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Delaware Chancellor Kathaleen McCormick held again last week that the pay package that Tesla’s board of directors awarded to Elon Musk in 2018 suffers from “fatal flaws,” and it was therefore rejected. This was the second time Judge McCormick reached this same result, and she issued her new ruling despite the fact that, after she tossed out Musk’s compensation plan back in January, the Tesla shareholders then voted overwhelmingly in June (by more than 70%) to approve the full stock award that the company’s board had granted to Musk. There is little doubt that Musk is a unique figure, and it is also significant that Tesla is a public company, but looking under the hood of the Musk/Tesla compensation battle provides some valuable lessons for non-public companies and their majority owners.

Some would say that with Musk at the steering wheel, Tesla is driving the “diva model” of company leadership. Whether one agrees with Judge McCormick’s rulings or thinks she overstepped her authority (Musk has made his position clear by pledging to move Tesla to Texas), her decisions highlight what constitutes good corporate governance, which applies to both public and private companies. As discussed below, committing to board independence, focusing on leadership that recognizes teamwork and building a strong company culture is an approach that will benefit companies of all sizes. 

1. Appoint and Foster an Independent Board

The importance of independent board oversight cannot be overstated. No majority owner of a private company needs to cede control over the business to an independent board, as this is not required for effective company governance. But majority owners and their companies do benefit when their boards are not populated solely by their family members and close friends. Specifically, owners will obtain an invaluable perspective and hard-earned insights from board members who have a track record working in the industry, have served on other boards, and do not shy away from offering their views about the company’s plans and operations.

It is not hard to understand why Judge McCormick questioned the independence of the Tesla Board members. Musk’s brother, Kimbal Musk, is one of five Tesla Board members with close ties to Musk, which include financial relationships with his other businesses like SpaceX, the rocket company. The court’s opinion from January set forth these concerns. 

The process leading to the approval of Musk’s compensation plan was deeply flawed. Musk had extensive ties with the persons tasked with negotiating on Tesla’s behalf. He had a 15-year relationship with the compensation committee chair, Ira Ehrenpreis. The other compensation committee member placed on the working group, Antonio Gracias, had business relationships with Musk dating back over 20 years, as well as the sort of personal relationship that had him vacationing with Musk’s family on a regular basis. The working group included management members who were beholden to Musk, such as General Counsel Todd Maron, who was Musk’s former divorce attorney and whose admiration for Musk moved him to tears during his deposition. In fact, Maron was a primary go-between Musk and the committee, and it is unclear on whose side Maron viewed himself.

For the majority owners of private companies, securing a board that is truly independent avoids these types of conflicts over decisions regarding the executive’s compensation. Just as importantly, an owner who receives input from an independent board is positioned to accomplish the company’s goals more quickly, while also steering past avoidable mistakes.

2. Share the Wealth with Others

The second point goes beyond fairness. Given the staggering appreciation in the value of Tesla’s stock during Musk’s tenure, there are strong arguments to justify his unprecedented pay package. But a different question is whether any company leader should receive compensation that is drastically higher than all other executive team members, who also contributed to the company’s success. By analogy, consider the lead singer/songwriter in a rock band who writes all the band’s songs and therefore receives royalties that provide him with compensation vastly greater than all other band members. The lead singer/songwriter can certainly justify his outsized compensation, but if he declines to figure out how to share royalties or other income streams more equitably, he will likely find himself becoming a solo artist on his next tour. 

Turning back to business leaders, even when a CEO is vital to the company there are other stakeholders in the company, who also play a meaningful role in helping the business achieve success. If the compensation of the other executive team members is dwarfed by the CEO’s pay package, they are likely to look for other places where they feel more valued. It also goes beyond the amount of the compensation because a CEO who takes all the credit and fails to recognize the contributions of others will not maintain a long-lasting team. Finally on this point, a CEO who receives an extremely high level of compensation will become a target much more quickly. The patience of the board and shareholders will run out much sooner when the high-paid CEO fails to consistently deliver extraordinary results.

