By Zack Callarman and Mark Johnson
Our previous posts have stressed the critical importance of buy-sell agreements for both majority owners and minority investors in private companies (Read here). For majority owners, securing a buy-sell agreement avoids the potential of becoming “stuck” in business with a difficult co-owner without the ability to force a buyout of this minority investor’s ownership stake. For at least some majority owners of private Texas companies, however, another option exists. This option is commonly known as a “freeze-out,” “cash out” or “squeeze-out” merger.
What is a Freeze-Out/Squeeze-Out Merger?
A freeze-out/squeeze-out merger is a merger of two or more business entities that results in one or more of the equity holders of one of the pre-merger entities being cashed out as a result of the merger (i.e., not allowed to own equity in the post-merger surviving company).
Mergers are governed by state corporate law, and most states have several similar, but separate, merger statutes for corporations, LLC’s and other forms of business entities recognized under state law that govern mergers of those entities under various different circumstances. In that regard, it is worth noting that a “freeze-out/squeeze-out” merger is not a distinct type of merger governed by its own separate statute, but rather is a “characterization” given to a merger reflective of the purpose behind the merger, irrespective of the specific merger statute under which the merger is effectuated.
The Requisite Authorization and Approval for a Freeze-Out/Squeeze-Out Merger
Under state corporate law, mergers typically must be authorized and approved by both the equity holders and the directors of each of the entities participating in the merger. In the case of corporations, that means that typically both the directors and the shareholders must authorize and approve the merger, whereas in the case of LLC’s that means that typically the members and the managers must authorize and approve the merger. The actual level of that approval (i.e., unanimous consent vs. 2/3rds consent vs. majority consent) is governed by the applicable state merger statute together with the operative provisions of the entity’s organizational documents. By way of example, under Texas law, unless the entity’s governing documents provide otherwise, (i) the affirmative vote of at least two-thirds of the outstanding voting shares is required to authorize and approve a merger of a corporation, and (ii) the affirmative vote of the holders of at least a majority of the outstanding voting membership interests is required to authorize and approve a merger of an LLC.
So, the gating question for any individual or group wanting to possibly effectuate a freeze-out/squeeze-out merger is: Do you have the requisite vote under applicable law and under the entity’s governing documents to authorize and approve the merger?
The Fair Market Value Presumption
It is important to remember that while a freeze-out/squeeze-out merger may well enable the “majority” to force one or more minority holders out of the company, a freeze-out/squeeze-out merger does not entitle the majority to steal, or cheat the minority holders out of, their equity interests. The minority members who are being frozen or squeezed out should receive fair value for their interests. Otherwise, the majority proponents of the freeze-out/squeeze-out merger will likely be vulnerable to claims by the minority interest holders for oppression, breach of fiduciary duties, etc.
In the case of corporations, the “fair market value” presumption is governed by statute. In many (but not all) mergers involving corporations, under state corporate law, the effected shareholders, including any minority shareholders who will be frozen or squeezed out as a result of the merger, have statutory “dissenter’s rights” or “appraisal rights”. In short, a shareholder with “dissenter’s rights” or “appraisal rights” who objects to the amount that he is going to receive in exchange for his equity interests as a result of the merger is entitled to go to court and appeal the valuation. The court then has the power to revise the amount that the shareholder will receive based on its determination of fair market value.
Curiously, LLC statutes do not typically include dissenter’s rights provisions. However, given (i) the well–established fair market value presumption that exists in the context of corporate mergers, together with (ii) the strong “fiduciary duties” overlay that exists under statutory and common law with respect to the duties and obligations of members of LLC’s with respect to their fellow members, prudence dictates that the majority proponents of a freeze-out/squeeze-out merger make every effort to honor the fair market value presumption in any freeze-out/squeeze-out merger they effectuate.
Logistics of a Freeze-Out/Squeeze-Out Merger
So, assuming that the majority proponents of a freeze-out/squeeze-out merger have the requisite vote under applicable law and under the entity’s governing documents to authorize and approve the merger, how do they do it? The answer to that question will again depend in part on the form of the entities involved, the governing corporate statutes, and the organizational documents of the entities involved, but with those qualifications, the answer is pretty simple: The majority proponents form a new entity with whatever ownership and capital structure they desire, and then they merge the existing entity (i.e., the entity in which the soon-to-be frozen or squeezed out equity holders hold an interest) into the new entity. Under the terms of the merger agreement, among other things, the new entity will be the surviving entity, and the equity interests of the frozen or squeezed out minority interest holders will be redeemed for cash in an amount equal to the fair market value of the redeemed equity interests.
The freeze-out merger is a legal avenue that may not be widely known by majority owners of private companies, but it is used with some regularity in Texas and is rarely disallowed by the governance documents of most companies. There should be a note of caution for majority owners in deploying this technique, however, because if dissenter’s rights apply and are exercised by the minority investors in response, the freeze-out merger may result in a time-consuming and a costly appraisal process.
Zack Callarman (Associate) and Mark Johnson (Shareholder) are members of Winstead’s Corporate, Securities/Mergers & Acquisitions Practice Group.