Experience teaches us that all relationships have ups and downs, including those existing between business partners.  When the relationship becomes strained between partners in a private company, however, the majority owner of the business must decide whether these problems are fixable, or whether the best decision is to remove the partner who holds a minority ownership stake in the company.  This is Part 1 of 2 posts, and it focuses on identifying some of the most common characteristics of difficult business partners.  When these vexing attributes exist in a business partner with a minority ownership interest in the company, the majority owner needs to consider whether to buy out the partner’s stake, or at least end his/her involvement in the day-to-day operations of the company.  In Part 2, we will discuss the process for the company’s majority owner to remove a difficult partner from the business, and we will also look at strategies that enable minority investors to exit the business and secure a buyout of their ownership interest in the company when serious conflicts arise with the majority owner.

Prevent Conflicts Before They Happen

The best way to avoid becoming involved in a dysfunctional business relationship in a private company is not to go into business with a difficult business partner.  This may sound like a high bar to overcome because it is hard to accurately predict how a relationship with a new business partner will ultimately pan out.  But, there are concrete steps potential business partners can take before they go into business together to determine if they are likely to be a good match when they join forces in managing and building a private company.

First, the potential partners can hire an experienced business coach who can evaluate their value systems, their approach to business issues, and how they handle conflicts that arise in the business.  The coach can then provide them with a recommendation as to whether they appear to be compatible or whether there are major differences between them, which may lead to conflicts in the future.  Second, the partners can also take available/standardized tests, which will provide an overview of their personality types and traits that help them to assess if they likely to gibe in working together.  Finally, the partners can work together on a detailed business plan for the company that covers the following items:  (i) their job titles and duties, (ii) how the company will be financed, managed, and marketed and (iii) how they will handle the exit of a partner from the business in the future.   The way the partners work through this business plan may confirm that they are compatible or it may highlight significant personality conflicts and/or differences in their values, which raise red flags as to whether they would work well together as partners.

This type of pre-planning requires time and money, but is worth the effort and expense, because it will help avoid a potentially disruptive and public legal fight over a partner’s future exit from the business.  Further, and discussed in Part 2, before business partners start, purchase or invest together in a private company, they should negotiate and adopt a buy-sell agreement or other form of a detailed, written partner exit plan. Continue Reading When to Pull The Plug: Is It Time to Say Goodbye to Your Business Partner? (Part 1)

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It is common for private company co-owners to have disagreements while they operate their business, but they typically work through these disputes themselves.  In those rare instances where conflicts escalate and legal action is required, business partners have two options—filing a lawsuit or participating in an arbitration proceeding.  Arbitration is available, however, only if the parties agreed in advance to arbitrate their disputes.  Therefore, before business partners enter into a buy-sell contact or join other agreements with their co-owners, they will want to consider both the pros and the cons of arbitration.  This post offers input for private company owners and investors to help them decide whether litigation or arbitration provides them with the best forum in which to resolve future disputes with their business partners.

Arbitration is often touted as a faster and less expensive alternative to litigation with the additional benefit of resulting in a final award that is not subject to appeal.  These attributes may not be realized in arbitration, however, and there are other important factors involved, which also merit consideration.  At the outset, it is important to emphasize that arbitrations are created by contract, and parties can therefore custom design the arbitration to be conducted in a manner that meets their specific needs.  The critical factors to be considered are: (i) speed—how important is a quick resolution to the dispute, (ii) confidentiality—how desirable is privacy in resolving the claims, (iii) scope—how broad are the claims to be resolved, (iv) expense—how important is it to limit costs, and (v) finality—is securing a final result more desirable than preserving the right to appeal an adverse decision. Continue Reading Feuding Business Partners in Private Companies: Considering Arbitration to Resolve Partnership Disputes

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.[1]  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 BuyOut 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

In February 2009, Pittsburgh Steelers wide receiver Santonio Holmes made a toe tapping catch in the back corner of the end zone[1] to secure a thrilling, come-from-behind win and crush the hearts of Arizona Cardinals fans in Super Bowl 43.  For private company owners running their own firms, the boundaries for their conduct are set by the fiduciary duties they owe to their companies.  But in both sports and the management of private businesses, team leaders can find it challenging to remain inbounds.  This post therefore reviews the legal lanes of proper conduct that owners will want to follow to avoid future claims.