3. Develop a Culture of Collaboration, Not Conflict

The third point relates to creating a successful company culture. In Musk’s case, Tesla’s board has largely given him free rein to run the company as he deems best as CEO, but he has had contentious relationships for many years with other officers, employees and stakeholders. It should be noted that this type of leadership conflict may not derail the company, and Tesla continues to perform well in the public market (in 2024, its stock began trading below $250 but is now closing in on its record high of almost $410 reached in 2021).

Notwithstanding Tesla’s notable success, most majority owners would prefer to govern their companies through collaboration rather than conflict, which requires focusing on collective efforts that celebrate teamwork. At a granular level, teamwork requires the owner to facilitate open lines of communication, to conduct decision-making through consensus and to maintain transparency throughout the process. This multi-faceted process may slow down the time for making key decisions as it requires more input and deliberation. When the members of the executive team have meaningful roles, however, and they are permitted to participate in the decision-making process, that will create strong buy-in. A collaborative company culture will sustain the company during good times, as well as through challenges, and the majority owner will not have to go it alone. Instead, the company’s success will be shared by the entire team.

Conclusion

The stock award granted to Musk at Tesla is so extraordinary, the legal conflict it has led to in Delaware has generated ample headlines. In more simple terms, however, the underlying dispute in the Musk case raises broad questions about how companies can be run effectively, including private companies controlled by founders. Although the diva model has worked well for Musk as a singular talent at Tesla, this approach may not provide majority owners in private companies with the best opportunity for success. Instead, majority owners may want to consider: (i) establishing a board that provides them with the benefits of independent judgment and input, (ii) creating a compensation structure designed to allocate financial rewards more broadly for all executives and (iii) fostering a culture of collaboration so that the company’s success is truly a product of teamwork.

Musk may well prevail in Delaware and finally receive his enormous stock award from Tesla after years of litigation. Whether private company majority owners would prefer to avoid this drawn-out legal conflict with their shareholders is worth considering, as well.

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Majority owners of private companies are empowered to exercise control over their businesses, but if they disregard the valid concerns of their minority partners, they may sow the seeds for a divisive business divorce in the future. The typical business owner is focused, decisive and driven to succeed. These characteristics are admirable, and they work best when paired with an approach to company governance that provides minority partners with transparency and some participation in decision-making. This post identifies three governance controls that are designed to help majority owners maintain goodwill with their business partners while keeping the company on track for continued success.

Adopt Governance Controls That Strike a Reasonable Balance

The majority owner’s gut instinct is to preserve unfettered power over the company, but insisting on this all-powerful, exclusive approach may undermine the owner’s goals and needlessly create conflict with and distrust by co-owners. Fortunately, adopting a more balanced approach to governance will not unduly tie the majority owner’s hands, and it will provide transparency and protections that are desired by the company’s minority partners. 

The governance controls that strike this balance will be set forth in corporate bylaws, in the LLC company agreement, or in written procedures adopted by the company’s board of directors or managers. These controls will provide for limits on the majority owner’s authority as explained below.

  • The governance controls will specify limits on the majority owner’s power to act in the capacity as CEO or president without obtaining approval from the board or managers.  For example, with approval, the majority owner may not be able to: (i) direct the company to enter into the sale or purchase of assets above a certain dollar limit, (ii) enter into any self-interested transactions with the company for loans, sales, or purchases, or (iii) enter into contracts to sell or issue any stock of the company. Ultimately, given the owner’s majority ownership, the owner should be able to overcome opposition to these proposed actions from the board or managers, but it will first require a discussion with these other participants in the management of the business.  
  • Similarly, to limit conflicts and dissension, the majority owner should not seek authority to set his or her own compensation, bonuses or the issuance of any additional interests in the company.  All of these should require the involvement and vote of the board or managers, and in some cases, a vote of the other owners. The board and managers may also decide that the majority owner is not permitted to set the compensation or bonuses of any other officers and that these compensation decisions need to be a topic of discussion and vote by the full board/managers.
  • Finally, the decisions regarding the hiring and firing of employees may also need to be subject to approval by the board/managers. If the majority owner is hiring family/friends and firing all naysayers who express any opposition to the majority owner’s views, this will lead to morale issues and may well create disputing factions within the company.  The better practice is to require the majority owner to seek/obtain input from the board or managers regarding employment decisions.

