Listen to this post

The opportunity to make a substantial investment in a private company can be exciting — it offers the potential to share in the rapid growth of the company and may permit the investor to participate on the company’s governance team. But private company investing is not for the faint of heart as it also comes with significant risks.

These risks are not limited to the uncertainty of the company’s future business prospects, because once the investor delivers the funds, the majority owner’s full control of the company poses additional risks. Further, unless the minority investor is able to secure a contract exit, the majority owner will also control the investor’s ability to monetize his or her interest in the company. Unlike public company shareholders, investors cannot sell their shares or their units whenever they wish, because no market exists for them. In short, getting out of the business for investors is much harder than getting in, which is why they are wise to secure a path to an exit (the right to sell their interest) when making their investment. This post reviews some of the significant risks that minority investors face in making their investment, it considers protective measures investors can negotiate for to protect themselves, and it outlines legal claims that may be available if the majority owner engages in improper self-dealing.

The Post-Investment Risk Scenario

The majority owner will serve, invariably, in a management role as the company’s senior officer, as well as heading up its board or serving as the lead manager. In practice, this means that the owner is responsible for all major decisions in running the business. This unchecked power means that the majority owner can engage in self-dealing conduct in a variety of ways, including by entering into various interested (related party) transactions that favor the owner, by diverting business away from the company for the owner’s benefit, or by paying excessive salary and/or bonuses to the owner or the owner’s family members. In addition, the majority owner can elect to issue new shares in the company to third parties that require the minority investor to furnish additional capital to the business or become subject to dilution — which reduces the investor’s ownership percentage. 

The investor likely lacks the power to block any actions taken by the majority owner, but if the investor openly expresses opposition, that can result in a vindictive response by the owner. Specifically, the majority owner can engage in squeeze-out or freeze-out tactics that may include removing the investor from any management role, terminating any compensated position that the investor holds in the business, cutting off all distributions, and effectively making the investor’s stake in the business worthless on a current basis unless or until the investor succumbs and sells out for a price well below the fair market value of the investor’s interest.

 Protective Measures That Reduce Investment Risk

The potential risks the investor may be exposed to after making the investment,  discussed in the previous section, can be mitigated to a large extent if the investor secures these protections in the governing documents before the investment is made. These contract protections are discussed below:

  • The investor can insist on securing veto rights in the operating or shareholders agreement over key decisions made by the company’s management. These also are known as super-majority rights and cannot be taken unless they are approved by 85% of all shareholders, which applies if the investor holds 15% or more of the shares.
  • Veto rights requiring approval may include making compensation changes above a certain percentage, adding new members or shareholders, taking on debt above a certain limit, selling the company or substantially all of its assets, removing the minority investor from a management role, and making any amendments to the governance documents. 
  • The final protective measure is for the minority investor to secure a buy-sell agreement as the exit mechanism that is available as a last resort. If the parties reach a point of impasse in their business relationship, the buy-sell provision gives the investor the contract right to require the company to purchase the investor’s interest for a value determined by an independent third party. We have written extensively about buy-sell agreements in previous posts.

Legal Claims Available for Improper Conduct by the Majority Owner

When a majority owner engages in conduct that is harmful to the business, that does not usually give rise to a direct action against the owner by the minority investor. This is due to the fact that the investor was not harmed directly and the injury was a decline in the value of the investor’s ownership interest in the business. For this reason, most investor claims must be made in a derivative capacity — the investor is required to bring the claims and seek relief in the name of the company. These derivative claims are governed by statute, and they are difficult to pursue successfully for shareholders and LLC members because they have to run the gauntlet created by the Texas Business Organizations Code (TBOC) (see TBOC Section 21.551 to 21.563 (corporate shareholders) and Sections 101.451 through 101.463 (LLC members)).

These statutory provisions create a number of procedural hurdles that shareholders and LLC members must surmount in bringing the derivative claim. These include the requirements that the investor must own the interest continuously from the time that the claim arose through completion of the litigation, demonstrating that the investor will fairly and adequately represent the company and, the most difficult of all, presenting the company with a written demand that specifies the act, error or omission that is the subject of the claim and requests the company to take suitable action(see TBOC Section 21.553(a)). Unless the company has suffered or will suffer irreparable injury, the shareholder cannot file a lawsuit against the fiduciary until the earlier of 90 days or a notice from the company that it has rejected taking the specific action that was called for by the shareholder’s demand letter.

