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Hindsight can be a wonderful thing, especially if hard-earned lessons are adopted by others who are willing to learn from past mistakes. When private company owners and investors share with me some of the wisdom they have gained from their past dealings with business partners, they often cite the same three mistakes they made in relationships with their partners. In summary, these are (1) choosing difficult partners, (2) failing to enter into well-crafted buy-sell agreements with their partners at the outset, and (3) doling out ownership interests (equity) in the business too freely to new investors.

Avoiding Bad Apple Business Partners

The importance of picking good business partners cannot be overstated. Problems with a company’s services or products can be fixed over time, but a partner who is dysfunctional or who is hostile to the business can create conflicts and distractions that ultimately destroy the company. Of course, no one agrees to enter into business with other partners they believe to be dysfunctional. Instead, people become partners with others optimistically and with a sense that their interests and business objectives are aligned. It is only later they are dumbfounded to learn that their partners are selfish, inflexible, disruptive, or worse, unethical and uncontrollable.

Unfortunately, there is no fool-proof test to apply that will guaranty that a new business partner will be a great longtime fit for the business. But there are two approaches to consider before going into business with someone new, which will lessen the chance of picking a bad business partner. These two approaches focus on, first, checking known attributes of the potential partner and, second, avoiding serious red flags discovered as part of a due diligence process.

The first approach focuses on four aspects of the potential partner, which can be gleaned from this due diligence. The first aspect is experience: Does the potential new partner have a track record of success at other companies, and is he or she well regarded by former employees? Or does the potential partner’s past reflect a string of problem companies and fraught relationships with former employees? The second aspect is flexibility. Change is a constant in business, and a partner who is rigid and resistant to change is likely to be a difficult partner. The third aspect is reliability. Success happens when partners show up consistently and reliably and demonstrate accountability. The final quality may be the most important: integrity. Partners need to be open, honest, and loyal to each other – the opposite is not just bad for relationships, but detrimental to the company. It is a challenge to determine whether a potential partner has these qualities, but a discussion of these qualities should be discussed by the partners. A process should take place where some of the potential partner’s former colleagues are asked if this person exhibits these qualities or whether there are concerns in these areas.

The second approach is the red flags test. Every potential new partner should be subject to a formal background check, which also needs to include a credit report. In addition, each potential partner should be asked about all past and pending litigation in which they have ever been a party, as well as whether they ever filed for bankruptcy. The time and expense of conducting these tests and background checks are well worth it, and a potential partner who balks at providing this information is raising a red flag right at the outset. 

Get a Business Prenup in Place, Adopt a Buy-Sell Agreement

We will not delve deeply into buy-sell agreements here as we have discussed them in the past, and you can read about them in previous posts here and here. Suffice it to say that it is not uncommon for business partners to become at odds, and when their conflicts are irreconcilable, they will want/need a business divorce. If the partners have wisely put a partner exit plan in place, they will have a buy-sell agreement to follow that governs the process for the partner’s exit, which will avoid or limit headaches, heartache and expense.

The buy-sell agreement should cover (1) when the agreement can be triggered by the parties, (2) how the ownership interest of the departing partner will be valued, (3) the terms for payment of the purchase price to the departing partner, and (4) what happens in the event of a default in the payment of the purchase price.  

Retaining Majority Control Over the Business

The final mistake takes place when the company’s founder needs to secure additional capital to grow the business. To obtain this growth capital, the founder will issue stock or units to new investors, which dilutes the founder’s ownership percentage. As the investments mount and the extent of the dilution increases, the majority of the business may become controlled by the new investors. I have represented multiple founders of private companies who were later removed by the new investors from any role in the continued management of the company they had created. This undesirable outcome is likely be a source of significant disappointment for the founder, as well as bad for the business.

Growing companies will need to obtain capital, but that does not mean that the founder needs to cede control of the business to new investors. The founder can negotiate to ensure that he or she remains in control by requiring the investors to accept a minority ownership share. The tradeoff is that this will likely reduce the types of investors who are willing to invest in the company on this basis as many private equity firms will not invest in a company if they do not secure control over the business when they make their investment.

Even if the founder is willing to accept a loss of control over the business to obtain the new investment in the company, there are some fallback positions that the founder can take. The founder should consult with experienced counsel to evaluate the available options, which will enable the founder to maintain continued rights regarding the management of the business while also protecting the founder’s ongoing economic stake in the company.

