The Florida Marlins recently made news when a profit-sharing deal with Miami-Dade County resulted in zero profits to the county, even though Jeffrey Loria sold his baseball team for about $1 billion more than what he paid for in 2002. In 2009, Loria signed a profit-sharing deal with Miami and Miami-Dade, which gave the Marlins public funds to build the stadium. Under that profit participation arrangement, Miami-Dade had the right to receive a portion of the net proceeds from the future sale of the team. However, when the team was sold last year, the county got nothing, in part because of the particular wording of the net proceeds calculation in the parties’ agreement.
This recent controversy should serve as a cautionary tale for anyone who is advising any company, employee, governmental agency or other participant who is negotiating the terms of a profit participation arrangement in a business transaction (whether participating in the target company’s operating profits or proceeds from a sale event). Of critical importance is how the formula for determining the participant’s percentage share of profits is structured. Profit participation formulas typically provide that the participant has the right to a certain percentage of “net profits” or “net sale proceeds” (or some variation thereof). Herein lies the fundamental difficulty, as a company has lots of flexibility in how it chooses to define what “net” means.
Essentially, the formula will typically begin with a reference to the target’s “gross profits” or “gross sale proceeds” followed by a series of deductions or exclusions from such term. Like with an insurance policy, it is these exclusions that ultimately become the tail which wags the metaphorical dog in these provisions, so read these exclusions carefully. Depending on the nature of the transaction, such exclusions often include all of the company’s debt and other obligations; transaction-related expenses; payment to the company’s equity holders of all preferred returns and a full return on their capital contributions; or (even worse) (all appropriate reserves that the company’s management deems necessary for the operations of the company.
The participant and its counsel should delve deeper into these exclusions to understand the implications of these exclusions and to what extent the target company could interpret them broadly, so as to reduce the “net profit” calculation far below the participant’s expectations. In performing this analysis, determine what terms need to be further described or limited (including defining certain of the terms used in these exclusions). For example, the term “transaction-related expenses” is very broad; consider making such term a defined term in the agreement, which describes in detail what that term means; or providing for a cap on the amount that such term represents or, at a minimum, requiring a reasonableness standard. Similarly, be wary of defined terms within the “net profits” calculation. For example, how is the company defining “gross profits” in determining a participant’s right to a certain percentage of “net profits,” or how does the company define a “sale event” triggering a participant’s right to “net sale proceeds?” Moreover, make every effort to have control over how the profit participation calculation is determined and who performs same, such as choosing an independent accounting firm to prepare the final accounting or at least providing for the right to object to such calculation (including a process for final and binding dispute resolution) and having the right to review and have access to the company’s books and records and all relevant supporting documentation related to the company’s business; related to its proposed sale transaction; or otherwise used in making such calculation. Be wary of pitfalls in the profit participation provision limiting the participant’s rights, such as the company having certain termination rights or the participant’s profit participation being subject to dilution, a vesting schedule, participant agreeing to certain restrictive covenants in favor of the company or the participant remaining in compliance with certain other obligations owed to the company.
Additionally, consider what tax-related impact your proposed profit participation language has on the participant. It is prudent to work in conjunction with tax counsel or the participant’s own accountant in the negotiation process to ensure favorable tax treatment to the participant. One of the best ways to ensure there is no ambiguity or other trip-ups in negotiating profit participation provisions is to include therein a detailed illustration of a hypothetical profit participation calculation based on the agreed-upon terms. It is also helpful to include a non-circumvention provision whereby the company expressly agrees that there shall be no set-offs, undisclosed reductions, side agreements, discounts or other accommodations regarding the profit participation calculation, the result of which would circumvent the amount due participant or otherwise delay the payment thereof to the participant.
To sum up the foregoing, when negotiating the terms of a profit participation arrangement in a business transaction on behalf of your participant-client, just remember one thing … “the devil is in the details,” so proceed accordingly.
Jay M. Rosen is a partner with Saul Ewing Arnstein & Lehr in Miami. He focuses on corporate and securities law in mergers and acquisitions, securities offerings and disclosures, corporate governance, financing and general corporate matters.