The Scope of Fiduciary Duties

The fiduciary duties of corporate directors and officers are not included in the Texas Business Organizations Code (“BOC”), but Texas case law for more than a century makes clear that both directors and company officers owe duties of obedience, care, and loyalty, and these duties are owed to the company, not to the individual shareholders.  See Tenison, v. Patton, 95 Tex. 284, 67 S.W. 92 (1902); Ritchie v. Rupe, 443 S.W.3d 856, 868 (Tex. 2014).  These same fiduciary duties also apply to LLC managers and officers, and all of these parties are referred to in this post as “control persons.”

The Ritchie case focused on whether minority shareholders have a legal right to secure a court-ordered buyout of their minority ownership interest based on claims that control persons engaged in shareholder oppression.  The Court held no claim for shareholder oppression exists in the BOC or at common law that would authorize a trial court to order the company or majority owners to buy the minority owner’s stake in the business.  But, the Ritchie Court did uphold the right of minority shareholders to pursue claims against officers and directors for breach of their fiduciary duties, and recognized that these claims could be brought on a derivative basis.

In this regard, the Court stated that:

“Directors, or those acting as directors, owe a fiduciary duty to the corporation in their directorial actions,and this duty “includes the dedication of [their] uncorrupted business judgment for the sole benefit of the corporation.”
443 S.W.3d at 868.

The BOC permits the fiduciary duties of control persons to be limited in the company’s governance documents, but the statute does not permit a company to remove the duty of loyalty owed by control persons.  The remainder of this post focuses on what the duty of loyalty requires from governing persons in their business relationship with their companies.

Conflicts Transactions by Control Persons Can Lead to Claims

Owners of private companies commonly engage in transactions with their businesses in their capacity as control persons.  Majority owners may buy, sell and lease property from or to their companies, buy and sell products or services from other businesses they also own or control, and loan money to their companies to fund their business operations.  All of these transactions are not at “arm’s-length” and, instead, they are “interested party” transactions, which are sometimes referred to as “conflict transactions.”  These types of conflicts transactions may result in claims by the minority owners who allege that the transactions breached the control person’s fiduciary duties because they were not fair to the company.

Once again, the Supreme Court in Ritchie addressed this problem:

“[T]he duty of loyalty that officers and directors owe to the corporation specifically prohibits them from misapplying corporate assets for their personal gain or wrongfully diverting corporate opportunities to themselves. Like most of the actions we have already discussed, these types of actions may be redressed through a derivative action, or through a direct action brought by the corporation, for breach of fiduciary duty.
443 S.W.3d at 887.

There is a “safe harbor” provision in the BOC for company control persons when they engage in business with their company for their personal benefit.  Section 21.418 of the BOC provides that when a control person enters into a transaction with the Company, which would otherwise be void or voidable, the transaction will be nevertheless be upheld as valid if certain conditions are met.  We discussed this safe harbor statute in more detail in a previous post (Read Here).  In summary, a conflict transaction by a control person will be upheld if (i) the details of the transaction were fully disclosed to and approved by a majority of the shareholders and/or by a majority of the disinterested directors or (ii) if the transaction is deemed to be objectively fair to the company.

Fairness is not defined in the BOC provisions, but fair is defined in Webster’s dictionary as “characterized by honesty and justice” and “free from fraud, injustice, prejudice or favoritism.  Once the minority shareholder brings a claim and demonstrates that a control person engaged in a conflict transaction, the control person will then bear the burden of demonstrating in the case that the terms of the transaction were fair to the company.  To avoid being forced to litigate the issue of fairness, control persons may want to avoid the following types of conflict transactions or, alternatively, they may want to take steps to head off the expected challenge from minority owners that the transaction was not fair to the company.

Examples of Conflicts Transactions

The following are the most common types of conflict transactions that control persons engage in with their companies, and for each of these, an approach is suggested that can either eliminate or reduce the potential for future claims.

  • Theft of corporate opportunity
    The duty of loyalty requires control persons not to take business opportunities for themselves that rightfully belong to the company.  When control persons take company opportunities, this is referred to as usurpation or misappropriation and it is a breach of fiduciary duty.  There is a clear way, however, for control persons to avoid this claim.  In 2003, the BOC was amended to allow for a company to include in its certificate of formation, bylaws or in its company agreement an express waiver of the control person’s duty not to usurp a company opportunity.  See. BOC Section 2.101(21).  The specific language gives the company the power to:

 . . . renounce, in its certificate of formation or by action of its governing authority, an interest or expectancy of the entity in, or an interest or expectancy of the entity in being offered an opportunity to participate in, specified business opportunities or a specified class or category of business opportunities presented to the entity or one or more of its managerial officials or owners. 