If the directors or managers reject the shareholder’s or member’s demand, the trial court will consider in any lawsuit only whether the decision was made in good faith by directors (or managers) who are independent and disinterested, after conducting a reasonable inquiry. If the court determines that the decision was made in good faith, the derivative suit will be dismissed, and the shareholder will have no further recourse.

The three procedural hoops discussed above make it difficult for a shareholder or an LLC member to successfully prosecute a derivative lawsuit. Importantly, these requirements, do not apply to “closely held” companies (seeSection 21.563). A closely held company has fewer than 35 shareholders and is not listed on a public exchange. If the company is closely held, then the minority shareholder or member is not subject to the procedural requirements of establishing continuous ownership, proving fair and adequate representation, or issuing a written demand to the company before filing suit. Further, a shareholder or member in a closely held company who files a derivative lawsuit is permitted to recover legal fees if he or she can show that the proceeding resulted in a substantial benefit to the corporation.

In considering potential derivative litigation claims, minority investors need to be aware of the Texas Legislature’s passage of Senate Bill 29 last year, which amended the TBOC in ways that make it even more challenging for them to pursue claims for breach of fiduciary duties against company control persons, e.g., directors, managers and officers. Specifically, SB 29 eliminated the common law burden-shifting framework that previously applied to these claims, which had placed the burden on fiduciaries to demonstrate that they acted with fairness when engaging in self-interested transactions. The Legislature created a new affirmative pleading requirement: The plaintiff shareholder or member must now plead with specificity that the fiduciary’s conduct constituted fraud, intentional misconduct, an ultra vires act, or a knowing violation of law. If the company existed before Senate Bill 29 was passed, it must opt in to these requirements.

Outside of the derivative claim context, investors can pursue a breach of contract claim if they can establish that the majority owner or another control person at the company breached any of the terms contained in the company’s governance documents or in a shareholder agreement. Finally, investors can bring fraud claims if they can prove that they were fraudulently induced to make their investment by false statements made to them by the majority owner or others. 

Conclusion

Investing in private companies has a strong potential upside, creating the opportunity for outsized returns from a fast-growing business. But this is a classic risk-reward scenario, because a private company investment often involves a degree of risk that far exceeds the investment in a public company. This is attributable to the majority owner’s largely unchecked control over the business, which brings to mind Lord Acton’s famous historical warning: “Power tends to corrupt, and absolute power corrupts absolutely.”

That assessment is unfair and inaccurate if applied to most private company majority owners, but majority control remains a risk factor. In exercising control, some majority owners will engage in self-dealing conduct causing economic harm to the company, will substantially dilute the investor’s stake in the business and will engage in squeeze-out tactics that place the investor in a difficult financial position without effective recourse.

In sum, an ounce of prevention is worth a pound of cure, and investors need to protect themselves before things go off the rails in their dealings with the company’s majority owner. This protection is secured by obtaining veto rights in the company’s governing documents or shareholder agreement and by securing a buy-sell agreement that will provide the investor with the right to sell the investor’s interest in the business. Absent these protections and without a buy-sell agreement in place, if the majority owner engages in an abuse of power, the investor will be left to seek legal relief against the owner by asserting derivative or other claims that are both procedurally challenging and expensive to pursue.

Listen to this post

The idea of starting a new business on a 50-50 basis with a close friend or family member sounds exciting, because it involves sharing creative ideas, a mutual desire for success in a new venture and, at least initially, enthusiasm in starting a promising, new company. But hopefully, these potential partners consult with a trusted advisor before they go down this road who sagely advises them: Just don’t do it. It would be an overstatement to suggest that all 50-50 owned new businesses are doomed to fail, but the steep risks inherent in this ownership structure are so high, they should be avoided, if at all possible, especially when there are better options available.

