Conflicts with business partners are not just a serious distraction for majority owners of private companies, these ownership disputes can be expensive, time-consuming and harmful to the long-term prospects of the business. The start of a new year is therefore a great time for majority owners to consider whether there are steps they can take to head off disagreements with business partners. Fortunately, the answer is yes, and this post looks at New Year’s resolutions that majority owners may want to consider that will lessen or completely avoid these ownership conflicts.
The Sweat Equity Problem
The first New Year’s resolution majority owners may want to make is to decline to issue “sweat equity” in the company. Sweat equity refers to the grant of an ownership stake in the company to employees or outside consultants who provide services to the company, but who do not provide any financial capital for their interest in the business. Sweat equity is granted most often by new or emerging companies that are short on cash, and they therefore issue stock rather than paying compensation for the services needed. In other cases, owners provide sweat equity to longtime employees as part of a succession plan.
While no ironclad rule is presented here against issuing sweat equity, we do caution majority owners to think long and hard before granting an ownership stake in the business to others who do not pay anything to acquire their shares or units in the company. Equity owners have important rights granted to them under both the provisions of Texas law and the company’s governing documents. The majority owner may therefore find that after issuing sweat equity, he or she is suddenly answering to these new owners of the business, who exercise their rights to call shareholder meetings, push for shareholder resolutions, demand access to books and records and, worst of all, threaten claims against the majority owner for breach of fiduciary duties.
As a New Year’s resolution, therefore, majority owners should consider other options rather than issuing sweat equity. These options include: (i) issuing phantom stock or stock appreciation rights that provide for cash bonuses based on the performance of the company rather than issuing stock (READ MORE), (ii) taking on short or long term debt to obtain the necessary services, or (iii) raising funds from a private equity or venture capital firm, which will involve a negotiated set of parameters regarding company governance more favorable than those that are likely to exist if there is a sizable group of employees or others who are the stockholders in the company.
Installing a Clear Exit Plan for Departing Partners
We have written extensively about the need for business partners to develop an exit plan at the time the investment is made. The absence of an exit plan is a recipe for disaster when a business partner wants to leave the company and no contractual path to an exit from the business exists.
- The Perfect Buy Sell Provision
- A Win-Win Buy Sell Agreement
- Hope for Minority Investors Who Failed to Obtain a Buy-Sell Agreement Before Acquiring Their Interest
Both majority and minority owners have an interest in installing this business partner exit plan. The majority owner wants the right to redeem the minority interest if the minority investor has become a thorn in the majority owner’s side in operating the business. And by the same token, the minority investor wants to be sure there is a means to secure a buyout, and that the investor is not stuck holding a minority equity stake in the company forever that is illiquid and unmarketable.
Therefore, if business partners are working together cooperatively in the company, the start of a new year is a good time to discuss adopting an agreed exit plan among them, which will address all of the following issues: (i) the factors that trigger the exercise of a redemption right (by the majority owner to buy the minority interest) or a buyout right (by the minority investor seeking to sell the minority stake), (ii) the manner in which the ownership interest will be valued at the time of redemption or buyout right is exercised and (iii) the structure and timetable for the company’s payment of the buyout price to the departing partner.
Improving Communication and Transparency
In our experience, disputes arise among business partners when communication breaks down and/or has become non-existent. In this type of dysfunctional situation, no formal meetings of shareholders/owners are held, information is not shared with company owners, and mistrust has replaced good corporate governance. One simple path leading to a resolution of these conflicts is for the owners to begin to hold regular meetings and for the company to start issuing financial reports on a periodic basis. Allowing these problems to fester will only lead to additional and more serious disputes. Starting the year with better “corporate hygiene” is a great way to improve the company’s operations and relations between owners.
More specifically, even in small companies where people work in close proximity, it is advisable to schedule regular monthly or at least quarterly meetings of all of the business owners. Financial reports regarding the company’s performance should be issued to owners on a set schedule that creates transparency. Business plans and performance goals should be shared, and majority owners should not only welcome, but also solicit feedback, input and suggestions for improvement. Providing other owners with clear information on a regular basis will facilitate constructive dialogue and allow concerns to be aired before they become serious accusations. In sum, open, regular communication and transparency are good medicine for business partners.
The challenges for majority owners in achieving success are daunting enough without adding the burden of dealing with significant conflicts with their business partners. While all disputes between partners cannot be avoided, majority owners may be able to head off major disagreements with other owners by: (i) approaching the issuance of sweat equity in the company with great caution, (ii) installing a clear, defined exit plan for departing business partners, and (iii) significantly increasing communications and the information provided to other business partners. With a little luck, adopting these resolutions now will help make 2019 a prosperous year for majority owners free from significant conflicts with their business partners.