Conclusion

It is often said that those who do not learn from history are doomed to repeat it. In the private company space, some of the lessons to be learned from owners and investors include (1) taking the time and effort to conduct due diligence regarding potential business partners to avoid being stuck with bad partners; (2) negotiating and adopting a buy-sell agreement at the time the new partner invests in the business to ensure that a business divorce can take place as necessary in the future; and (3) for company founders, if possible, seeking to avoid growing the business in a way that turns over control of the company to new investors. Taking these steps will help to avoid, or at least limit, major problems in the future with business partners. 

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As a business trial lawyer representing private company owners and investors in business divorce disputes and civil litigation for many years, my experience teaches that business partners should approach litigation with caution. Specifically, and for the reasons discussed in this post, I would advise business partners to sue their business partners only when it is required to stop wrongdoing or when a partner’s contract rights have been clearly violated.

First, business divorce lawsuits are expensive to litigate because the disputes are fact intensive, the value of the business will be likely be the subject of intense conflict, and a cadre of experts who need to be retained will add to the fees. Second, these cases are rarely resolved by motion practice, which means the litigation will likely go on for two years (or longer) before trial and eventual appeals. Third, courts in Texas have limited powers, and the verdict rendered by the jury at trial may not resolve the conflict. Specifically, Texas trial courts are not authorized to remove a corrupt partner from the business or order the company or majority owner to buy the interest held by a minority partner in the business. Finally, in many cases, the partner who is sued will respond by filing counterclaims, and as a result, the business partner who launches the lawsuit will be required to prosecute and also defend claims in litigation.

For these reasons, a business partner who is considering filing suit against other partners should consider whether there are alternatives to litigation that would resolve the conflict. If the ultimate conclusion is that litigation is necessary, the partner pursuing the action should evaluate what specific goals the litigation is designed to achieve, and work with trial counsel to develop a realistic budget and timetable for achieving those goals. 

Alternatives to Litigation

When business partners are in conflict about their views regarding the operation of the business, they may be unable reach consensus on a path that resolves their differences, but they may agree that a business divorce is their best option. The issue then becomes whether they can agree on the terms for a partner buyout. This is where a dispute over the company’s valuation (and the resulting buyout price) may create a roadblock that precludes a business divorce from taking place. This situation arises when the parties have not entered into a buy-sell agreement, and thus the minority investor cannot require either the owner or the company to purchase the minority interest via the terms of the buy-sell agreement.

When the partners reach an impasse in buyout negotiations, my suggestion is for them to consider participating in a pre-suit mediation. For the majority owner, the mediation provides the opportunity to secure a buyout of the minority investor without becoming embroiled in years of litigation. The majority owner can attempt to secure this buyout through a variety of creative strategies. As just one example, the majority owner may be able to secure an agreement to buy some, but not all, of the interest that is held by the minority investor, with the remaining interest converted into a contractual obligation that requires the owner to make a further payment tied to the future performance of the business. Unless the investor is demanding an exorbitant price for the minority interest, the majority owner should strive to secure a buyout that ends the distraction the investor has created, avoids the expense of litigation, and regains the shares for the company, which then become available for sale to another party.

From the minority investor’s perspective, a pre-suit mediation is an attempt to negotiate a reasonable sale price for the minority interest without devoting time and expense to litigation. Moreover, the investor may not even have the remedy of a buyout available in the lawsuit, so the mediation may offer the only path to secure a buyout of the investor’s minority interest. A sober assessment from the investor’s perspective includes accepting the reality that the investor will not be receiving any additional salary/bonuses or distributions from the company as these will all be eliminated by the majority owner. The bottom line is that the investor should be incentivized to strike a deal for the sale of its minority interest on reasonable market terms. 

Determine Whether Non-Litigation Options Exist

If the pre-suit mediation is not held or if the mediation is not successful, each side should evaluate if there are any non-litigation options available. The majority owner should be scrutinizing the governance documents to determine if they are subject to amendment. Under the Texas Business Organizations Code, unanimous consent is required to amend corporate bylaws and LLC agreements, but the owners can opt to give a bare majority or a super majority the right to amend. Where amendment is possible, the majority owner could elect to adopt a new buy-sell provision that authorizes the company to buy the interest held by the minority investor. Making these changes may result in litigation by the investor, but the majority should be on solid ground if the changes are consistent with the governance documents. 

For the minority investor, it may be possible to sell the minority interest to an interested third-party buyer. In all likelihood, the majority owner will have a right of first refusal, which will enable the owner to match any offer that is made to the minority investor, but which may lessen the investor’s ability to secure a purchase offer on favorable terms. The investor should, however, at least investigate whether a market exists for the minority interest if the majority owner is only offering to buy the interest for a low-ball price. The investor may find that other partners in the business will pay a price higher than what the majority owner offered for the minority interest.