This post reviews substantial risks involved in owning and operating a 50-50 owned private business, and it evaluates a different ownership structure that is designed to avoid the pitfalls of forming a new business on a co-equal basis.

Why 50-50 Owned Businesses Are So Problematic

The primary risk of starting a 50-50 owned business is that the co-owners will end up in deadlock when a disagreement arises between them about important matters that relate to the company’s operations. When a disagreement takes place, if neither of the partners agree to compromise, this deadlock can bring the business to a halt and ultimately cause the company to shut down permanently. This may seem unlikely at the outset when the partners are aligned in their vision. But as challenges arise over time, the partners will have more opportunities for disagreement, and the potential for an impasse between them becomes much greater.

Even when one partner has clearly engaged in wrongdoing, the ability of one partner to show that the other partner engaged in wrongdoing will not result in the wrongdoer being removed as a partner from the business. For example, a partner who misuses funds or assets of the business can be sued for breach of fiduciary duty.  But under Texas law, the violation of a fiduciary duty does not give rise to a forfeiture remedy that would permit the non-breaching partner to force a buyout of the other partner. The wrongdoer may have to pay damages to the company or to the other shareholder, but one 50% owner of a private company cannot remove the other 50% owner of the business based on misconduct as the remedy for the claim is money damages.

In sum, there is no legal remedy available to a partner owning 50% of the business that will allow him or her to secure a court order judicially removing the other 50% owner from the business based on the other partner’s misconduct. The remedies that may be available to a 50% owner who believes the other owner is running amok are to seek the appointment of a receiver or to dissolve the company, but these harsh remedies are difficult to secure in court. Further, these remedies may not be attractive because they will require the majority owner to transfer control over the business to a court-appointed third party — a receiver — or to seek dissolution of the company entirely.

Adopting Tie Breaker Mechanisms to Avoid Deadlock  

If potential 50-50 partners cannot be dissuaded from forming a company on this basis, their governance structure should include a tie-breaking mechanism that prevents deadlocks between them from arising in the future. There are a number of tie-breaking options available to consider:

  • A board – The partners can appoint a board that could be limited solely to resolving disagreements (breaking deadlocks) between the partners, or they could empower the board to assist with the management of the business on an ongoing basis. They will need to protect the board from any potential lawsuit by a disgruntled partner unhappy with an adverse decision, which can be done through immunity and safe harbor provisions, as well as the commitment to pay any/all legal fees the board incurs in any dispute.
  • Individual arbiter – Rather than appointing an entire board, the partners could select just one trusted advisor from their mutual contacts who will resolve all disagreements and break deadlocks between them. Again, they need to protect this decision-maker through immunity provisions and coverage of legal fees.
  • Flip a coin or staggered governance – Some business partners require the partners to flip a coin when they are in conflict over a business decision. Other 50-50 partners rotate decision-making authority for some period of time so that one partner makes decisions for a defined period before the authority rotates back to the other partner. These provisions seem unwieldy, but they do reflect forethought by the partners to avoid a deadlock scenario.    

If these tie-breaking mechanisms are not adopted, the partners may have no method to resolve their deadlock. Even worse, if one partner leaves the company in frustration to start a new business, the remaining partner may allege that the departing partner misappropriated the company’s trade secrets/confidential information. While this claim by the remaining partner may not be valid, it will put a damper on the departing partner’s efforts to start over at a new company.  

The Better Alternative: 51%-49% Ownership, But With 50-50 Economic Impact

There is an alternative to the 50-50 owned business that will fully avoid any potential deadlock but also align the partners’ economic interests in the company.

Specifically, the partners can structure the ownership of the business on a 51%-49% basis, which means that one partner will have final decision-making authority and thereby avoid deadlock between them. But they can also agree that the parties will share equally in the financial returns from the business, which provides them with the same compensation (including bonuses) and same distributions, as well as ensures they have the identical financial return from the company. Further, the 49% owner can also insist on some veto rights so that the minority partner has to approve certain major decisions.

