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As the year winds down, majority owners can hit the ground running in the new year if they adopt business resolutions that motivate their executive group and create the potential for the company to reach new heights. The benefits of these resolutions include achieving more efficient operations, establishing better teamwork, and instilling a renewed sense of purpose that will position the business for greater success. It won’t happen by accident, however, and will take both thoughtful analysis and a definite action plan to complete. This post identifies key areas in which New Year’s resolutions – if they are actually carried out – can create positive impacts for the business not just in the next 12 months, but for years to come.

Open the Window – Improve Transparency

Smaller companies tend to operate in a more siloed fashion than larger businesses. The majority owner makes decisions that may not be explained or fully understood by others, which can include minority partners in the business. This lack of clarity can be addressed by creating more transparency in the management and operation of the business. This will require more formality in the way the business is governed, including by holding regularly scheduled meetings of the leadership team, as well as meetings with all owners and more written communication being provided to managers and the ownership group. 

This is referred to as good business hygiene. Formal meetings — with agendas issued in advance — should be held regularly, at least monthly, by the management team. Meetings also need to be held with the ownership group on a quarterly or semi-annual basis. In addition, the majority owner should arrange for the company to distribute quarterly financial reports to all managers and owners, along with a year-end summary report and a projection of the company’s anticipated financial performance for the year ahead.  

The majority owner’s reaction to providing this level of transparency may be that it will create new burdens that are significant and unnecessary. That response is understandable, and more transparency will require more planning and more effort. But the important upside is that the owner is likely to receive greater buy-in from other stakeholders in the business when they are permitted to participate more actively. Further, other stakeholders may have valuable input to share with the owner, including constructive feedback, that would otherwise be missed.

Fix the Gutters — Improve the Company’s Foundation

In addition to creating transparency, the owner should evaluate the business to improve its foundation. In this regard, it may be time to update the existing governance documents – the bylaws or the LLC company agreement – which have become stale and/or outdated. Similarly, if the owners in the business do not already have a buy-sell agreement in place, that is an important missing piece that can be addressed to provide the majority owner with a redemption right and to enable the minority partners to secure a future buyout of their ownership interest when they choose to depart. Buy-sell agreements were the subject of a previous post, which can be reviewed here

Why should the company’s governance documents be updated? If these documents were created five to 10 years ago, they may no longer fit the business or the manner in which it is currently governed. As just a few examples, the LLC agreement may not reflect the current size of the board, it may include provisions that are not being followed by management, the amendment provisions may be unwieldy, and the governance documents may no longer fit the business or the manner in which it is being governed. This governance review is therefore a step in positioning the company for streamlined operations and for future growth. 

In addition to reviewing the governance documents, the owner should evaluate whether the company’s location is ideal, or whether a move to another state or another office location would unleash more potential. Similarly, if the company does not already have any incentive stock option plan in place to incentivize employees, that should be considered. These plans do not have to provide the employees with equity, i.e., there are ways to create “phantom” stock that provides considerable motivation to employees as it allows for additional compensation to be earned but does not create a new class of ownership in the business.

Finally, the company may also want to adopt a formal dividend or distribution plan that calls for distributing some portion of the company’s profits to owners. This will be a flexible plan that does not constrain the growth of the business. The plan would provide the owner with discretion to retain most of the earnings for reinvestment, if desired, but allow the ownership group the opportunity to participate to some extent in the company’s success on a current basis.

Clean Out the Attic – Address Lingering Personnel Problems

The last area involves making hard decisions about personnel changes. This may require the owner to remove dysfunctional board members, managers, employees or minority partners.  Personnel problems rarely improve over time, and instead, they tend to become more dire. As a result, it may be challenging to take the difficult, but essential, step of engaging in addition by subtraction by removing people from the business who do not share the owner’s vision, who are blocking the company’s ability to grow, or who take too much of the owner’s time.

While this removal process can be arduous, it will likely open the door to some new possibilities. With the removal of management personnel or minority partners, this may permit the owner to expand the board or management group to add new enthusiastic members who have different skill sets and approaches and/or or allow for investment in the company by new owners who can contribute both financial and knowledge capital to the business.

