A recent SEC investigation gives a new spin to the old adage of caveat emptor in the context of employee stock repurchases by private companies. Virtually all portfolio company management equity arrangements contain “call rights”—i.e., the rights that allow a portfolio company (or, often, the private equity sponsor itself) to repurchase shares held by an employee on termination of employment. Typically, call rights are exercisable for a limited period of time following the termination at “fair market value.” Without the benefit of a public market for the stock, fair market value is usually established by the board of directors, with varying degrees of discretion, and sometimes based on a valuation received from an independent valuation firm. Though distinguishable from customary private equity portfolio company practices in a number of important respects, a recent lawsuit filed by the SEC against Stiefel Laboratories, Inc. and its former CEO, Charles Stiefel, is a reminder to boards of directors of portfolio companies that determining fair market value can be risky, especially if the business is sold shortly after the employee’s termination.
The SEC’s complaint in the Stiefel Labs matter alleges that, from 2006 to 2009, Stiefel Labs repurchased common stock from a significant number of its employees (both inside and outside of a tax-qualified plan) at far below fair market value. More importantly, the SEC alleges that this conduct amounted to securities fraud on the employees. According to the SEC and related court cases, the disparities between the repurchase prices and potential fair market values were dramatic:
- In late 2006, at a time when Stiefel Labs was repurchasing the employees’ common shares at a “fair market value” of $13,012 per share, the company was fielding five offers from third party investment firms to invest in the company at valuations that were 50–200% higher than the valuation used for employee repurchases.
- In August 2007, Blackstone purchased a 19% preferred stake in the company for $500 million, valuing Stiefel Labs’ equity at approximately $2.6 billion (which, according to a related court case, implied a valuation of roughly $60,000 per common share). TA Associates had also offered to invest and valued Stiefel Labs’ equity at approximately $2 billion. At the same time, Stiefel Labs was valuing the employees’ shares at a value that equated to a $786 million valuation of the company.
- Between November 2008 and April 2009, Stiefel Labs was valuing the employees’ shares at a price which equated to a $877 million valuation of the company. At the same time, Stiefel Labs was trying to sell itself. During this process, the company was told that it could expect bids of between $2.25 billion and $5 billion for the company. After an auction, Stiefel Labs ultimately agreed to be acquired by GSK for $2.9 billion in cash, the assumption of $400 million of Stiefel Labs debt and a $300 million earnout. This resulted in a payment of roughly $68,000 per share to the employee shareholders who had not sold their stock earlier.
Not surprisingly, private suits from current and former employees who had sold shares in 2008 and 2009 immediately followed GSK’s acquisition. These suits make claims under a variety of theories, ranging from securities fraud to breach of fiduciary duty under ERISA. Some plaintiffs were dismissed from these suits as a consequence of having signed general releases of claims after selling their shares; others were permitted to continue because the releases they signed did not cover prospective claims. In May 2012, the first of these suits reached a verdict, with a former employee winning a $1.5M judgment.
The SEC joined the chorus in December 2011, when it filed its civil fraud suit against Stiefel Labs and Mr. Stiefel. The SEC’s suit seeks (among other things) disgorgement from the company and Mr. Stiefel of an estimated $110 million of profits from the alleged fraudulent activity. Stiefel Labs and Mr. Stiefel have filed an answer, admitting uncontroversial facts and otherwise generally denying the SEC’s allegations. A recent news reports suggests that the case is currently in mediation.
Because the only facts we currently have regarding this case are from the SEC’s complaint, it is difficult to know what conclusions private equity firms should draw from the SEC’s action, other than the obvious conclusion that valuations in this context are a risky business. For example, we know that Stiefel Labs used an independent appraiser for valuation purposes, but the SEC does not say who the appraiser was—a storefront in Yonkers or a national firm—although a newspaper article identifies the appraiser as a CPA firm in Rhinebeck, New York. (A related case by the employees charges the CPA firm as neither independent nor competent to conduct valuations.) We know the method that the appraiser is said to have used—a valuation by reference to Stiefel Labs’ financial performance against public company peers (presumably without regard to hypothetical control premiums)—but we do not know what information Stiefel Labs provided to the agent as part of this process. The SEC alleges that Stiefel Labs did not inform the agent of any of the non-plan transactions that could be seen to affect valuation (i.e., the pending third party offers, Blackstone’s actual investment or the decision to auction the company and related valuation guidance). The SEC also points to e-mail traffic that (in its view) indicates that the CEO and others were aware that Stiefel Labs was purchasing shares from employees below any reasonable estimate of fair market value.
Nevertheless, there are steps that private equity firms can take to mitigate the risks associated with fair market value determinations of employee equity:
Obtain Informed Periodic Appraisals. Periodic appraisals by a well-informed and “brand name” independent appraiser should go a long way to undermining potential claims by employees. The SEC takes great pains in its complaint against Stiefel Labs to portray the independent appraiser as lacking all of the relevant facts, and we expect that both the valuation activities of the independent appraiser and communications between Stiefel Labs and the appraiser will be a crucial dispute in the case. In addition, the SEC points out that Stiefel Labs performed valuations only once per year and then used that same valuation throughout the year. A customary approach in private equity would be to obtain an annual valuation, with the portfolio company board updating that valuation on a quarterly basis based on developments during the year (or more frequently during volatile periods or as the portfolio company moves closer to an exit event or an IPO).