The type of major decisions that require the minority partner’s approval may include all of the following, as well as other decisions that are negotiated between the partners: (1) adding new shareholders or members, (2) selling the business or selling the majority of its assets, (3) removing the minority partner as a board member or manager, and (4) making changes to the corporate bylaws or to the LLC company agreement.

While many partners who are seeking a 50% interest in a new business may not be willing to accept a minority interest and cede most of the control over the company to the other partner, this approach is worth considering. First, it confirms that the partners will not become deadlocked over operational decisions and prevents the company from being derailed on a day-to-day basis. Second, it assures the minority partner that the financial benefits he or she receives will mirror those of the majority owner. Finally, to secure the 51% ownership stake in the company, the majority owner may be required to make a much more substantial capital contribution to launch the business than the minority partner contributed.

Conclusion

The idea of a 50-50 owned business sounds reasonable on paper, but it often leads to serious conflicts in the future between partners in the real world. Even closely aligned partners at the start can end up having major disagreements when challenges arise in the business or when they experience problems in their personal lives such as a divorce or health issues. The legal options for deadlocked partners are limited, and these types of conflicts can be devastating to the business. When a business cannot address problems or make important decisions, this dysfunctional situation creates stress that may cause the company to flounder and lose both clients and employees.  

To avoid the negative consequences of deadlock, potential 50-50 partners may want to adopt a 51%-49% ownership structure, but one where they agree to share all financial returns from the company on a 50-50 basis and which also provides the minority partner with veto rights over key decisions. If this ownership split is not acceptable, the partners who are committed to forming a 50-50 owned business should insist on adopting some form of a tie-breaking mechanism that avoids the calamity of a deadlock in the future that seriously impairs the business or results in its ultimate demise. 

Listen to this post

The warm summer months are almost here, and many business owners will be spending some time relaxing away from the office. Before or after that well-deserved summer vacation, however, owners may want to tackle important issues concerning the company’s key agreements that have not kept pace with the growth of the business. Changes in these agreements may be necessary due to the expansion of the company’s intellectual property (IP) assets, the larger size of its workforce, and/or the growth in the appreciated value of the business.

While growth is generally positive in a business, the company’s agreements with its employees and third parties may no longer adequately protect its interests, and the company may need to implement new practices to preserve the confidentiality of its sensitive information. This post focuses on changes the majority owner can make that are designed to (i) provide enhanced protection for the company’s confidential information, (ii) limit the scope of the fiduciary duties that apply to the company’s management team, and (iii) create buy-sell agreements that permit the owner to redeem ownership interests that are held by minority investors in the company.

Protecting the Company’s Confidential Information

The company’s continued success may be due, in part, to the growth of its IP, including its confidential information and trade secrets. The company’s IP may have grown through acquiring new patents, securing exclusive licenses or further developing its own trade secrets. As the company’s IP assets have expanded, the majority owner will want to assess whether the legal agreements that protect the company’s IP have kept pace with its impressive growth.

The specific questions the majority owner will want to consider regarding the growth of the company’s IP are (1) does the company need to bolster its confidentiality agreements with both employees and third parties, (2) do the company’s current employment and/independent contractor agreements sufficiently protect the company’s IP, and (3) should the company create or change the protocols it has in place to protect confidential information? These changes are each discussed below.

To protect the company’s IP from misuse by insiders, the company will want to secure confidentiality agreements with its officers, employees and agents. These agreements should describe the IP in meaningful detail (without revealing any confidential information of course), because courts generally give more weight to specific descriptions of confidential information in a legal proceeding. The training that the company provides to employees regarding its confidential information should also be referenced, because offering this type of training confirms that the company intentionally disclosed its confidential information to its employees to enable them to perform their duties for the company.

The more extensive the company’s IP becomes, the greater the likelihood that it will be shared with third parties. As a result, the company also needs to secure confidentiality agreements or non-disclosure agreements (NDAs) from third parties, including vendors, advisors and clients, if these third parties are provided with access to the company’s confidential information. Once the company’s confidential information has been disclosed to third parties without protections in place, this type of unprotected disclosure waives the company’s claim that the information is confidential.

