October 2022 issue 'the Age of Uncertainty', Volume 101, No. 5, Centenial Issue.
 Gibson, Dunn & Crutcher LLP.M&A Practice Guide. LexisNexis Practice Guide (2018) §9.10.
 Gibson, Dunn & Crutcher LLP.
 See Chapters 3, 'Private Equity Funds and Institutional Investors in M&A' and 4 'Venture Capital Investments: Key terms and Avoiding the Battle of the Forms' of this guide.