Consider Expanding Blackout Periods. Many portfolio company equity plans provide up to six months for repurchases to occur. This period might be sufficient time for valuation-influencing events to resolve themselves, either by coming to fruition or dying on the vine. While it is not a common practice currently, it may be advisable to consider permitting a portfolio company to further toll repurchase events if it decides that a repurchase would create excessive risk of employee claims. It can be particularly difficult for a portfolio company board to consider how to take into account offers from third parties to purchase minority stakes or the company as a whole, especially if unsolicited. These offers are usually preliminary and subject to legal and financial diligence, and, as noted throughout the SEC’s complaint, they can vary considerably. Often, the right answer is that these offers should not influence value at all. The SEC seems to anticipate this argument by emphasizing the number of offers that Stiefel Labs received in 2006—five— and that one of the offers, Blackstone’s, was ultimately consummated at a price well above the price that Stiefel Labs was then using. One must wonder how strong the SEC’s case would be if neither the Blackstone investment nor the sale of the company had actually been consummated.
Get Releases from Departing Employees. At least one court has dismissed claims against Stiefel Labs by employees who signed releases that covered the share repurchases. While it is not clear that all courts in all states (or outside of the United States) would enforce releases under these facts, obtaining releases from employees in connection with share repurchases should create a valuable defense to subsequent litigation. Better yet (but also less frequently obtained), a repurchase agreement with a departing employee could specify that the repurchase price is an agreed-to price that may or may not be fair value.
Be Clear About Discounts. In the SEC complaint, there is a cryptic reference that the independent appraiser, after performing an initial calculation of fair market value based on financial information, applied a 35% discount to the result. One assumes that, in discovery, this will be shown to be either a minority discount or a marketability discount, or both. It does not appear that Stiefel Labs ever made known to the employees that this discount would be applied and, to the SEC, this lack of disclosure appears to have been part of the alleged fraud. It would be advisable for portfolio companies to consider making clear to employees the discounts that will be applied in the valuation process and to so provide in the definition of “fair market value” in any relevant agreements. Reading the Stiefel Labs complaint, it appears that, if these discounts were not applied to the employees’ shares, the valuation of the independent appraiser would likely have been within (or close to) the range of the five investment firms’ indications of interest in 2006, albeit at the low end. Discovery in the case may ultimately show that the economic and/or governance terms of the Blackstone securities made its preferred stock materially different from the common stock held by the employees, therefore justifying a higher valuation.
Consider Using Formula Definitions. Some private equity sponsors use formula prices to define fair market value in their portfolio companies’ stock incentive plans (e.g., X times 12 months’ trailing EBITDA). Use of a formula price should be helpful in defeating employees’ claims because the employees’ contractual rights in a repurchase would be determined by reference to the formula. However, formula prices raise issues of their own, including complicated tax issues if the application of the formula is waived outside of the IPO context, and so they should only be used after careful consideration of the pros and cons.
Avoid Having Private Company Stock in Qualified Plans. It appears that most of Stiefel Labs’ repurchases occurred under a tax-qualified stock bonus plan, which requires that employees be provided with periodic put rights. These plans generally require broad-based employee participation, including employees with little or no sophistication as to ownership of private company stock. Consequently, Stiefel Labs’ use of the qualified plan, which was surely intended to motivate employees to achieve positive company performance, also exposed Stiefel Labs to lawsuits from literally hundreds of its employees. In addition, some of the employees’ claims arose under ERISA, the federal employee benefits statute, which protects plan participants by (among other things) imposing expansive fiduciary duties and disclosure obligations.
Add Valuation Issues to the Diligence Checklist. When considering new acquisitions of private companies, private equity sponsors should diligence the target’s valuation and repurchase activities, particularly in light of the price to be paid for the target and with a special emphasis when the target is owned by a private equity firm. One of the hardest questions to emerge from the Stiefel Labs complaint is whether the customary method of valuing a portfolio company by reference to the financial performance against public company peers (without regard to hypothetical control premiums) is now problematic. It shouldn’t be, but it is a fairly common fact pattern for a private equity buyer to pay a price above (and sometimes well above) recent valuations made by the target for compensatory purposes. If there is a risk that employees may make similar claims as those made against Stiefel Labs, that risk should be expressly allocated between the parties.
Be Aware of Conflicting Fund Valuations. Private equity sponsors should also monitor, and have a ready explanation for, any differences between valuations at the portfolio company made in connection with employee repurchases and valuations at the fund level.
For now, it is not clear how the SEC’s decision to sue Stiefel Labs will turn out. While the facts alleged by the SEC seem egregious (especially the disparity between the price paid to the employees for their stock and the prices paid by Blackstone and in the ultimate sale to GSK), cogent explanations for these facts may eventually emerge during discovery and at trial. However, in light of the publicity that the case has generated, coupled with the SEC’s recent announcement that it intends to focus more closely on valuations by private equity funds of their portfolio investments, private equity sponsors should expect, and actively plan for, greater scrutiny of valuation activities in the future.