Divorcing spouses often have a number of business issues to resolve, but one key aspect that is often overlooked takes place when divorce settlements involve the division of an ownership interest in a private company.  Typically, the business is not a party to the divorce, but the absence of the company as a named party does not mean that financial or other business issues relating to the company should not be addressed by the parties in the settlement agreement. If spouses fail to consider and deal with issues relating to the company when they negotiate their divorce settlement, that may lead to adverse future results for the spouses and also for the company in the future.

This post reviews some of the important issues that spouses will want to consider when they negotiate the terms of the division of their ownership interest in a private business. 

Settlement Agreement Should Confirm Full Transfer of All Rights and Ownership Interests

It sounds straightforward to confirm that whenever a spouse transfers his or her ownership of an interest in a private business in a divorce settlement (the “transferring spouse”), the documents that confirm this transfer must make clear that the spouse is conveying all interests and rights held by the spouse in the company.  But, it is essential to use language that makes this clear, because an ownership interest in a private company may include many different rights, including the right to receive dividends or distributions, retirement contributions, health benefits, deferred compensation and reimbursement of expenses, among others. It is therefore critical to make sure the transfer of these interests and rights to the receiving spouse is carefully documented in the parties’ divorce settlement. The settlement agreement should therefore include language that is broad and inclusive to reflect the parties’ intent that the transferring spouse will not retain any ownership interest or rights of any kind in the company and will not receive any future benefits or financial consideration from the company or from the other spouse in the future.

Transferring Spouse Should Secure Release from the Company

It is common for divorce settlement agreements to include a mutual release in which each spouse releases the other from all claims that existed as of the date of the divorce. It is less common, but also important, for the transferring spouse to secure a release in the settlement agreement from the company of all claims that the company may have against that spouse. A release granted by a spouse likely does not constitute a release by the company, as well, because the company is a separate legal entity, i.e.,the company has its own rights that are separate and independent from the rights of the receiving spouse (the spouse receiving the transferred interest). The transferring spouse will therefore want to make sure to receive a release from the company that prevents it from bringing any claims against him or her after the divorce becomes final.

Transferring Spouse Should Also Seek Indemnity/Insurance Protection

In addition to securing a release from the company, the transferring spouse should also seek to obtain an indemnity from the company that provides protection in the event that a lawsuit is filed in the future in which the spouse is named as a party.  An indemnity provision will require the company to pay for counsel for the transferring spouse and cover any liability that results in future litigation. The transferring spouse should also request that the receiving spouse arrange for the company to extend the protection of the company’s directors and officers insurance (D&O) policy if one exists. This type of policy extension will provide continued insurance coverage to the transferring spouse under the policy for some period of years after the transfer takes place. This is referred to as “tail coverage,” and it is generally available for a reasonable cost to the company, but the continued coverage will likely be made available only if it is requested and obtained at the time of the divorce. 

Potential Non-Compete Restriction and Protection of Intellectual Property

A final point relates to the operation of the business after the divorce becomes final. The receiving spouse should consider whether the transferring spouse poses a competitive threat to the company after the divorce. If so, the receiving spouse may want to request that the transferring spouse accept some type of non-compete restriction in the terms of the divorce settlement. In this situation, the receiving spouse will likely need to provide additional consideration to the transferring spouse to compensate that spouse for accepting this restriction on future employment or business opportunities, and these terms will be subject to negotiation between the parties.

In addition, to protect the company’s trade secrets and confidential information, the receiving spouse will also want to include confidentiality restrictions in the divorce settlement that apply to the transferring spouse. The receiving spouse should not be required to provide additional consideration in the divorce settlement, however, for requesting that the transferring spouse continue to maintain in confidence all of the company’s trade secrets and confidential information after the divorce. 

Conclusion

When spouses divide assets of their marital estate in a divorce settlement, they will want to consider issues that arise when they own an interest in a private company that is transferred to the other spouse in the divorce settlement. Specifically, the couple will want to consider issues that relate to their rights as owners of the business and also determine what is in the company’s best interests after the divorce has concluded.  If the couple fails to give the company a seat at the table during the negotiation of the divorce settlement, this omission may give rise to significant future problems and conflicts between the spouse that they could have addressed in their divorce settlement.  

Corporations and LLCs both provide their shareholders and members with limited liability to operate a for-profit business, and while these two forms of business entities are similar in many ways, they also have some important differences. For example, there are key distinctions between corporations and LLCs in their ability to modify or eliminate the fiduciary duties that the directors, officers, or managers owe to the corporation or to the LLC.

Once they have been formed, corporations may also be converted to LLCs (and vice versa). These conversions come with a number of consequences, however, and should therefore take place only after careful analysis. This post reviews some of the corporate governance, tax, and disclosure considerations that shareholders of a corporation may wish to evaluate before converting their corporation into an LLC.

Converting a Corporation to an LLC Under Texas Law

The shareholders of a corporation may make the decision to convert the form of the business into a limited liability company by adopting a plan of conversion under Section 10.101 of the Texas Business Organizations Code and by filing a certificate of conversion with the Texas Secretary of State under Sections 10.154 and 10.155. The conversion may take place immediately or it may become effective as late as 90 days after filing.

