Private company majority owners and minority investors often focus on the company’s financial health and growth prospects, and may not take the time to review the operating documents of the business – bylaws for corporations or company agreements for LLCs. These governing documents are legal in nature, but they should not be left to the purview of the lawyers because they are not cookie-cutter agreements. Instead, by studying and making necessary changes to the provisions of controlling documents, owners and investors may head off disputes with their business partners or substantially limit the scope of future conflicts.
This post reviews a number of key provisions that are normally included in governance documents of private companies, which control the company’s operation. This post does not discuss Buy-Sell Agreements, but these agreements also play a critical part in lessening or avoiding conflicts between when a partner exit from the business takes place. Read our post discussing Buy-Sell Agreements.
The key provisions discussed in this post include:
- Control provisions and veto rights of minority partners
- Distribution/dividend policy and management discretion
- Addition of new business partners and dilution provisions
- The right to amend the governance documents
- Dispute resolution provisions
In most company governance documents, the majority owners have the final say regarding company decisions. But as the company grows and needs new capital, it may add new partners who invest in the business, and these new partners will want to have some voice regarding management decisions. It is therefore common for substantial minority investors to have “super-majority” rights, which effectively give them a veto over certain management decisions. For example, when the minority investors hold at least 26% of the units in the company, the LLC Agreement may require that a decision to expand the board of managers requires a 75% vote of the members. Minority investors therefore need to decide what key decisions by management over which they want to seek super-majority voting rights.
Management decisions that are commonly subject to super-majority provisions in governance documents include:
- The size of the board of directors or managers
- Appointment of a new CEO/president
- Company mergers or major new acquisitions
- Taking on debt over a certain prescribed limit
- Adding new partners above a certain percentage
- Dissolving the company or filing for bankruptcy
- Amending the governance documents
Distribution and Dividend Policy and Related Discretion
Typical governance documents also give full discretion to the majority owner (or to a board of directors or managers controlled by the majority owner) to decide whether or not to issue a dividend or distribution. The minority investor, however, should consider whether to seek a mandatory dividend policy before making an investment. At a minimum, minority investors may want to insist that the governance documents require the company to issue dividends or distributions in an amount that is sufficient to cover the tax liability of all partners based on the profitability of the company.
LLCs and Subchapter S companies are “pass through” entities, which means that the companies do not have to pay taxes on their income, and instead, the tax on the company’s profits is paid for by the owners. Therefore, if the company does not make distributions to the owners to cover their tax liability, the owners will be subject to “phantom tax,” i.e., they will have to pay their share of the tax on the company’s profits, but without having received any actual cash distribution from the company. This can happen when a company is retaining earnings to pay for investments that will grow the business. Thus, the company is profitable, but if it retains all of its earnings, the owners will have to pay the taxes on those profits based on their percentage ownership in the company.
Minority investors could go farther, however, and insist that at least some amount of the profits be distributed to the owners each in addition to the distributions that are made to cover the tax liability of the owners. This discussion will require the company’s owners to decide whether or not they want to reinvest all of the profits in the business or whether they want to provide that the owners will receive a current return of some percentage of the company’s profits.
As the business grows and new partners are added to the company, the percentage held by the existing owners will have to decline (unless another class of stock or units is created). Minority owners may therefore want to insist that their ownership percentage not be subject to this dilution resulting from the addition of new owners. That may not be acceptable to the majority owners, however, who recognize the need to bring new owners on board who provide additional capital for the business. The argument by the majority owners is that while dilution is taking place (the piece of the pie owned by minority investors is getting smaller), the size of the business is increasing (the pie is getting larger).
Whether dilution will apply to the minority owner’s interest – and if so, on what terms and to what extent – is a subject that the owners should discuss before the minority owner makes an investment in the business. For example, the minority owner could agree that dilution of his/her interest will take place, but only to a point, i.e., the minority owner who holds 15% of the company originally could agree to dilution, but also provide that his or her ownership stake will not go below 10% at any point.
Right to Amend Governance Documents
The right to amend the governance document rarely receives much attention. This provision, however, can turn out to be of great importance if the majority owners choose to amend the bylaws or the company agreement in a manner that negatively impacts the rights of the minority owners. In this regard, the majority owners could amend the governance agreement to (i) lessen management rights of minority investors; (ii) restrict access to documents; and even (iii) allow the majority owners to remove the minority investors from the business by creating new stock redemption rights, which set the terms on how they will be compensated for their ownership interest in the company.
To avoid this scenario, minority investors may want to insist that any changes to the governance documents be adopted only with unanimous approval of all shareholders or members, or at a minimum, that a super-majority of the shareholders or members must approve any amendments. The limit on the majority owners’ ability to amend the company’s governance documents is potentially a game changer that should not be overlooked.
Dispute Resolution Provisions
A final key provision of governance documents is the method by which disputes between the owners of the business will be resolved. Typically, serious ownership disputes are resolved through litigation, but one alternative to consider is the use of arbitration as a dispute resolution device. While arbitration may not be right for every company or situation, it is something the owners should consider, because arbitration provisions can be tailored to (i) require the claim or dispute to be resolved quickly in a matter of just a few months; (ii) sharply limit the scope of discovery; (iii) permit the arbitrator(s) to award legal fees to the prevailing party (including a party against whom the claims are made if that party successfully defends against the claims); and (iv) dictate that only certain types of disputes or claims will be subject to arbitration.
For example, the parties could agree that disputes regarding the value of the business, or the value of a minority owner’s interest in the business, are subject to arbitration. This avoids a lengthy court battle over the value of a minority ownership stake in the business, as the parties can agree that a dispute over value will be resolved in 60 days. The parties could further agree that the manner for them to resolve a valuation dispute will be for each side to call a valuation expert and then let the arbitrator or arbitration panel decide the value.
Knowing the rules of the road is critical when traveling, and the same holds true in regard to owners and investors in private companies. The governance documents of private companies are specialized documents that should be read and understood by all owners in the company. For majority owners, they need to have a good grasp of their authority and the specific rights that they are exercising in controlling the business. For minority investors, if they have not read the governance documents, they may be surprised to learn they are in a poor bargaining position because they ceded authority to the majority owners that they never intended. Minority investors may be especially stunned when majority owners amend the governance documents in a manner that is prejudicial to their interests.
Thus, the takeaway is that private company governance documents may contain unwelcome news for the unaware majority owner or minority investor. It is far better for owners and investors to take the time to closely review the governance documents of the company before they add any new partners to the business or become a new investor. This preview of the documents opens the door to a discussion and negotiation of the terms that both parties want to include in the governance documents to meet their business objectives as co-owners in the company.