In addition, the minority investor may also want to exercise the right to require the company to provide access to books and records if the majority owner has engaged in any type of self-dealing conduct. Highlighting misconduct by the majority owner is the right thing to do because it will stop the majority owner from continuing to harm the company. The process of investigating the majority owner’s conduct may also help to incentivize the owner to focus on negotiating a reasonable buyout of the minority investor’s interest.           

Assess the Strength of Claims and Remedies Available, Including Legal Fees

Certainly there are cases where litigation is not just necessary, but essential, which is the case when a business partner is engaging in misconduct that is harmful to the business. In these cases, the final step before filing suit against a partner is to engage in a pre-suit evaluation with assistance from experienced trial counsel. This process will include evaluating the merits of the claims, analyzing what remedies are available – including whether there are claims that provide for recovery of legal fees – and finally, developing an understanding of the legal budget and an estimate of the timetable for getting to trial. 

Regarding remedies, the majority owner may desire to oust the minority investor(s) from the business, but that is not likely to be a remedy the court can award even if the owner is able to successfully prove the claims alleged in the lawsuit. Similarly, if the minority investor is focused on securing a buyout, the court is not permitted in most cases to grant an order for the company (or majority owner) to purchase the shares or interest held by the minority investor. The court can award monetary damages to the minority investor to recover for the harm the company has suffered based on the majority owner’s breach of a fiduciary duty, but Texas courts have never awarded a buyout remedy to an investor based on a majority owner’s breach of fiduciary duty.

Conclusion

Civil litigation can be a powerful tool when one business partner sues another, but this litigation typically involves an expensive and lengthy process, which is unlikely to be positive for the underlying business. For these reasons, business partners are wise to consider whether there are options available that would allow them to achieve their business objectives without filing suit. In many cases, a pre-suit mediation is advisable where the parties can meet and attempt to negotiate mutually acceptable terms for a business divorce.

In those cases where litigation is necessary, the party filing the suit should evaluate the specific claims to be asserted in the case against the other partner(s), the remedies that will be available for those claims in the suit, and the litigation budget for pursuing them. The final point is that the business partner who is filing suit should consider what steps can be taken to mitigate any harm to the business once the suit becomes public. This includes developing messaging strategies to communicate with the company’s employees, clients and key vendors to provide assurances the litigation will not negatively impact the business. 

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Business owners of private companies invest huge amounts of time and resources in their business, which may include the bulk of their financial capital. For owners who do not want most of their net worth to remain tied up in the business, there are options available that would allow them to take some of their chips off the table without walking away from their business. Some of these options may be attractive to owners who want to secure liquidity in a manner that does not require them to forfeit the right to maintain control over their business.

The Private Equity Option

Private equity (PE) fund raising slowed during 2023, but PE firms raised the staggering sum of more than $550 billion in each of the past two years. Significantly, the total number of deals that PE firms completed in 2023 was 20% higher than 2019, but the total aggregate value of these deals still fell below the pre-pandemic level. Perhaps the key takeaway for business owners is that PE firms are still on the hunt to invest in private companies as PE firms raised more than half a trillion dollars in each of the past two years, which needs to be invested for PE firms to generate a return for their investors. 

Although PE investments can be structured in a number of different ways, there are two basic paths the investment will take. The PE firm will buy the whole company or a majority interest that provides the PE firm with control over the business, or it will purchase a minority stake that does not give it complete control over the company. Most PE firms prefer to make investments that provide them with control over the business, but increasingly, PE firms are making minority investments in order to deploy their capital.

From the perspective of the majority owner, selling a minority interest in the company to a PE firm may be attractive because it allows the owner to remain in control of the business. In this scenario, while the PE firm will not secure control over the business, it is likely to have veto power over certain major business decisions that could otherwise be made by the majority owner such as (1) giving the PE firm the right to prevent stock sales that would dilute the PE’s firm’s interest, (2)  restricting the owner’s right to take on new debt above a certain level, (3) requiring the PE firm to approve any proposed bonuses to be paid to the owner, and (4) preventing the owner from selling the business without the PE firm’s approval. 

