Forming a Newco to be the Shareholder Rep

We’ve seen a few transactions on which the shareholders form a new entity (“Newco”) to be the shareholder rep. The new company is then typically controlled in some fashion by one or two of the major shareholders or members of management. There can be some circumstances in which this might make sense, but the logic for forming the Newco is often misplaced and is really just a false security blanket.

The most common objective for using a Newco as the rep is to create a liability shield for the individuals doing the work. While that sounds intriguing, it’s very questionable whether that actually works. The Newco will almost certainly be a shell entity with little to no capitalization that meets few if any corporate formality requirements. Therefore, in the event of a legal action, it may not be difficult to “pierce the corporate veil” of this entity, causing the individual owners or officers to be personally liable. This means that the blanket of liability protection that the parties are trying to create with the Newco could be completely illusory. At a minimum, the principals should not feel like they have any sort of bullet-proof protection because they formed a Newco. Additionally, even if the Newco is technically the rep, some individual still has to do the work. The Newco doesn’t eliminate any of the burdens of serving as the rep. It’s still a tedious, time consuming and difficult task.

Forming the Newco also adds a chunk of extra work for the M&A attorneys during a period when they’re already scrambling to get the deal closed and creates additional work for the individuals ultimately doing the work of the rep. Putting the Newco in place requires state filings to form the entity and the drafting of other formation documents. While none of this is brain surgery, it all adds to the cost of the transaction and could cause delays. Forming a Newco also requires the managers of the Newco to file annual tax returns for the Newco and possibly distribute K-1s or similar forms to the Members. While these are pretty simple tax documents, it creates additional work for the Managers over the escrow period. Finally, when the role of the rep is done, these Managers will have to do the work of winding down and dissolving the Newco.

The parties ultimately need to ask whether using the Newco actually does much and whether it is worth the cost and burden of putting it in place. In our view, the advantages are usually minimal, and it is usually not the answer that the players in the transaction hope it is.