As a final note in this area, company owners who are not already involved in leadership groups may want to consider hiring an executive coach for one-on-one strategy sessions or join a leadership forum with other business owners such as YPO, EO or Vistage. These groups provide business owners with support and valuable feedback. 

Conclusion

A strong leader knows how to motivate others. In Inc. Magazine, Jim Tobin discussed leadership lessons he had picked up from spending time with “Coach K” – Mike Krzyzewski — Duke’s renowned basketball coach. One of these was to “motivate with the why.” As Tobin explains:

. . . it may be tempting to jump into the minutiae, to attack the meeting

agenda, make decisions and move on to the next thing. One of Coach K’s

strengths is his ability to step back, help the group see the big picture and

remind everyone of what we’re all working to achieve. It’s quite motivating

. . . Periodically reminding people of the “why” is a skill any leader can use

to motivate others.

A majority owner who evaluates and then implements the resolutions discussed in this post will explain the why, motivate others at the company, and energize the business for success.

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The one who has the gold often makes all the rules, but the majority owner of a private company who has minority partners in the business does not have complete freedom, because majority owners owe duties that apply to their operation of the company. Majority owners also typically serve as officers, directors, managers or partners in the business, and when they hold these governing positions, they owe fiduciary duties to the company.[1] The company bylaws (for corporations), the company agreement (for LLCs) and the partnership agreement (for LPs) may permit the company to restrict the scope of these fiduciary duties, but Texas law does not permit companies to eliminate the duty of loyalty that is owed by governing persons. This post reviews some of the ways that these fiduciary duties impact the way that majority owners can manage and direct their companies and avoid liability for claims by minority partners. 

Majority Owners Must Treat Company Fairly in Business Dealings

As a general rule, the fiduciary duty of loyalty requires majority owners who act in a management capacity to put the interests of the company ahead of their own self-interest. More specifically, company officers, managers and directors cannot engage in one-sided transactions with the company (sales, purchases, leases, etc.) that provide them “sweetheart deals” that are more favorable than terms that are available in the marketplace, and they cannot take business opportunities for themselves that belong to the company. As just two examples, the majority owner cannot buy a tract of land or a piece of equipment from the company for a low-ball price, and similarly, the majority owner normally cannot buy a property next door to the company if it would deprive the business of the right to expand its operations.

The foregoing are general statements that apply to the conduct of majority owners, but they do have statutory and common laws defenses available when they face claims alleging that they breached their fiduciary duties. Specifically, under Sections 21.418 and 101.255, of the Texas Business Organizations Code (TBOC), also known as the Interested Director Rule, governing persons in corporations and LLCs — under certain conditions — are granted a “safe harbor” immunity when they engage in transactions with the business. This safe harbor applies to transactions when:  

  1. The transaction was approved by a majority of disinterested directors with knowledge of material facts;
  2. The transaction was approved by a vote of shareholders with knowledge of material facts; or
  3. The transaction was objectively fair to the corporation when the contract or transaction was authorized, approved or ratified.

Thus, the safe harbor statue essentially requires the governing person to obtain advance approval for the transaction from disinterested parties at the company. If no vote happens on the transaction before it takes place, the governing person will have establish after the fact that the challenged transaction was fair to the company. In the absence of a vote held by disinterested parties approving the transaction in advance, the question of “fairness” will likely require a trial on this question rather than having the case dismissed by the court on a pre-trial motion based on the safe harbor provision. 

The governing person can also assert the business judgment rule defense, which protects officers, directors and managers from claims for breach of fiduciary duties when the minority partner contends they were negligent, unwise or imprudent. The business judgment defense applies when the actions of the governing person were “within the exercise of their discretion and judgment in the development or prosecution of the enterprise in which their interests are involved” (Sneed v. Webre465 S.W.3d 169, 178 (Tex. 2015)). To overcome this defense, the minority owners generally need to show that the governing person engaged in some type of self-dealing that provided the director, officer or manager with a personal benefit. 

