David F. Johnson co-presented “Minority Investor Rights in Private Companies: Buy-Sell Agreements, Court-Ordered Buyouts, Breach of Fiduciary Duty” for a nationwide audience for Stafford Webinars on January 20, 2021. David was honored to present with Peter A. Mahler and Peter J. Sluka from Farrell Fritz, PC from New York. The presenters discussed the rights of minority investors in private companies (including the right to vote, inspect books and records, preemptive rights, derivative actions, petition for dissolution, and receiverships), the limitations on those rights (expulsion, dilution, transfer limitations, freeze out merger), and factors to consider in drafting a buy-out agreement and securing a buyout of their ownership stake.
The season finale of the hit reality TV show The Bachelor attracted more than 8 million viewers. My wife and teenage daughters help make up this devoted fan base, and watch every episode. Yet, when I question them about whether the subject of a pre-nup agreement has ever come up on the show, I get eye rolls, and comments like, “Dad, don’t be such a downer.” Assuming that the Bachelor and his new fiancé do make it to the altar, however, the show also does not mention that marriages in the US still have just a 50% chance of lasting despite the continuing decline in the national divorce rate. Continue Reading Buy-Sell Agreements: Don’t Leave Home (Or Invest) in a Private Company Without One
The owners of a corporation may enter into shareholder agreements. In Richie, the Texas Supreme Court stated: “Shareholders of closely-held corporations may address and resolve such difficulties by entering into shareholder agreements that contain buy-sell, first refusal, or redemption provisions that reflect their mutual expectations and agreements.” Ritchie v. Rupe, 443 S.W.3d 856, 871 (Tex. 2014).
Regarding shareholder agreements, the Texas Business Organizations Code provides:
(a) The shareholders of a corporation may enter into an agreement that: (1) restricts the discretion or powers of the board of directors; (2) eliminates the board of directors and authorizes the business and affairs of the corporation to be managed, wholly or partly, by one or more of its shareholders or other persons;
The legal front remains forbidding for private company minority investors who seek to secure a buyout of their ownership stake based on claims for oppression against the company’s majority owners. It has been six years since the Texas Supreme Court eliminated a court-ordered buyout as an available remedy for minority shareholders claiming oppression, and no other legal avenue exists that provides minority owners with a buyout of their interest based on claims for mistreatment by business owners who manage the company. See Ritchie v. Rupe. The best advice for minority investors therefore is simply this—before investing in a private business, minority owners need to insist on securing a buy-sell agreement.
We have written extensively about the terms of buy-sell agreements in previous posts (Read Here). A buy-sell contract provides investors with the right to obtain a buyout of their minority ownership interest in the company at a future time.
No Buy—Out For Breach of Fiduciary Duty
When minority owners have claims for misconduct by majority owners, these claims most commonly include: (1) breach of contract, (2) fraud, and (3) breach of fiduciary duty. None of these claims permit the trial court, however, to award the minority owner with the remedy of a buyout of his/her or its minority interest. Instead, the remedy for these claims is typically the recovery of actual damages. In the case of fraud, if the minority owner can prove that he/she was fraudulently induced to make the investment in the company, the court could rescind the transaction and require the majority owner to return the investor’s purchase price. Instances of outright fraudulent inducement are relatively rare, however, and this will not be a claim or remedy available to most investors. The fiduciary duty claim against the majority owner in control of the company does give rise to a potential shareholder derivative action, however, which is discussed below. Continue Reading The Plight of Oppressed Private Company Minority Investors: No Legal Escape Available Without a Buy-Sell Agreement in Place
A search for the perfect buy-sell provision for use by private company owners and investors may be akin to hunting for a unicorn, because the business objectives of majority owners, on one side, and minority investors in the business, on the other, are rarely, if ever, fully aligned. But, if this search is limited to focusing solely on the terms of a buy-sell provision that addresses the critical business concerns of both majority owners and minority investors, that task is not beyond the rainbow. What is clear is that majority owners and minority investors share an interest in putting a buy-sell agreement in place at the start of their business relationship. This post therefore covers the essential terms that owners and investors will both want to consider in a provision that strikes a balance in a mutually acceptable buy-sell agreement.
Peace is not the absence of conflict, but the ability to cope with conflict by peaceful means.
— President Ronald Reagan, Commencement Address at Eureka College in Illinois, May 9, 1982.
The business relationship between private company majority owners and minority investors does not have to be a zero sum game—there are positives available for both sides in their business dealings. But, a win-win approach for majority owners and minority investors needs to begin at the outset when they negotiate and adopt a buy-sell agreement at the time the investment is made in the company, which provides terms that will govern the eventual exit of the minority investor from the business.
