Legal Blind Spots In Business Transactions

RIA Business Owners Are Often Unaware Or Have Misconceptions About Asset Valuations, Minority Investments And Restrictive Covenants
Brian Hamburger, Founder, President & CEO, MarketCounsel Consulting, and Founder & Chief Counsel, the Hamburger Law Firm
Brian Hamburger, Founder, President & CEO, MarketCounsel Consulting, and Founder & Chief Counsel, the Hamburger Law Firm

Many advisors in the wealth management industry stay informed on the legal requirements for financial advisors, broker-dealers, investments and similar industry-centric topics. But there are blind spots: Often advisors have misconceptions about or are completely unaware of legal trends that may have powerful effects on their businesses but are not specific to wealth management or financial services.

Ignorance is not bliss, however. RIA business owners can suffer losses and be ensnared by resource-consuming situations with difficult outcomes if they do not know or lack understanding of hidden legal traps that are not specifically related to the industry but affect their firms, regardless.

I frequently see these become problem areas for our clients. Below are three increasingly common situations where some awareness and planning can avoid headaches (and unnecessary legal fees).

Restrictive Covenants

Non-competition covenants prevent a person who signed a contract from opening a competing business or joining a competitor, while non-solicitation covenants prevent a person from soliciting the firm’s clients or employees to join them after they leave the firm. It’s widely known that California is very wary of such contractual provisions.

But it’s not just California – what starts in California often makes its way across the country. Along with California, the federal government (through the Federal Trade Commission) and many other states are trying to limit the applicability of these provisions. One example that demonstrates that this trend bears no correlation to political tendencies is Alabama. Alabama generally prohibits non-solicitation and non-competition covenants, with an exception for reasonable covenants, with “reasonable” often meaning 18 months or less after a person leaves a firm.

Recent Federal Trade Commission (FTC) rulemaking is even more sweeping. It seeks to severely limit the use of noncompetition provisions in all but a few, narrowly construed scenarios. However, non-solicitation provisions and agreements protecting legitimate trade secrets should survive the final rules proposed by the FTC. And, with significant legal challenges, the use of noncompetition provisions may even remain an effective tool.

There are many good policy reasons why a state may wish to restrict the enforcement of these types of covenants, but there are also many reasons why companies may legitimately need them. The cumulative effect of banning such provisions is like using a Howitzer to kill a fly.

The cumulative effect of banning such provisions is like using a Howitzer to kill a fly.

Currently in our practice we still use non-solicitation and non-competition covenants, but the terrain is becoming full of pitfalls. We are witnessing states develop a patchwork of what is allowed and prohibited and create uncertainty since many modern courts haven’t addressed certain scenarios of late.

Some states complicate the issue further by overriding the contract’s agreed ‘choice of law’ provisions. In other words, they will force their laws (along with their views on these covenants) to apply even though the contract explicitly states that another state’s laws should apply. Advisors must proceed carefully.

Minority Investment Covenants

In the past, advisory firms would often raise capital through loans originating from local banks, but today the trend has shifted to an influx of minority investments. We often see advisory business owners who rushed excitedly into a deal, giving away valuable rights in their covenants with the mistaken belief that minority equity investments are a less expensive form of capital. In truth, equity in a high growth firm is always going to be the most expensive source of money.

Equity in a high growth firm is always going to be the most expensive source of money.

As you might imagine, minority investors are disciplined with the covenants and promises they insist upon. There’s nothing wrong with this – they are simply trying to protect their interests – but the promises and covenants they ask for are often undervalued or overlooked by the advisors receiving the investment. Years after the investment, the restrictions caused by these promises can lead advisors to feel as if they have become employees of the minority shareholder.

One of the most common is the right of first refusal, where future shares for sale must be offered to the minority investor first. Firm owners will give the minority investor this right, believing it will not be significant when it comes time to exit. Later they learn that some suitors don’t even want to bid on the business once they learn that there is someone with a right of first refusal waiting in the wings. Sometimes the right of first refusal is accompanied with a valuation provision. The valuation provision may or may not be beneficial to the firm owners.

Beyond the right of first refusal, there are many covenants that can complicate issues for the firm’s owners including restrictions on the amount of debt they can take on or the ratio of new partners they can add. We have seen covenants as broad-ranging as needing the minority shareholder’s permission to break a lease, enter a lease, hire employees beyond a certain threshold or enact compensation restrictions. We’ve also seen covenants requiring permission to resign. Sometimes the minority shareholder even gets to choose the law or accounting firms.

We have also come across problems with Financial Crimes Enforcement Network (FinCEN) reporting requirements, in which there are penalties for not disclosing a firm’s controlling persons. Often minority shareholders do not want to be disclosed, arguing they don’t have sufficient control, which leaves the owners in the precarious position of potentially facing penalties because the minority shareholders decline to be named, or have provided a restrictive covenant which is in the form of a confidentiality restriction.

Advisory business owners considering minority investments should not let themselves be distracted by the zeros in a check and instead objectively apply their skills in prudently evaluating investments to their own business – which is typically their largest, mostly concentrated securities position.

This isn’t to say that owners shouldn’t take on minority investments. Minority investments can be very useful in the right situation and under the appropriate circumstances. But owners must consider why they are taking on the capital and think strategically about the exit strategy in either direction – whether things go well or don’t meet expectations.

Business Valuations Can Hurt

Asset valuations may at first appear harmless and, from a certain perspective, make good business sense. Businesses need good metrics, and a recurring valuation helps business leaders identify trends and track their progress. The problem arises when someone else gets the valuation information and wants to use it against the firm to achieve their own objectives.

The problem arises when someone else gets the valuation information and wants to use it against the firm.

In truth, valuation is as much of an art as it is science. It’s placing a number on a host of variables including demographics, yield, cost of services, employee compensation, scope of services, age of clients, interaction with clients’ heirs and more. The weight placed on certain factors or the methodology used can change a valuation drastically. In other words, the answer is highly dependent on asking the right questions and aligning with the future projections of the business.

If a valuation is an aggressive one, it could be used in litigation against the firm or even create the dispute itself. For example, an owner has the firm valued for $15 million and brags about it to a friend at the local country club. This valuation gets back to an employee equity holder or minority investment partner, who previously believed the firm was valued closer to $5 million. Now, that minority investor wants to cash out, causing headaches and consuming expensive resources for the owner.

One method that can prevent valuations from being used in litigation is hiring legal counsel to engage a third-party valuation expert. The legal counsel reviews the completed valuation report with the client under the shroud of confidentiality. By making the valuation subject to attorney-client confidentiality, it may be able to be shielded from discovery in litigation. However, if the valuation is ever revealed outside of that attorney-client relationship, it becomes discoverable.

RIA business owners need to think about the purpose of the valuation, the safeguards in place to protect the information and whether the valuation is needed at all.

Brian Hamburger is Founder, President and CEO of MarketCounsel Consulting and Founder and Chief Counsel of the Hamburger Law Firm.

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