Intended Consequences: Corporate Governance Flexibility

One important reason that shareholders may wish to convert their corporation into an LLC is that it provides a business with greater flexibility in matters relating to corporate governance.

By law, the powers of a for-profit corporation are exercised or authorized by its board of directors, which directs both the management and affairs of the corporation. Tex. Bus. Orgs. Code § 21.401(a). A for-profit corporation must have at least one director, a president, and a secretary, although the same person may serve in all of those roles. Id. §§ 21.403(a), 21.417. The officers and directors of a for-profit corporation owe fiduciary duties to the company of obedience, loyalty, and due care. See Ritchie v. Rupe, 443 S.W.3d 856, 869 (Tex. 2014). These fiduciary duties may be mitigated (but not eliminated) through limits adopted in the bylaws, see Tex. Bus. Orgs. Code § 7.001(b), (c), or through permissive indemnification. This allows a corporation to indemnify a director or officer who breaches his or her fiduciary duties of obedience and care (but not the duty of loyalty), if the director or officer acted in good faith and reasonably believed that his or her conduct was in the corporation’s best interests, id. §§ 8.101(a), 8.102(b). Providing indemnification to directors and officers encourages them to make decisions for the corporation without fear of incurring personal liability if their decisions turn out poorly, so long as they made those decisions loyally and in good faith. See Hibbert v. Hollywood Park, Inc., 457 A.2d 339, 344 (Del. 1983) (explaining the indemnification’s “larger purpose is to encourage capable men to serve as corporate directors” (internal quotation marks omitted)).

LLCs permit their members more flexibility in these governance matters. More specifically, LLCs are run according to the terms of a company agreement, which sets out the relations among the members, managers, and officers of the LLC. Tex. Bus. Orgs. Code § 101.052(a). Unlike a corporation, which must be managed by a board of directors, an LLC may be run directly by its members (owners), or by managers (who are appointed by the members). See id. § 101.101. Further, unlike corporations, LLCs afford substantial flexibility to expand or restrict the fiduciary duties that governing persons owe to the LLC and its members. See id. §§ 7.001(d)(3), 101.401. There are risks associated with investing in an LLC that is run by persons who owe restricted fiduciary duties to the LLC or its members, and investors should carefully consider those risks before investing.

Intended Consequences: Tax Consequences of Conversion

The conversion of a C corporation to an LLC is a significant taxable event, because the conversion is treated as a distribution of all of the corporation’s assets and liabilities to its shareholders in exchange or a surrender of their stock. Thus, a corporate conversion to an LLC has the potential to generate a substantial tax bill, and shareholders will want to carefully consider the tax consequences before moving forward to convert a C corporation into an LLC.

Unintended Consequences: Disclosure of Ownership

Shareholders who choose to convert a corporation into an LLC have likely evaluated the corporate governance and tax consequences of the conversion. But there may also be other, unintended consequences. One example came to light in a recent case involving federal court jurisdiction.

As a general rule, a lawsuit can be filed in federal court if it involves a federal question – interpretation of a federal law or of the U.S. Constitution – or if it involves diversity jurisdiction. Diversity jurisdiction comes into play when all of the parties bringing suit are citizens of different states than all of the parties being sued. Individuals are citizens of the state in which they are domiciled – a maximum of one state. Corporations are citizens of the state where they are organized and of the state where their principal office is located – a maximum of two states. LLCs, on the other hand, are citizens of every state where one of their members has citizenship. If one of an LLC’s members is also an LLC, then the citizenship of that second LLC’s members is also the citizenship of the first LLC. Depending on how many members an LLC has, and whether any of those members are LLCs, this can lead to citizenship in many jurisdictions.

In Ben E. Keith Co. v. Dining Alliance Inc., the plaintiff brought suit, invoking the federal court’s diversity jurisdiction to assert claims under state law. The plaintiff had not been aware, however, that the defendant had converted from a corporation to an LLC before the lawsuit was filed. As discovery progressed, the parties realized that diversity jurisdiction may not have existed when the case was first filed. By that point, the parties had added federal claims, the defendant had filed counterclaims, and the defendant had filed third-party claims against new parties. The court ordered the parties to establish their citizenship to confirm that diversity existed to support federal court jurisdiction, which required the LLC defendant to identify each of their members and their citizenship. As it turned out, the LLC defendant had members who were also LLCs or partnerships, and it claimed that some of those members had a complex ownership structure that included multiple tiers of partnerships and funds whose citizenship it was not able to determine. The court ultimately sanctioned the LLC defendant by dismissing all of its counterclaims and third-party claims with prejudice.

Conclusion

There are a number of factors that corporate shareholders should take into account before converting their corporation into an LLC. These include the flexibility of corporate governance and management after conversion and the potential tax consequences of undertaking the conversion. But there are other potential consequences, including disclosing the identities of an LLC’s members if the LLC is (or becomes) involved in litigation in federal court. Shareholders should undertake the process of converting a corporation to an LLC only after carefully considering these and other possible consequences.

