So You Want to Share the Pie?
"Many private business owners sell (or grant options to sell) minority ownership interests in their business to employees, investors, family members, friends and others. The majority owner selling these minority interests may be motivated by many reasons, such as: the desire to obtain new capital, incentivize, reward or put "golden handcuffs" on employees, strive for family harmony, obtain estate planning goals and reap the emotional feeling of power or largesse.
"The majority owner’s goals, while certainly well intended and understandable, often focus only on these positive aspects, but seldom factor in the countervailing concerns" that are addressed in this article [from Business Law Today]."
The article notes that, "The sensitivity of majority owners to common pitfalls in their relations with their minority partners, together with their taking reasonable precautions prior to and after offering ownership positions to minority owners, can minimize litigation, improve harmonious inter-owner relations and improve the business’ prospects for success."
The article provides the following list of factors to consider when taking on minority investors:
Overall fundamental fairness/exercise of fiduciary duty. A vigilant or persistent minority owner will be entitled to scrutinize carefully every action or inaction by the majority owners. These rights exist, within reasonable limits, whether the minority owner sincerely questions the majority’s conduct or is trying to use its position to frustrate or hinder the majority.
In general, minority owners may assert that the majority breached its fiduciary duty or engaged in bad faith and unfair dealing and other contractual breaches based on various fact patterns. To support those legal conclusions, minority owners will seek to weave a tapestry of facts showing that the majority regularly or systematically, or at least occasionally, favored itself over the best interests of the business or the minority...
Affiliate agreements. Minority owners seeking to challenge a majority owner’s conduct may be entitled to carefully scrutinize all contracts, agreements and other arrangements between the business and suppliers, customers, consultants and other businesses owned or operated by the majority. The fairness of the price, comparative quality of performance and openness of the bidding for the affiliated company’s goods and services are often subject to criticism...
Salaries, bonuses. Similar to issues raised under affiliate agreements, compensation arrangements with key employees, particularly those employees who are majority owners or related to majority owners, will be subject to scrutiny on the same basis...
Distributions of excess cash vs. reinvestment. The different priorities of majority and minority owners are magnified in the area of a privately held business...Majority owners want the untrammeled flexibility to reinvest the free cash in the business, buy additional businesses (whether or not in the same line of business as the existing business) or make distributions to owners...while the minority...often looks to the business as a source of cash...
Sale of business and structure. The minority owner may challenge all aspects, substantive and procedural, of the ultimate sale of the business. Besides the obvious substantive areas for challenge such as the timing (either too soon or too late) and the price and payment terms, minority owners may examine other aspects of the transaction that allegedly favor the majority. Substantive areas often challenged for their alleged mischief include:
• allocations of the sale price to noncompete and consulting and similar arrangements in favor of the majority (thereby reducing the net consideration available to the minority),
• other post-closing arrangements between the buyer and the majority (such as leases or purchase-and-supply contracts) and
• the overall tax structure and financing of the transaction...
Business focus, priorities. A minority owner, whether wanting to make mischief or fervently convinced of its position, will scrutinize and criticize the business priorities and focuses of the majority. Frequent areas of dispute involve new business opportunities, geographic areas of sale, distribution practices, treatment of disappointing product lines, joint ventures or outsourcing and hiring or retaining key personnel...
Dissenters’ rights on sale. While dissenters’ rights are a creature of and will vary with state law, they typically provide grounds for challenges to the fairness of the price of the sale or merger transaction. Absent a showing of fraud or other egregious abuses, dissenter rights statutes will not allow a minority owner to block a transaction, but rather, to seek a higher price for its shares...
Information rights....Two major implications flow from such disclosure of information. First, to the extent that "knowledge is power," a minority owner may be better equipped to ask questions, challenge entity action and cause unwanted delays and confrontation. Second, dissemination of information increases the risk that it will be disclosed to competitors or those who could otherwise use the information to the entity’s detriment...
Participation rights. Minority owners frequently try to expand their rights to participate in the affairs of the business in a manner disproportionate to their minority position. They may seek rights to approve fundamental transactions through super-majority thresholds for any number of matters. These may include the right to approve a sale, major acquisitions, budgets, capital spending, borrowing, compensations, hiring and firing of key personnel and a litany of other areas...
Future opportunity rights. A majority owner may desire to expand the business — or buy a competing or complementary line — by forming a new entity in which the minority does not participate, and thereby exclude the minority from benefiting from this new opportunity. This raises issues such as affiliated entanglements discussed above, the loyalty of the majority to the existing business, breach of fiduciary duty and usurping corporate opportunity...
Co-sale rights. Minority owners...will attempt to assure the right to sell their interests in the business at the same time, and on the same terms, as the majority...These "tag-along" rights...may impinge on the majority’s flexibility if:
• it desires to reap a premium for itself, at the expense of the minority, for possessing control of the business,
• it desires to sell, or the buyers desire to buy, only a portion of its interests and, therefore, the minority’s tag-along rights will reduce the majority’s sale proceeds accordingly or
• certain procedural requirements in the tag-along process are not followed and render the sale susceptible to challenge.
Conversely, if a buyer desires to purchase all ownership interests in a business, the minority’s refusal may result in a blocked sale or reduced price...
Redemption rights....Obligations to repurchase the minority’s interests could affect the business’ free cash flow and divert resources from investment in more productive activities, or distributions to shareholders, to recapitalization...