Create a Culture of Transparency in Management

Providing transparency has been referred to as the key antidote for partner conflicts. Keeping significant owners in the business informed of major decisions by management will go a long way toward building trust, and it will also help all the co-owners feel connected to and supportive of the company’s direction under the majority owner’s leadership.

To achieve this type of internal transparency, the majority owner will want the company’s governance documents to provide for the following:

  • A well-run company will hold regular meetings of boards/managers, as well as and owners (shareholders or members). The minimum would be annual meetings, but boards/managers in particular should meet more often to provide consistent management oversight and to avoid allowing major problems to fester. Owners’ meetings could be held semi-annually if having quarterly meetings is viewed as too burdensome. 
  • In addition to holding regular meetings, the company will also want to provide financial reports to owners on a consistent periodic basis. The bare minimum would be to issue these reports annually, but to achieve the goal of healthy transparency, it is advisable to issue these reports on a quarterly basis, if not more frequently. 
  • The final transparency point is to provide prompt notice to owners when major variances or problems arise. For example, most private companies issue dividends or distributions each year to all the owners to cover their “pass through” income tax liability. If there are problems that will require the company to retain an unusual amount of earnings and issue a smaller amount of dividends/distributions than is customary, notice of this reduced payment should be provided as soon as possible. This will alleviate the problem of a sudden, unwelcome development for the owners that is presented to them with no advance notice.

Provide for Meaningful Participation in Governance

The last governance control procedure for majority owners to put in place is to provide co-owners with the opportunity to participate in the company’s governance in a way that is not perfunctory. This is a due process concern, because minority partners will never have the right to direct or control the management of the company, but they should have participation rights.

More specifically, minority partners should be able to bring items up for the full board or managers to consider, and they should have the opportunity to vote on matters of substance. This will require that certain procedures are established before and during governance meetings to ensure that all owners can exercise these rights. These procedures are reviewed below.

  • All board/manager meetings should be scheduled in advance, and agendas for each meeting also should be circulated listing the items for discussion and vote by the members at the meeting.
  • The board/managers should outline company goals, review the progress that has been made in achieving the goals and provide an overview of the current challenges the company is facing.  
  • When minority partners request that items be included for discussion at the meeting, they should be added to the agenda as appropriate.
  • Minutes should be prepared of each meeting and circulated before or at the meeting for approval by the board, managers or owners.

Conclusion

Companies that create and maintain a strong management consensus are built to last, and they will weather the storms that inevitably come their way. By contrast, a majority owner who wields governing power by giving short shift to the interests of the company’s other co-owners is setting the stage for discord that may lead to a business divorce. While a business divorce that results in the removal of minority partners from the business is rarely fatal to the company, it is likely to create a significant internal distraction, and it may also be negative for the company in its dealings with clients, vendors and others outside the company.

In sum, going through a business divorce is rarely a positive for majority owners, but this distracting conflict is less likely if minority partners remain focused on the company’s long-term success. This goal is achievable when majority owners adopt a governance structure designed to provide minority partners with transparency, predictability and the opportunity to participate to some extent in management.  Further, none of the procedures discussed in this post will deprive the majority owner of ultimate power over the company, and instead, they are intended to assist the owner in building a strong, lasting consensus with all of the company’s owners.

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Money talks when the majority owners of private companies add new business partners who contribute additional capital. When these investors are high-powered PE firms or high-profile companies, with large balance sheets and impressive portfolio companies, they may seem too good to be true. That may be the case, as well, with high-net-worth individual investors who promise to meet all of the capital needs of the business. 

Majority owners need to be wary, however, as they bring additional partners into the fold — these new investors may seem exciting, but they may believe their money shouldn’t just talk but scream. There is no fail-safe formula for choosing good business partners, but this post identifies potential red flags to help avoid business partners who may create problems in the future, including by seeking to exert control over the business. In all cases, majority owners should secure a redemption right (a business prenup) from their new partners to ensure that if conflicts do arise in the future, the disagreements will not derail the business.

