5 ‘hidden’ accounting risks in a stock purchase agreement

An Stock Purchase Agreement (SPA) is supposed to be the document that tells you what you’re getting and describes your rights. The good news is that when you’re dealing with good people and things are going well, you’ll probably be treated well. The bad news is that regardless of a contract, bad people will try to screw you. A well-written (from the buyer’s POV) may give the buyer better ammunition in court, assuming you ever get to court and assuming the people you’re suing have anything left when it’s all done.

Why is an SPA like an iceberg?

Purchasing stock in someone else’s company is a bit like looking at an iceberg.  The stock purchase agreement represents the part of the iceberg you see above the water.  You can examine it, measure it and sort of know where you stand (or float); but it’s hard to see inside.  Still, the part of the iceberg that can do the real damage is below the water that you can’t see by looking at just the top.  Similarly, the part of buying stock in a company that can do the most damage is what the stock purchase agreement may not tell you; especially if (a) the issuing company is not a publicly reporting company subject to SEC rules, or (b) the stock is being purchased directly from a shareholder rather than the issuing company.

So, here are 5 hidden risks of an SPA:

1. Multiple classes of stock and disproportionate voting rights:  The purchaser’s class of stock may represent 75% of the equity, but another class may have multiple votes per share under all or designated circumstances, giving the holders of that class total control.
2. The opportunity for related party dealing
   
   1. Employment agreements and perks of majority holders; options/warrants/perks/bonuses/phantom stock
   2. Majority holders creating employment agreements for themselves before the stock sale, maybe with golden parachutes in event of or to defend against takeovers
   3. Majority holders creating employment agreements for themselves after the stock sale, maybe with golden parachutes in event of or to defend against takeovers
   4. Related party/Employee loans – favorable rates, effect on cash flow, repayment or forgiveness
   5. Cross-ownership of multiple businesses – possible diversion of business
   6. Related party transactions- e.g., transfer pricing
   7. Personal use of company assets
   8. Acquisitions of assets of questionable company value – e.g., the company boat or plane
3. Majority holders giving rich employment contracts to unrelated parties, maybe with golden parachutes in event of or to defend against takeovers
4. Distributions/dividends
   
   1. Not required – When distributions/dividends are discretionary, purchaser should consider history and goals of controlling shareholders/board to determine if the investment is consistent with the purchaser’s goals.
   2. Even when required, if conditioned on “net income” for tax purposes, maybe never if capital intensive business has a lot of capital assets that are depreciated or amortized
5. Dilution
   
   1. Additional issuances – Required vote?  Same as normal matters or supermajority or majority of each class or majority of majority holders & minority holders? Any minority input? Any cap on dilution?
   2. Calls – Required vote? Same as normal matters or supermajority or majority of each class or majority of majority holders & minority holders? Any minority input? Mandatory or voluntary? Any cap on dilution?

That’s if the business is successful…

If the business is going down, majority holders may be able to systematically strip the company.