Regarding the misappropriation of a corporate opportunity claim, the governing person also has several factual arguments available to assert in defense against this claim. These factual defenses include that the alleged corporate opportunity was not in the company’s line of business, that the company lacked the funds, personnel or other means needed to pursue the opportunity, or that the opportunity was not actually available to the company and could only be pursued by another party. Most of these defenses are fact intensive, and unless the facts are undisputed, a trial may be required to determine the outcome. Thus, to avoid having to prevail at trial in this type of dispute, a majority owner could choose to seek confirmation from minority partners that the opportunity falls outside the company’s line of business, or that it is not available to be pursued by the company for other reasons.    

Majority Owners Have Discretion Regarding Distributions/Dividends

Another significant issue of concern to majority owners is whether they have complete discretion over the issuance of dividends/distributions. Most governance documents give full discretion to company management to decide whether to issue distributions, and if so, in what amount. Therefore, this is one area where the majority owners who are part of the management team have relatively unfettered authority. But most private companies are pass-through entities from a tax standpoint, which means that all owners are required to pay taxes on the company’s profits based on their specific percentage of ownership. As a practical matter, this tax obligation means that majority owners typically issue distributions each year, at a minimum, that will be sufficient to cover the income tax liability of all owners, including their own. 

A related issue that arises in this context, however, is whether majority owners also have unlimited authority to issue bonuses to themselves for the services they provide to the business.  Bonus payments to officers and other employees are not shared with the minority partners, who may not be employed by the company. The minority partners may therefore believe that bonus payments issued to majority owner/managers or officers are actually “disguised dividends” that should be issued as distributions, because bonus payments are not shared with the other owners. 

The key question, then, is whether minority partners have a valid claim that a majority owner’s vote to issue themselves a bonus is a breach of the fiduciary duty of loyalty, i.e., that the issuance of the bonus is a self-dealing transaction. The Texas case law on this issue is fairly sparse, but majority owners can take specific steps to avoid or limit this claim. In this regard, the majority owner can direct the company to hire an outside compensation expert to provide a report regarding market compensation, and the company can make decisions based on this objective data. When management decisions regarding compensation/bonuses are based on reports from independent, third-party experts, these decisions should be protected by the business judgment rule, and a minority partner’s claim should not have much legal traction. This defense is even stronger when other directors or managers at the company (who are unrelated to the majority owner) also vote to approve the compensation or bonus paid to the owner. 

Minority Partners Are Entitled Access to the Company’s Financial Information

Finally, majority owners need to keep minority partners reasonably informed about material events in the business. There can be debate about what level of disclosure is required, but minority owners have the affirmative right to insist on receiving information, particularly concerning the company’s financial performance. In most cases, the governance documents of the company, as well as Texas law, provide minority partners with the clear right to access the company’s books and records, including its financial information. The statute does require minority partners to have a proper purpose for seeking access to the company’s books and records, and courts should act properly to deny access when no proper purpose exists(seeTBOC Section 21.218 (for corporations) and Section 21.218(b) (for LLCs)). The “proper purpose” requirement is regularly given a broad interpretation, however, which includes requests seeking information necessary for the minority partner (or experts retained by the minority partner) to calculate the value of the minority partner’s interest in the business. Further, if the minority partner has to go to court to force the majority owner to provide access to the company’s books and records, and the court finds that the partner had a proper purpose and grants the request, the minority partner will be permitted to recover legal fees. 

Courts will support companies when they seek to preserve their secrecy of confidential information, however, which includes preventing minority partners from misusing the company’s trade secrets and other business-sensitive information. This is handled through a protective order issued by the court in ongoing litigation, or in the absence of litigation, the company can request the minority partner to enter into a non-disclosure agreement. If there are disputes regarding the scope of restrictions requested by the company, these disputes may have to be decided by a court. A majority owner who requests the minority partner to agree to customary restrictions in this type of agreement to prevent the disclosure of confidential information is on solid legal ground.     