The Due Diligence Process for New Investors

Potential new investors should be subject to a vetting process, which is critical to identify potential red flags. One of the best ways to gain insights about new investors is to speak with others who have firsthand experience with them. This is basic due diligence and a check on the investor’s track record. In the case of PE firms, these will be members of portfolio companies in whom the PE firm invested. Questions may include: Did the firm live up to the promises it made before investing? What was the firm’s approach to management? How did the firm resolve conflicts that arose?

In these interviews of members of portfolio companies, the goal is to determine whether the PE firm was a good partner, was helpful to the growth of the business, played a constructive role in the company’s management, and was collaborative in finding resolutions when conflicts arose. On the downside, red flags will be raised if the reports indicate that the firm sought to dominate the leadership meetings, take control over the business, and showed a lack of respect for and no deference to the company’s existing management. 

The PE firm typically provides a list of references for vetting, but the majority owner should go beyond the listed references and, instead, request that the firm provide a list of all investments it made during the past 10 years. There are likely to be some problem investments included on that list, and the interviews should therefore include people who were members of successful portfolio companies in which the PE firm invested, as well as people who experienced challenges during the period of the PE firm’s investment.

Setting Mutual Expectations

One way to determine if potential new investors will be good long-term partners is to gauge whether their interests are aligned with the majority owner’s vision for the company. In making this assessment, the majority owner will want to focus on these questions to the investor: What is the potential new partner’s investment horizon? What approval rights is the investor is seeking to include over management decisions in the investment documents? Is the investor open to some dilution in connection with potential future rounds of investment?

As just one example where alignment with the investor may not exist, if the majority owner does not expect a liquidity event (sale, merger, IPO) to take place for more than five years, that is likely to be a problem if the investor has a shorter time horizon and desires to monetize its investment in five years or less. Another example is if the investor is insisting that its interest will never be subject to dilution of any amount. This position is likely to make it more difficult for the majority owner to raise additional rounds of financing.  

In addition, this approach is a bit formal, but it is generally a good idea to require the investor to describe its expectations in writing to confirm the alignment between the majority owner and the new investor. In fairness, the investor will want to maintain flexibility and retain the right to adapt to changing situations at the company. But, if the investor declines to describe its expected role at the company and to share details of its vision in any written form, that is a red flag. This refusal signals that the investor is saying, in effect, you just have to trust me. In light of this intransigence, the investor’s reluctance to provide any written statement about its role and vision signals that this trust may be misplaced. 

Secure a Business Prenup

Even with the best of intentions, majority owners and investors may find themselves in conflict over the company’s direction at some point in the future. When frank dialogue between the majority owner and investor does not resolve these conflicts, both sides will be glad that they negotiated and adopted a buy-sell agreement (BSA) at the time of the investment. The BSA provides the majority owner with a “call option” that allows the owner to redeem the investor’s interest in the company if the owner decides the investor’s continued involvement in the business has become too disruptive. By the same token, the BSA provides the investor with a “put option” that authorizes the investor to secure a buyout of its ownership interest if the investor becomes dissatisfied with the majority owner’s conduct.

The critical elements of a BSA have been covered in our previous posts, which address how the BSA can be triggered by either party, how the investor’s interest in the company will be valued when the option is triggered, and how the company’s payment for the investor’s interest in the business will be structured. If the parties reach an impasse in their conflict, they should have a clear, prompt method for securing a buyout of the investor’s interest that avoids a protracted, expensive legal battle.

Conclusion

Majority owners of private companies often need additional capital for their business, which they cannot obtain from traditional lending sources. And if the current company owners do not wish to to invest any more capital in the business, the majority owner will need to seek investment from outside sources. At this stage, when majority owners are considering adding new partners who will provide growth capital for the business, the owners need to be cautious or they risk finding out that bringing these new partners on board was a case of the expected cure for the company being worse than the disease.

No one has a crystal ball to know if a new business partner will be a positive, long-term addition to the company. But there are red flags that are likely to surface if the majority owner conducts a thorough vetting process regarding potential new investors, including by interviewing people who have had direct, firsthand experience with the potential investors. Finally, the fail-safe option is for majority owners to obtain a buy-sell agreement from all their new investors. This agreement will provide the owner with a redemption/repurchase right if things do go off the rails with the investors in the future.