As we noted in a previous post (Read Here), the disruption and dysfunction caused by a bad business partner who holds a substantial minority stake in the company can lead to the ultimate failure of the business. This is especially true when the company founder has no buy-sell agreement in place that will allow him/her to redeem the minority investor’s interest in the company. When the majority owner has no contract right to force the minority investor to exit the business, the owner’s options are essentially limited to: (i) going out of business and dissolving the company, (ii) selling the business to a third party (iii) or selling the majority owner’s interest to another party who will step into the owner’s shoes and take on the task of dealing with the minority investor.
None of these “end the business” options are likely to satisfy a company founder who worked very hard to bring the company to life. This post therefore considers options for the majority owner of the company to consider when no buy-sell agreement exists with the minority investor who has become a major stumbling block in the path to the company’s continued success.
Setting the Stage for the Exit of the Bad Business Partner
The bad business partner may believe that he/she has the upper hand in negotiations with the majority owner. Specifically, at the same time the minority investor is wreaking havoc at the company, the investor is refusing to be bought out or is demanding a grossly inflated price for the purchase of his/her minority stake in the business. In this situation, the majority owner may appear to be “stuck” with no recourse to force the exit of this bad partner and fix the problems the investor is causing at the company.
The majority owner will therefore need to change this frustrating dynamic and implement a series of actions to secure some leverage in the buyout negotiations between the parties. The following are specific steps that the majority owner can consider taking to change the parties’ bargaining positions, although the owner will need to confirm that each of these actions are not prohibited by the terms included in the company’s governance documents, e.g., the company agreement, partnership agreement or bylaws.
- Removing the minority owner from all management positions with the company, eg., removing minority owner as member of the board or as an LLC manager
- Terminating the employment of the minority owner if he/she is an at will employee
- Retaining the company’s profits for re-investment and declining to issue any profits dividends/distributions other than to cover the tax liability of all owners
- Providing an employee incentive compensation plan to key employees
- Increasing the majority owner’s compensation level
The net effect of these actions is to eliminate further financial payments by the company to the minority investor who will no longer receive any salary, bonuses, employment benefits or profits distributions. The minority owner will have to wait for a future liquidity event of some type, e.g., merger, sale, recapitalization or IPO to receive any financial return on the investment. At the same time, after the minority owner is removed from management and/or employment with the company, the remaining employees, including the majority owner will begin to receive increased benefits and/or compensation. Importantly, the majority owner should not increase his/her own compensation unilaterally, and any salary bump up should be based on the report of a compensation expert, who determines the level of compensation that is appropriate for the founder based on the industry, the company’s revenues and other key factors that are typically included in an executive compensation analysis.
The minority investor may view these actions as a hostile squeeze out technique, and every situation must be judged on its own facts. But as a general statement, if the minority investor does not have a contract to remain an employee (no employment agreement in place) and the company’s governance documents give the majority owner the exclusive right to decide whether to issue profits distributions, the minority owner likely has no available remedy under Texas law against the majority owner for the actions listed above. Again, each case must be determined on its own facts, but as long as the majority owner does not engage in any self-dealing conduct that breaches his/her fiduciary duties, the minority investor likely will not have a viable claim against the majority owner if the investor is removed from company management, fired as an “at will” employee and deprived of profits distributions from the company.
Once the majority owner takes these steps, the minority investor will realize that he/she will receive any payments from the company for years. This change in status may open the door for new buyout negotiations to take place. The minority investor has the choice of either putting the investment in the company the shelf for an undetermined period of years with nothing to show for it, or coming to the table in efforts to strike a deal to monetize the investment.
Buyout Structures to Secure Exit of Minority Partner
Even when the minority investor becomes motivated to sell so that his/her investment in the company does not become “dead money” for years, that does not mean that the investor will accept pennies on the dollar to cash out of the investment. The minority investor will continue to seek favorable terms on which to sell his/her investment in the company. Nevertheless, once the minority investor becomes willing to accept a buyout of his/her ownership stake, that creates a situation where there is both a willing buyer and seller, and this will permit the parties to discuss different structures to achieve a mutually acceptable buyout transaction. Some of these potential buyout structures are reviewed below in the remainder of this post.
- The Cash Buyout
The most straightforward buyout is a simple cash transaction in which the majority owner pays a cash price at a closing to purchase the minority investor’s full ownership interest in the company. Payment of the full cash price at closing to the investor is not common, however, because the majority owner rarely has the funds available to pay the full buyout price to the investor. In addition, the cash price buyout approach leads often to a hotly contested dispute between parties over the company’s value and the amount of the investor’s share in that value.
The more common scenario is one in which the majority owner purchases the minority investor’s interest over time (often 3-5 years), including paying interest. The owner’s payment obligation will be backed up by a secured interest in the investor’s ownership interest until the investor has been paid in full by the majority owner.
- Buyout Based on Percentage of Revenues
An alternative to the cash buyout is for the majority owner to provide the minority investor with what equates to a royalty payment stream. Specifically, the parties in this type of structure will agree that the minority investor will be paid a set percentage of the company’s revenues for a specific period of time. If the company has a strong track record and history of generating substantial annual revenues, this royalty payment formula may provide the investor with a strong and satisfactory buyout arrangement.
As a further incentive for the minority investor, the parties can also agree on a cap and floor for the buyout. The cap puts a limit or ceiling on the total amount that can be paid to the investor by the majority owner/company based on the royalty percentage, but the majority owner will also agree to provide a floor, or a guaranteed minimum payment, to the minority investor and agree to make up any shortfall if the actual royalty payments should fall short of the amount that the majority owner has guaranteed that the investor will receive.
Under this royalty based approach, the parties do not have to come to terms to agree on the actual amount of the purchase price to be paid to the minority investor – it is a royalty percentage and not a specific or set dollar amount that is being paid. The parties’ belief as to the value of the investor’s ownership interest in the company, however, will obviously drive their decisions regarding the royalty percentage they agree to apply and the length of time that the investor will receive the payment from the company.
- Guaranteed Sale of Company
Another, approach to the buyout scenario is one that is tied to the sale of the entire business. The minority investor wants to monetize his/her investment in the company, but the majority owner does not have sufficient cash readily available to do so. But if the majority owner will commit to either: (i) sell the business in a set period of years (and thereby cash out the minority investor) or alternatively, (ii) purchase the minority investor’s interest at a set value in the same time period, that purchase commitment may persuade the investor to exit the business on those terms. As with the buyout structure discussed above, this will be a more attractive option to the minority investor if the majority owner also provides a floor/guaranteed amount to be paid to the investor when the transaction takes place.
To avoid serious future conflicts with their business partners that threaten the continued existence of the company, company founders are advised to secure a well-crafted buy-sell agreement with all minority investors at the time of their investment. This allows the founder to trigger the buy-sell agreement and purchase the interests held by the minority investors if they turn out to be bad partners, who placed their own interests ahead of the company’s goals.
For company founders already dealing with conflicts with their minority investors with no buy-sell agreement in place, these majority owners will want to consider taking the steps outlined in this post to eliminate current financial returns to these investors on a current basis. Once the minority investors appreciate that they will not be receiving any payments from the company for an extended period, that may change the dynamic of the negotiations. Specifically, once the minority owners are removed from the company’s management, their employment is terminated and they are receiving no current financial returns from the company, they may be willing to monetize their interest. At that point, they may agree to negotiate their departure from the business on reasonable terms based on the fair market value of their interest in the company, which is the fair outcome the majority owner desires to achieve.
 The term “business partner” is used generically here, and is intended to include minority investors who are shareholders, LLC members and/or limited partners with a substantial ownership interest in the business.