The “Great Resignation” as it has been called reflects the large number of employees leaving the traditional workforce, and many of those departing employees are leaving hourly or salaried positions to start their own new businesses. The dramatic increase in start-up businesses has been documented by the Census Bureau, which reports that nearly 5.4 million applications were filed to begin businesses during 2021, the most of any year on record.  In light of this remarkable employee migration leading to the formation of new companies, now is an appropriate time to look at the investment side from the perspective of potential investors in these startups or early-stage new businesses. 

This post reviews some of the important red flags that investors should consider before making a minority (non-controlling) investment in a new or emerging growth, private company. Not every red flag should scuttle the proposed investment in a private business, but prudent investors will want to evaluate all red flags before becoming a minority partner in a private company. The issues that potential investors are wise to consider relate not only to potential problems regarding the operational plan for the new business but should include key provisions in the company’s governance documents, which the minority investor will be required to sign when making the new investment.

Avoid a Management Team Embarking on Its “First Rodeo”

Common sense suggests that the safer bet when investing in new businesses is to choose a management team with a track record of success with start-up businesses. A management team with little or no previous experience in launching a new business will have a steep learning curve. Another way to look at this is that an inexperienced management group doesn’t know what it doesn’t know, which means that the company’s leaders are more likely to make mistakes and miss opportunities that more veteran leaders would avoid or capitalize on at the right time.  

If the management team is new, one way to mitigate this problem is for the majority owners to include senior leaders on the company’s board or on an advisory committee. These experienced board or committee members can then provide important input to company executives on a regular basis and help to mentor them to provide the benefit and wisdom of seasoned leadership. When inexperienced executives decline to surround themselves with more veteran leaders, however, investors may be in for a steep and bumpy ride with their start-up company.

Will the Minority Investor’s Stake in the Business Be Protected from Dilution?

Successful companies need capital to fund their growth, and the cash from the business typically falls short of meeting this need. As a result, it is likely that the company will continue to seek additional investment from new investors, and when these new investors join the company, the percentage of the original investor’s investment may be subject to dilution. Therefore, the investor in a start-up company may want to have some type of “dilution protection,” which can take a number of different forms.

One example of dilution protection is a provision providing that no matter what new investment is received by the company, the percentage ownership that is held by the original investor cannot fall below a certain minimum – this is a form of downside protection. Another option is to agree that the original investor’s ownership interest (in whole or in part) is converted into some type of preferred stock or interest, which gives the original investor preferred treatment that could be additional voting rights and/or the right to receive additional dividends of some amount. The point here is that the original investor’s ownership interest may be subject to dilution and the slice of the pie held by the investor may be reduced greatly if the investment agreement does not address this issue. 

A Buy-Sell Agreement Is Critical for Minority Investors

In the absence of a buy-sell agreement (a contractual type of exit right), the minority investor in Texas typically has no contract or other right to require the majority owners to purchase the investor’s interest in the business at any price. Instead, the minority investor has to wait for some type of liquidity event to take place to obtain the value for his or her stake in the business. This could be a sale or merger of the company, a complete recapitalization of the business, or an initial public offering (IPO). If none of these things takes place, however  ̶  even if the company is profitable and has a high value  ̶  the minority investor may be stuck for years holding an illiquid, unmarketable investment with no means to monetize the substantial value of this holding.  

A buy-sell agreement allows the minority investor to give the required notice to the company, and under the terms of the agreement, the company is required to purchase the investor’s interest. The buy-sell agreement will specify the timetable for completing the purchase, the procedure the parties will use to determine the value of the investor’s ownership interest, and the payment terms for purchasing the minority interest once the value has been determined. 

The buy-sell agreement will also specify when the agreement can be triggered. For example, the agreement may provide that the minority investor cannot trigger the buy-sell for some period of years after making the investment. This is referred to as a “delayed trigger,” and it assures the majority owner that the minority investor cannot require the company to purchase his interest in the business for some extended period of time. In sum, the delayed trigger gives the majority owner more breathing room to run the company before having to worry about the investor demanding a buyout of his or her interest.

Limit the Right to Amend the Governance Documents

This last point may seem obscure, but it is vitally important. Potential investors will want to check the amendment provisions of the company agreement (for LLCs), the LP agreement (for limited partnerships) and the bylaws for C Corporations. Many company agreements, LP agreements and corporate bylaws permit these governance documents to be amended by a bare majority (51%) of the business owners. In this situation, the majority owner(s) can completely rewrite the operative rules of the company, including major changes such as revisions to the distribution policy, the addition of new partners and dilution of existing partners, and the procedure for removing partners from the business.

The amendment provision in corporate governance documents is often overlooked, but it can make an important difference to the rights of the minority investor once the investment has been made.  Often the minority investor learns only after the fact that the majority owner is changing the way that the company operates and when majority owners make these types of changes, they are rarely done in a manner that provides a benefit to the minority investor.

Conclusion

The opportunity to invest in a start-up company presents a high-risk/high-reward scenario, and the major upside that exists with these investments can make them seem very attractive. But, the potential investor should also beware of the substantial risks involved, and the foregoing points should therefore be included on the checklist the investor considers before going forward with the investment.