Conclusion

Private company majority owners do call the shots in managing their businesses. But, when majority owners also have minority partners who have ownership interests in the company, the owners are subject to fiduciary duties that limit their discretion as directors, managers and officers. These fiduciary duties prevent majority owners from operating the company solely for their own benefit, and they also require the majority owners to provide minority partners with access to the company’s financial books and records when the partner has a proper purpose for seeking this information. Therefore, majority owners are on the best legal footing in dealing with their minority partners when (i) the owners seek advance approval for any transactions they enter into with the company, (ii) they base important management decisions on objective data from outside experts, including decisions relating to the award of compensation and bonuses, and (iii) they seek to apply reasonable restrictions that protect the company’s confidential information when their minority partners seek access to this information.


[1] The existence of fiduciary duties provides shareholders, members and limited partners of the company with the right to enforce these duties in claims against officers, directors, managers or general partners, which the minority owners can bring either directly or in derivative lawsuits filed in the name of the company. 

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Marital divorces are often difficult under the best of circumstances, but tensions may be even higher when the marital estate includes substantial interests the married couple own jointly in private companies, which they are seeking to divide in their divorce proceeding.  The issues likely to create conflict include (i) determining the fair market value of the business(es) included in the marital estate, (ii) negotiating the amount one spouse will pay to acquire the interest that is held by the other spouse in the business, and (iii) negotiating the payment terms to acquire this spousal interest. This post reviews options for spouses to consider that will help them reach an objective value of the private company interests they have and divide these interests in a manner that prevents their divorce from dragging on for years at great expense. Adopting some of these options for resolution, however, would require the spouses to agree to adopt an outside-the-box approach to their divorce settlement. 

Preparing for a Successful Business Divorce

The planning process for a business divorce in a marital case involves securing a number of business and financial records the parties will have to exchange. Before they can negotiate a divorce settlement that involves a division of their ownership interests in private companies, they need to confirm the ownership of the business (identify all owners), review the governance rules that apply, obtain financial information about the company’s performance that will enable them to determine the value of the company, and assess the financial resources available in the marital estate. In this planning stage, the parties will want to focus on the following issues:

  • Were there previous valuations that were conducted of the business, internally and externally by third parties, and were written offers for sale (term sheets, letters of intent) to buy the business made to the company/owners in recent years?
  • Do any buy-sell or other similar agreements exist between the company and/or the partners that provide an agreed method to calculate the value of the business?
  • Who are all the partners in the business, and if there are other partners, are there restrictions on transferring interests in the company’s governance documents that require other partners to approve transfers between spouses?
  • Are there sufficient assets in the marital estate to support an immediate buyout of the interest held by one spouse in the business, or will the couple have to negotiate the terms of a structured payment for the spousal interest?
  • What is the level of debt on the business, i.e., if the business is wholly owned by both spouses, is it possible for the business to secure sufficient financing to enable a buyout of the interest held by one spouse in the business?

Determining the Value of Spousal Interest in the Business

In a marital divorce, the ownership interest the couple holds in a private company may be their most valuable asset. Therefore, negotiating the price to be paid by one spouse to acquire the interest in the business held by the other spouse may be one of the most contentious aspects of their divorce. Determining the value of a company may seem like a simple exercise, but valuing a business involves considering many different variables that can lead to large variances between experts regarding the value. Further, the spouses have opposing goals with the spouse who is transferring his/her interest desiring a high value for the business and the spouse who is paying for the spousal interest desiring a low value to apply to the business.

Both spouses likely share the goal, however, of avoiding a protracted dispute over the value of the business, which will then become a battle of the valuation experts, and result in high legal and expert fees that require a lengthy time period to resolve. When the spouses share the goal of reaching a prompt, cost-effective and fair agreement regarding the value of the company on an objective basis, the following are some options they may want to consider:

  • Retain Single Valuation Expert – The spouses could jointly retain a single business valuation expert who they both respect and agree that they will be bound by this expert’s report on the company’s value and the transfer price to be paid. They could also request the valuation expert to consider the company’s financial performance over the past three years to determine its value, i.e., they could attempt to have the company’s value based on what amounts to a three-year average.
  • Retention of Multiple Valuation Experts – Each spouse could retain their own expert to prepare a valuation report, and if the values determined by the two experts are more than 10% apart, they could agree these two experts would then select a third expert, and they would agree to be bound by the value determined by the third expert. Alternatively, they could agree that after the third expert issues his or her valuation report, the company’s value will be based on the average value of all three reports or an average of the two reports that are closest together in value. Thus, the couple is agreeing to allow the third expert to establish the value of the company, and to be bound by that determination.
  • Arbitration of Company Value – The couple could agree they will authorize the value to be decided by an arbitration panel at a timely hearing, i.e., they could set a date for an arbitration hearing to be held in 90 days, which would allow for them to each secure reports from their own valuation experts. The spouses would submit their valuation reports (and any related testimony) to a panel of arbitrators to decide the company’s value. The panel could also decide the specific structure for payment of the transfer price to be paid by the acquiring spouse if the couple cannot agree on the payment terms. 

Additional Creative Options to Consider

In addition to the approaches discussed above for determining the value of the company (or companies) at issue in the divorce proceeding, there are some other, more creative options that are also available for the spouses to consider, but that will require them to accept less common/traditional settlement structures. These options are reviewed below.

  • Company Value Determined by Trusted Advisor(s) – Rather than directly retaining the business valuation expert themselves, the couple could retain a single trusted advisor or appoint a committee of three advisors and task them with determining the company’s value. This sole advisor or panel of advisors could also be retained to set the terms for payment of the transfer payment/price. Thus, the couple would turn this decision over to a trusted individual or group to retain the valuation expert, oversee the determination of value, and establish the payment terms for the transfer of the spousal interest.
  • Defer Payment Until Company is Sold – Rather than transferring the spousal interest in the business from one spouse to the other at the time of the divorce as is customary, the couple could agree to each retain their ownership in the company after the divorce. This continued ownership, however, would be with the stipulation/agreement that the business will be sold in the next five years and the couple will split the net sales proceeds at that time. In this scenario, the couple will need to discuss what division of the sale proceeds is appropriate on a post-sale basis. In most cases when the transfer of the spousal interest takes place at the time of the divorce, the parties will agree, or the court will require the parties to split the value of the business on a 50-50 basis. But if the couple continues to own their interests in the business after the divorce, they may negotiate a different split that takes into account either the appreciation or the decline in value of the business when the sale of the business takes place years after the divorce. Importantly, when the couple continues to jointly own a company after their divorce is final, they will also need to take steps to create transparency, including providing the non-operating spouse with periodic financial reports. They also need to include restrictions on the powers of the operating spouse that adequately protect the interests of the non-operating spouse. By way of example only, during the holding period before the business is sold, the operating spouse cannot declare large bonuses for himself or herself and cannot add new owners that would dilute the ownership interest of the non-operating spouse.  
  • Grant of Options to Exercise in the Future – Another option, which is similar to the one above, is one in which both spouses continue to own the business after the divorce is final. In this scenario, however, each spouse receives an option to exercise in the future, perhaps in three years or five years. Specifically, the spouse operating the business would have a “call option,” providing that he or she can purchase the interest held by the other non-operating spouse when the option is exercised. The non-operating spouse would have a “put option” that would allow him or her to trigger the option and require the operating spouse to purchase his or her interest. The company would have to be valued at the time that the option is exercised by either spouse, but they could agree on a specific formula in their settlement agreement to determine the value of the business at the time the option is exercised. Finally, and similarly to the previous option, the couple will need to include transparency regarding the company’s ongoing financial performance, as well as restrictions that protect the non-operating spouse during the holding period.

Conclusion

Divorces can be stressful, and the conflicts involved may be heightened when the couple jointly owns valuable interests in private companies. Determining the value of the business and the terms for payment of the spousal interest can be a challenge, because so much is riding on the outcome. But, having this conflict over the value of the business can become a protracted battle that will be very expensive and time consuming, which is not good for either spouse or for the business. If the couple is willing to be creative in their approach to the valuation of the business, however, there are options available that will provide them with a path for the division of their ownership interests in private companies in a manner that is objectively reasonable to both of them.