Disclosing IP to employees also provides the company with a legal basis to require them to be bound by noncompete provisions and similar restrictions in their employment agreements. For current employees who have already worked for the business without any noncompete restrictions in place, however, it may not be possible to bind them to enforceable restrictive covenants on an after-the-fact basis. Instead, the company will need to require these employees to sign confidentiality agreements or NDAs that prevent their unauthorized use of the company’s IP.

Finally, securing NDAs and confidentiality agreements with employees and third parties is just one part of the process that the company needs to undertake to protect its valuable IP. In addition to these agreements, the company will also want to implement specific protocols that are designed to maintain the secrecy of its IP. The process required for a company to maintain the confidentiality of its IP goes beyond the scope of this blog, but these steps include (i) limiting access to confidential information solely to those with a need to be privy to the information, (ii) marking the information as confidential on the actual document so that its protected status is clear, and (iii) regularly training employees on how to protect and maintain the confidentiality of business-sensitive information.

Analyzing the Fiduciary Duties That Apply to Those Governing Private Companies

In a recent post, we discussed the scope of fiduciary duties that apply in Texas to directors, officers, and managers of private companies. As noted in that discussion, the Texas Legislature made important amendments during 2025 to the Texas Business Organizations Code (TBOC), which will potentially have major impacts on the fiduciary duties owed by governing persons (see TBOC Section 101.401).

The owners of existing private Texas companies now have the opportunity to opt into to the changes the legislature made last year to the TBOC, which permit owners to restrict or even eliminate the fiduciary duties that apply to those who run the business, and/or to limit the liability of the members of their management team. Whether or not to accept any of these changes for the protection of the company’s management team is an important analysis that majority owners will want to consider.

On the one hand, limiting the scope of fiduciary duties may provide the company’s directors, officers and managers with more freedom and flexibility in the way that they operate the business. For example, business managers may be able to more freely enter into transactions with affiliated companies that will benefit the company but also provide returns for the managers who have interests in both companies. On the other hand, potential investors may be more reluctant to provide investment capital for the business if these changes are implemented. Understandably, investors may be leery of providing growth capital to the business when they perceive that the members of the management team are no longer subject to the fiduciary duties that had traditionally applied under common law to those charged with running the company. In this situation, sophisticated investors will almost certainly insist that fiduciary duties apply to all company directors, officers and managers before they will agree to make a substantial investment in the company.  

Creating or Revising Buy-Sell Agreements

We have written extensively about buy-sell agreements (BSAs), which serve the interests of both majority owners and minority investors, and they can be created after the fact, even if these provisions were not adopted by the parties at the time the investment was made. For majority owners, BSAs provide them with a redemption right that allows them to acquire the interest of a minority partner if the owner wants to consolidate the interests held by minority partners, or if the minority partner becomes disruptive to the business. For minority investors, the BSA ensures that the investor will have the right to monetize its minority ownership interest in the business at the time that the investor decides to exit from the company. In short, a BSA allows either party to secure a business divorce in the future when it becomes necessary or desired.  

As the company grows, the majority owner will want to review the terms of the BSA to ensure that the formula used in the agreement to determine the value of the minority owner’s interest will continue to accurately reflect its fair market value. This assessment is necessary because, depending on the language that is used in the BSA, the valuation formula may produce a result that varies widely from the actual value of the minority owners’ interest. If the BSA is not updated, there is a risk that the original formula could result in a valuation of the minority interest that is unfavorable for the majority owner, which is not fully consistent with the actual market value of the interest.

Conclusion

Majority owners who have guided their companies to achieve growth deserve to celebrate that success with a relaxing summer getaway. The long days of summer are also a good time for business owners to consider whether they need to upgrade their company agreements to better protect the business in light of substantial growth that has taken place within the business.

Majority owners may want to (i) strengthen agreements that guard the company’s confidential information and create/revamp protocols that provide enhanced protection of this information, (ii) revise their governance documents to limit their exposure and liability to fiduciary duty claims from minority investors, and (iii) adopt or improve their buy-sell agreements to ensure they accurately determine the fair market value of the minority owner’s interests. These changes will better position both the company and the majority owner as the company continues its growth curve, and they also will offer more protection if storms arise in the future.