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Common sense tells us that a minority owner of a closely held business wields less power than a majority owner. While state statutes provide some protection (in the form of dissenters' rights, etc.), a minority owner may be forced to file suit to protect his interests if he feels mistreated by a majority owner. These fights arise in a variety of situations, including when the business is far exceeding expectations, when it is failing, and where the owners no longer share enough common interests to continue together. When owners disagree, it is usually the majority owner that is in a position to act unilaterally. At these times, the majority owner tends to perceive that he is exercising business judgment that is at least arguably within the fiduciary duties he owes to the minority owner. The minority owner looks at the same actions and, instead of seeing a valid exercise of business judgment, he perceives intentional acts to rob him of the value of his business interests. When this happens, litigation may quickly follow.
While it would be impossible to plan around all of these scenarios, minority owners should seek protections at the beginning of their relationships that can prevent some disputes from blowing up into litigation.
HOPE FOR THE BEST, BUT PLAN FOR THE WORST
An easy way to limit the likelihood of litigation is to craft a well-conceived and well-documented exit strategy. Often, when a business is adding a minority owner, it is happy times – nobody wants to spend the time and energy necessary to think through the permutations of death, disability, disagreement, or sale to a third party. As a result, it is common for operating agreements and shareholder agreements to ignore the exit strategy, or to only include boilerplate mechanisms incorporated from some other company's agreement. The reasons why this happens are understandable, but it is an invitation to litigation.
If a minority owner wants to be sure that his goals and expectations are the same as those of the majority owner, it is important to work through all of the possibilities – good and bad – and document the parties' intentions. There are many common methods to plan an exit strategy. One is to have the parties agree on a formula by which an ownership interest will be valued in the event of a sale by one owner to another. These formulas are usually based on the book value of assets or a multiple of earnings. Any agreement that has a formula-based exit strategy should also require the owners to annually assess whether the formula still makes sense given how their business is operating at that time.
Another frequently used exit strategy is to establish mechanisms where an owner may initiate a bidding process that leads to the sale of one party's interest to the other. The specific combination of procedures that any business employs in drafting an exit strategy should be determined by the special characteristics of the business. The final product should be limited only by the creativity of the drafters and the needs of the parties. A careful exit strategy that tracks the parties' intentions is a good way to avoid litigation down the road.
NEGOTIATE FOR SPECIFIC PROTECTIONS
There are other tools that minority owners should employ to help guard their position in advance of litigation. For example, a minority owner can negotiate to require a supermajority vote on key events – like the sale or merger of the business, or the size of profit distributions. Regarding profit distributions, minority owners should also explicitly negotiate the circumstances under which there will be distributions. This is especially the case for minority owners of limited liability companies, S-corporations or partnerships because they are pass-through entities for tax purposes. In pass-through entities, business owners pay income tax on profits even though they are not distributed to them. This can create the situation where a relatively low paid minority owner could owe tax on "phantom income." If this is a possibility, minority owners can be minimally protected by having the majority owner guaranty to distribute enough cash to cover the income tax liability associated with the phantom income. Another protection that may be possible depending on the business is to negotiate guaranteed participation in management of the business. For example, a minority owner might accomplish this by entering an employment agreement for a senior management position. A minority owner may also negotiate for a position on the board of directors of a company. This might not stop decisions that are unfavorable to the minority owner, but it should ensure that he is at least aware of all important decisions.
In addition to these technical legal reasons why it is a good idea for minority owners to consider these issues, there is a practical consideration. When potential business partners take the time to talk through these hard issues, it tends to either strengthen their bonds or drive them apart. Either way, it is usually the right result. For those that successfully work through the issues, the process tends to confirm the parties' belief that they will work well together in the long run. It also provides the building blocks for dealing with tough decisions in the future. On the other hand, those who cannot reach an accord on their business deal probably would not have lasted long in any event.
CONCLUSION
In summary, when a person is considering becoming a minority owner of a closely held business, he should look carefully at how to protect himself from an overreaching majority owner. While minority owners almost always have less bargaining power, the front end of the relationship is the best time to build adequate protections in writing. Even a few small checks on the power of the majority can be enough leverage to negotiate – or litigate – a satisfactory conclusion to the business relationship if necessary.
For more information about this topic, please contact Bob Mendes (rjm@mglaw.net) or one of our other Litigation attorneys. |
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