A buy-sell agreement will not eliminate all conflicts between company owners and investors, but signing off on a “corporate pre-nup,” which carefully balances the rights of both parties should help lessen the potentially contentious nature of the investor’s ultimate departure from the company. This blog post therefore reviews some of the critical terms that majority owners and minority investors will want to include in their buy-sell agreement to provide for a more peaceful future Business Divorce between them. Those terms are listed and discussed below: Continue Reading Threading the Needle: A Win-Win Buy-Sell Agreement for Private Company Majority Owners and Minority Investors
There are many reasons for business owners to consider adding new partners, including to secure additional capital, to add needed expertise to help grow the company, to bring family members or close friends to join in building the business and to put a succession plan in place. Adding new partners can therefore provide a boost to the company’s revenues, lighten the load carried by the founder, and put the business on course for long-term success. But this decision is not without risk because the new business partners may create conflicts, disrupt the business and insist on making changes that put the company’s existence in peril.
If after carefully weighing the pros and cons, business owners decide to move forward in adding new partners, this post reviews important steps they can take to protect themselves and the business from the decisions and actions of these new stakeholders in the company.
Equity Ownership Can Be Conditional or Subject to Cancellation
One protective step business owners can take when adding a new partner is to make the addition of a new partner’s ownership conditional or subject to cancellation. This approach permits the owner to wait to grant the ownership interest in the company to the new partner until he or she has met specified business goals by a certain date or to cancel the grant of equity to the new partner if the specific goals have not been achieved by the agreed date. Continue Reading Keeping Eyes Wide Open When New Members Join the Pack: A Cautious Approach to the Addition of New Business Partners
“Adversity does not build character, it reveals it.”
James Lane Allen, Novelist, 1849-1925
The sudden onset of the Coronavirus has required private company business partners to confront unprecedented challenges. In some cases, the partners’ actions in dealing with the Pandemic have led to conflicts revealing incompatible views between them in how to operate the business in a time of crisis. As a result, the partners may want to engage in a Business Divorce after the virus subsides, but separating one or more business partners from the company is not likely to be simple or smooth if they have not already put a buy-sell agreement in place. Fortunately, the absence of a current buy-sell agreement is not an insurmountable hurdle if the partners will take the time to negotiate and adopt a mutually beneficial partner exit plan. Reaching agreement on a buy-sell agreement is a critical step for business partners to avoid a prolonged and expensive conflict that will be both disruptive to the company and also potentially destructive to their personal relationship.
This post discusses the key factors that both majority owners and minority investors will want to consider in negotiating a mutually acceptable buy-sell agreement that allows for partners to depart the business on amicable terms in the future.
The Trigger Point
The first question business partners will need to address is when the buy-sell agreement can be triggered. To be fair to both sides, the parties will both want the right to trigger a buyout or redemption. From the majority owner’s perspective, he or she may not want to be required to remain in business with the minority investor. The majority owner will therefore want to secure a “redemption right” to repurchase the investor’s ownership interest at some point. By the same token, the minority investor will not want to be stuck holding an illiquid, unmarketable interest in the company with no exit right. The minority investor will therefore want to ensure to obtain a “put right” that enables the investor to secure a buyout from the majority owner and the right to monetize the investor’s ownership interest in the company. Continue Reading Time for A Buy/Sell Agreement? Private Company Owners May Need to Put a Partner Exit Plan in Place
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.
In his famous “To Be or Not to Be” soliloquy, Hamlet anguished over whether his future was worth living.  Hopefully, private company founders picture a future less bleak than Hamlet’s grim outlook. When the founders of fast-growing private companies accept new investment capital, however, they need to consider the future of the resulting ownership structure of the business, particularly when the financing involves issuing new company shares.
When a private equity investment is made in a private company, a balance must be struck between the competing interests of the company’s founders, on one hand, and the private equity or venture capital firm (the “PE investor”) on the other. From the PE investor’s perspective, an investment in a private company makes sense only if the founders maintain their continued commitment to the company’s success. Once the investment is made, founders will want to make sure they have an exit plan in place that provides them with ample rewards when they depart based on the financial success (hopefully) they helped the company to achieve.
This balancing of interests between founders and PE investors is often handled through a vesting process regarding the founders’ stock or equity ownership. This post, therefore, focuses on the use of vesting schedules by private companies when issuing stock. Ideally, the use of vesting schedules that apply to stock ownership is complimented by buy/sell exit planning, i.e., founders will want to secure some type of a buy/sell agreement that permits them to monetize their interest in the company at the time of their exit. Continue Reading “To Vest, or Not to Vest” —The Question for Company Founders Who Receive Equity/Stock In Connection with a New Private Equity Investment in the Business