It may be a reflection of summer’s lazy days or a simmering frustration that has built up over time, but it is not uncommon for a majority owner or a minority investor in a private company to decide the time has come to separate from his or her business partners. The majority owner may wish to remove the minority investor from the ownership group, or the investor may have become disenchanted with the owner and want to exit the company. In either case, there are key issues for business partners to consider before they start down the road toward a business divorce, and this post highlights important issues that will likely arise in this process.
The Governance Documents: Do They Include a Buy-Sell Provision?
The starting point for a business divorce is a close review of the company’s governance documents. Neither the majority owner nor the minority investor can trigger a redemption unless they have a contractual right to do so. If there is a buy-sell agreement or some other form of a “corporate prenup” in place, it may be in the company agreement of the LLC or in the bylaws of the corporation, or it could be set forth in a separate shareholders’ or owners’ agreement. But if a buy-sell agreement does exist, it will spell out how the redemption of the minority interest can be triggered by either party, the process for valuing the minority interest, and the payment structure for the purchase of the interest.
When there is no buy-sell agreement in place, the majority owner does not have a contractual right to redeem the minority investor, and the investor has no ability to contractually require the owner to purchase his or her minority interest. An exception to this rule may exist for the majority owner, however, in the company’s governance document. Specifically, if the majority owner has the right to amend the governance document, this right of amendment may include the right to add a buy-sell provision. This is likely the case if the governance document does not require unanimous consent or does not have a supermajority provision that allows the investor to block the amendment. In the absence of a blocking right, the majority owner can amend the governance document to include a new right to redeem the minority interest.
From the minority investor’s perspective, if no buy-sell agreement exists, the investor can attempt to negotiate a voluntary buyout with the majority owner or wait for a liquidity event that will allow for a redemption to occur. The minority investor can also evaluate pursuing potential against the majority owner for misconduct, but the investors’ rights are generally limited in this regard to recovering monetary damages. Since the Texas Supreme Court’s decision in Ritchie v. Rupe in 2014, even when a minority owner is able to show that the majority owner engaged in shareholder oppression, Texas courts lack the power to award a buyout of minority investor’s interest based on this finding. Similarly, in the fiduciary duty context, no Texas court has ever held that the forced buyout of a minority investor is a remedy that is available to the investor based on a majority owner’s breach of fiduciary duty.
Minority investors who do not have a buy-sell agreement to enforce may seek to obtain an involuntary dissolution of the company based on the Texas Business Organizations Code (TBOC). Under Section 11.414 of the TBOC, a dissolution is authorized if a district court concludes that one of the following three conditions exist: (1) the company’s economic purpose is likely to be unreasonably frustrated, (2) the majority owner has engaged in conduct that makes it “not reasonably practicable” to carry on the business with that owner, or (3) it is no longer reasonably practicable to carry on the company’s business in conformity with its governing documents (see Section 11.314). These are difficult legal standards to meet, however, and to date, this section of the TBOC has never been applied to an LLC. Thus, it will be difficult to obtain a court-ordered dissolution of a successful, ongoing business, and the dissolution remedy is not likely available unless the company is a corporation or partnership.
The takeaway here is that both majority owners and minority investors are best served by negotiating and then adopting a buy-sell agreement at the outset of their business relationship. A buy-sell agreement enables the majority owner to secure a redemption of the minority investor when desired, and it allows the minority investor to trigger a buyout of its interest when the investor is ready to exit the business. Our discussion of the critical terms of buy-sell agreements is available at this link.
Determining the Value of a Minority Interest
If there is a buy-sell agreement in place, it will govern the process for determining the value of the interest held by the minority investor. The key focus here is likely to be whether the valuation will or will not include what are termed minority discounts. These are discounts that typically apply in the valuation of minority interests in private companies based on the facts that (1) minority investors do not control the business (lack of control discount) and (2) typically, the company’s governance documents impose onerous restrictions on the transfer of minority-held interests (lack of marketability discount). These two minority discounts are steep, and together, they often result in a reduction of the value of the minority interest by 40% to 60%.
If there is a buy-sell agreement and it is silent on whether minority discounts apply, it may refer to using “fair market value” (FMV) as the standard for determining the value of the minority interest. Valuation experts would likely view the FMV standard as one that includes application of minority discounts to the valuation, because it refers to what a willing third-party seller would pay a willing buyer for the minority interest. A third-party buyer who is considering the purchase of the minority interest when it is subject to lack of control over the company and lack of marketability would insist on applying these discounts to the purchase price.
The issue of valuation is another reminder that a buy-sell agreement should be negotiated when the minority investor acquires an interest in the company. The point of entry is the time to ensure that each of the parties’ respective views about minority discounts is addressed.
Payment Terms and Security for Payment
Even when a buy-sell agreement exists, it is very rare for it to require that payment of the full price be made at the closing of the purchase of the minority interest. Much more commonly, the purchase price is paid out over a period of years, and the agreement may also provide for the investor to have some type of security if there is a default in payment. Generally, this will allow the investor to have some right of foreclosure to regain a portion of the interest in the company.
A minority investor attempting to secure a voluntary buyout when no buy-sell agreement exists may need to consider creative ideas that appeal to the majority owner. One option is a sale with a carried interest, which provides the majority owner with a discounted purchase price. In this scenario, the investor accepts a lower sale price, but the investor is also potentially entitled to receive an additional payment depending on future events. As one example, the minority investor could accept a purchase price equal to 75% of the market value of the minority interest but would also receive a future payment tied to a formula if the company is sold within three years, or if no sale takes place, the investor could receive an additional payment that is based on an increase in the company’s revenues during this period. This is just one example, but when a minority investor cannot enforce a buy-sell agreement, the investor will likely need to be creative in efforts to secure a buyout from the majority owner.
Breaking up is hard to do for business partners, and that is particularly true when they do not have a partnership exit plan in place as documented in some type of buy-sell agreement. In the absence of this type of corporate prenup, the parties would have to agree to a redemption on a voluntary basis, which may not be possible if the partners have become adverse to each other. Given the importance of a buy-sell agreement in lessening conflicts when a business divorce takes place, business partners who do not have one, but who are currently on good terms with each other, may want to consider adopting a buy-sell agreement after the fact. Creating a path providing for a partner to depart the business by agreement is truly in both parties’ interests.