As indicated by this provision, the certificate, bylaw or provision of the company agreement needs to make clear the specific type or category of opportunities that are being excluded from the duty.  By including this limitation on the duty of loyalty, however, the control person will be immune from any liability for usurping a corporate opportunity of the company as it is defined in the bylaws or in the provisions of the LLC agreement.

  • Purchase or sale or lease of property to company, and loans to company 
    It is common for control persons to either sell, purchase or lease property, assets or services to/from the company they control or to provide loans to the company.  These are all conflict transactions that can, and often do, give rise to claims for breach of fiduciary duty and fights about whether the control person engaged in a transaction that was unfair to the company.  To avoid or at least limit claims related to these types of transactions, there are a number of common sense, practical steps that control persons can take before they engage in the transaction.

First, the control person should fully disclose all material terms of the transaction to other shareholders, the board and/or managers of the company and seek their approval, which if given, should eliminate all future claims.  Second, when there are objections raised to the transaction, the control person should consider securing input from outside experts to provide objective information.  For example, if the control person is selling or leasing property to the company, the control person should arrange for an independent appraiser to provide a written appraisal to set the property’s market value.  If a lease of property is at issue, an independent broker can provide market value lease rates for the type of property at issue.  Third, when the company is receiving loans from the control person, bankers can readily provide loan terms that reflect market rates.

Finally, the control person should consider structuring the transaction in a way that provides the company with a better deal on terms more favorable than market rates.  The control person does not need to give the company a gift in the transaction, but if the company receives a deal that is better than market rates, that will make it harder for the other shareholders or LLC members to complain that there was any lack of fairness in the transaction to the company.

  •  Compensation and bonuses 
    Finally, a hot button point with shareholders and members is often compensation, and more specifically, how much money is paid in base compensation and bonuses to the majority owner in his/her capacity as an officer, director or manager.  The obvious concern is that funds paid in compensation should, instead, be issued as dividends or distributions to all owners, and that the compensation paid to the majority owner is considered a “disguised distribution.”

If the other shareholders or members express concern regarding the compensation and bonuses that are being paid to the majority owners, this issue should be addressed by hiring an experienced and independent executive compensation expert.  The compensation expert will provide the company with a range of compensation that is being paid to executives at similarly situated companies in the same or similar industry and geographic region.  As noted above, rather than choosing a compensation/bonus level at the top end of the range determined by the expert, the majority owner is advised to select a range of compensation in the 70-80% range to limit the likelihood of any claim being brought by minority owners on this basis.

Conclusion

In King Henry IV, Shakespeare wrote: “Uneasy lies the head that wears a crown.”  One cause for this unease by private company owners who wear the mantle of leadership is that they are subject to suits by co-owners for breach of loyalty to the company.  But staying inbounds is by no means an insurmountable challenge for majority owners, as control persons, if they follow a few simple ground rules.  In short, majority owners need to be fully transparent in all of their transactions with the company, they should seek agreement when possible with other owners, but when an agreement is not possible, they need to secure specific input from outside experts who can validate the fairness of the transaction to the company before it takes place.  And regarding that Santonio Holmes TD catch, let’s look ahead and hope the Cardinals get another chance at a Super Bowl win soon led by their exciting QB and No. 1 Draft Choice, Kyler Murray.

_____________________________

[1] Cardinals fans like me continue to question whether Holmes actually managed to get his right toes down on the turf in the end zone before he was pushed out of bounds, and photographs of the catch prolong this debate.

According to the financial press, private equity investors are holding huge sums waiting for the right private company in which to invest.  In late March, CNBC reported that private equity firms have a staggering $1.5 trillion in cash on hand (more than double the amount from five years ago) and that they are actively seeking deals in the travel, entertainment and energy industries.   In April, Vanity Fair stated that in each of the past four years, private equity managers have raised more then $500 billion for investment, and noted that from 2013 to 2018, more private equity deals took place than in any five year time frame in American history.

Private equity firms are not the only ones who are making investments in private companies.  Angel investors and others are stepping up to fund privately held businesses, and there are many documented success stories of individual investors who have struck platinum with their private company investments.   It is is also true, however, that a sizable number of fast growing private companies hit the rocks and burned through all or most of the funds that were invested in them.