The business owner who accepts a PE investment needs to appreciate, however, that the PE firm has become a full-fledged business partner with specific legal rights. Further, the firm will be looking to make an exit from the company in five to seven years, which will generate pressure on the business to improve its financial performance in this time window. The rights of the PE firm are likely to include the veto power discussed above, the ability to participate as managers or directors of the business, and the right to question the owner and others about all significant business decisions presented to the directors or managers.   

Picking the right firm for a PE investment is therefore a critically important decision for the majority owner. When the investment works well, the PE firm provides financial support and various types of guidance and industry contacts that will be helpful in growing the business. In sum, the ideal PE firm is one that will be a solid business partner and actively help to enhance the company’s value. The flip side is a PE firm that fails to deliver on its promises, seeks to micromanage the business, and creates problems that hurt the company’s bottom line. 

Not all PE investments work well, and majority owners should conduct as much due diligence as possible about potential PE investors to determine if this will be a good fit, including interviewing other companies in which the PE firm invested to discuss their experience. This effort is time and money well spent to avoid, if not eliminate, future conflicts with the PE firm after the investment. When conflicts do arise with the PE firm, it helps to have a written agreement that governs the terms under which a business divorce could take place between the parties.    

The Family Office Investment

The family office investment is very similar to the PE investment but will provide the business with a longer time horizon before any exit has to take place. As noted above, PE firms tend to operate on a five- to seven-year time horizon for their investment. If the company is not ready for the PE firm to exit from the business on this timetable, that can create serious conflicts between the majority owner and the PE firm. By contrast, a family office does not have the same pressure to generate a return for outside investors on this specific timetable, and can wait a longer period before seeking an exit to monetize its investment.  

The challenge for the majority owner is that there are far more PE firms than there are family offices that are open to making private company investments. As a result, the majority owner may need to focus on securing an investment on favorable terms from a PE firm rather than holding out for a family office investment that may never pan out. 

In addition to the previous discussion of PE investments, the majority owner may decide it is best not to shut the door on selling a majority stake in the business to a PE firm. While this transaction would require the owner to transfer control, an investment by the right PE firm may not result in the loss of control that is the chief concern of the majority owner. The PE firm wants to generate a handsome return for its investors, and if it is confident in the majority owner’s leadership, it may leave the owner in control of the business for all practical purposes after the closing. The PE firm may also agree for the majority owner to retain a substantial stake in the business (25% or more) in the belief that the owner’s continued ownership interest will serve as a strong incentive for the owner to continue to grow the business.     

The Strategic Buyer Transaction

In this scenario, the majority owner sells the entire company to a buyer that is a larger firm, which wants the business to continue to operate largely in the same manner. Thus, after the transaction closes, the majority owner will continue to operate the business as a division of a larger company or as a subsidiary of a parent company. In either event, the majority owner will largely retain control over the business and will likely receive or be paid a combination of cash and shares of stock in the larger company.

This last option is one that presents the highest risk-reward scenario for the majority owner. The upside potential exists because the owner continues to run the company in a largely uninterrupted fashion and receives both cash and stock in the larger company. This stock may increase significantly in value over time, particularly if the transaction results in strong business synergies between the two companies after the purchase has been completed. 

One risk here is loss of control. Specifically, before the sale closes, the buyer may promise not to infringe on the majority owner’s continued control of the business, but after the closing, the buyer may then dictate to the majority owner how the business has to be run. There is also a financial risk as the stock in the larger company may decline due to unforeseen business issues that are wholly unrelated to the conduct of the majority owner or his business. A majority owner who goes down this path must be mindful of these risks, but they can be mitigated to at least some extent if the buyer will negotiate a contract that clearly defines the scope of the majority owner’s control over the business after the sale takes place.  

Other Tax-Advantaged Options

Finally, there are other tax-driven options for majority owners to consider, which include Employee Stock Ownership Plans (ESOPs) and exchanging assets for other qualified property as permitted by the Internal Revenue Code. These are complex strategies that will require assistance from specialized tax and legal professionals. These transactions can result in a lower value for the company, however, and the owner will need to decide if the tax savings that may be secured outweigh the lower value for the business that may result when the price is compared to the valuation determined by third-party investments or from the sale to a strategic buyer.

Conclusion

After business owners have shepherded their company to a high value, they may want to secure their financial future, but without engaging in a sale transaction that would require them to leave the business behind. There are a number of avenues available for business owners to attain liquidity in this way, including by bringing in a PE firm or a family office as an investor or selling to a strategic buyer that authorizes the company to continue to operate under the banner of the larger business. These various options should be carefully considered as they provide the potential for the owner to accomplish this financial goal with an acceptable level of risk.