The purpose of this blog post is not to help pick private company winners—that is a topic for others with the ability to discern which companies have the best ideas, management teams and the staying power to succeed on a long-term basis.  But picking a successful private company is only part of the story.   A private company’s success will not automatically make an investment in the business a success if the company’s governance documents do not provide the investor with a measure of protection on several important fronts.  This blog post therefore focuses on the critical terms that an investor will want to secure in the company’s governance documents before actually making a substantial investment in the company. Continue Reading Looking Past the Face of the Shiny Penny: Check the Fine Print of All Private Company Investments

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

Lawyers play a critical role in negotiating and drafting contracts, but when business owners and investors enter into significant agreements regarding or on behalf of their private company, these documents are too important to leave them solely in the lawyer’s hands.  The parties to these business agreements need to carefully read and understand their terms if they want to avoid unwelcome surprises when their agreements become the focus in a future legal dispute.  There are a number of issues to consider in documenting business agreements, and the elements that go into developing binding business contracts is the subject of this blog post.

The Terms of the Written Agreement Control

The starting point in securing an enforceable agreement is to “get it in writing.”  Virtually all business agreements are entered into after the parties have discussed the material terms of the contract, and in some cases, these negotiations may last for weeks or even months.  One party to the contract may therefore conclude that assurances it received from the other party during these negotiations should be as binding as the actual terms of the agreement.  Unfortunately, a party who seeks to enforce oral promises or assurances outside the contract faces a steep uphill climb under Texas law.

Standard contract terms will likely include both a “merger/integration clause” and “anti-reliance provisions.”  These terms exclude from being part of the agreement any offers that were made during the parties’ discussions, as well as any representations the parties made that are not expressly set forth in the contract.  Over the past two years, Texas Supreme Court has made clear that the actual terms of the contract control, and it has repeatedly rejected claims that are based on statements made outside the contract.  In 2018, in Orca, the Supreme Court denied a fraud claim without requiring a trial on the basis that the reliance element of fraud can be “be negated as a matter of law when circumstances exist under which reliance cannot be justified.”[1]  Just last year, the Court overturned large jury verdicts in two separate fraud cases setting aside judgments based on alleged misrepresentations that were not set forth in the contracts at issue. Continue Reading Did Your Business Deal Just Do a Disappearing Act? Securing Legally Binding, Enforceable Contract Terms

There has been considerable speculation that one consequence of the Coronavirus will be an increase in the divorce rate resulting from togetherness imposed by the quarantine that pushes marriages already on shaky ground over the brink.  Whether divorces will increase in the future due to Covid-19 remains an open question, but what is certain is that a sizable number of future divorces will involve the transfer of a business ownership interest between spouses as part of the divorce.  To address this situation, this post focuses on key business issues that arise when one spouse (the “Divesting Spouse”) transfers an ownership interest in a business to the other spouse (the “Recipient Spouse”) as part of a divorce settlement.  Addressing these issues will help the Recipient Spouse continue to run the business successfully and also avoid future conflicts with the Divesting Spouse, as well as with future investors and potential buyers of the business.

1. Don’t Rely on Divorce Decree or Settlement Agreement to Document the Transfer of a Business Ownership Interest Between Spouses

A divorce decree and settlement agreement will document the terms of the divorce and the division of property between spouses, but it is not a good idea to rely on the decree or the divorce settlement to memorialize the transfer of a business interest between spouses.  There are a number of reasons for the Recipient Spouse to insist on securing a stock transfer agreement (or its equivalent), including the fact that the Recipient Spouse will likely be required to show the transfer document to third parties in the future, including banks or other lenders, new investors, company officers or managers, and potential future buyers.  The Recipient Spouse will not want to show the decree or settlement agreement to these third parties, however, because they include private matters unrelated to the business.  This will therefore require the Recipient Spouse to prepare a heavily redacted document for review by third parties.  It is more efficient to simply require a transfer document to be signed that is limited solely to issues related to the business. Continue Reading Family Law: Transferring Private Company Interests in Divorce—Going Beyond the Basics to Ensure Continued Success and Avoid Conflicts

L to R: Tom Bronson, Ladd Hirsch

Recently I had the pleasure of sitting down for a virtual interview with my friend, Tom Bronson, as part of his Mastery Partners webcast series.   Tom has a wealth of experience helping business owners prepare to sell their companies, and we visited about how business owners can maximize value at the time of sale.  We also cover a number of issues related to buy-sell agreements and other Business Divorce topics.   Listen to the podcast here.

“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