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In a real-life case of adding insult to financial injury, companies harmed by the disloyal actions of their former partners, officers, managers or employees (the “former insiders”) may also have to pay their legal fees when the company sues them to recover for their misconduct. In this situation, if the company’s governance documents (and specific indemnity provisions) have not been carefully drafted, the company may have to pay the legal fees the insiders incur when they defend claims filed against them by the company. 

This situation arises because almost all corporate bylaws, company agreements for LLCs, and partnership agreements for limited partnerships contain indemnity provisions protecting current or former insiders if they are named in a lawsuit because of their position with the company. Frequently, the governing documents will provide these insiders with the right to receive current payment of their legal fees during the litigation and before the lawsuit is ever resolved. And in some instances, the governing documents grant these rights to every company employee rather than to just partners, officers, directors and managers of the company.

Companies include these indemnity provisions in their governance documents because they encourage business leaders to serve in management roles without fear of sustaining personal loss from lawsuits, regulatory actions, or other legal proceedings related to their services for the company. These assurances also support sound decision-making and responsible risk taking by managing leaders that benefit the company. But, as noted, if the indemnity provisions in the company’s governing documents are not carefully drafted, these often-overlooked terms can result in some costly unintended consequences for the company. More specifically, the company could be forced to fund the legal fees incurred by both sides of the company’s lawsuit against a disloyal former insider. This post provides an overview of well-drafted indemnification and advancement rights and how they should be used by companies to achieve their best effect.

Indemnification and Advancement Defined

Typically, a company’s obligation to indemnify will arise from a contract (i.e., a company agreement), a statute, or a combination of the two. When a company provides indemnity, it usually covers legal fees, settlements, and judgments that are incurred or entered against an individual who was sued because of his or her services for the company. Generally, a company’s indemnity obligation will either indemnify insiders against liabilities or damages, or indemnify them against both liabilities and damages. When a company indemnifies against liabilities, the indemnification is owed when the liabilities become “fixed and certain,” such as when a judgment becomes final. But when a company indemnifies against damages, the indemnity becomes due when the indemnitee is compelled to pay the judgment or debt.

Although the right to indemnification and advancement are related, they are separate and distinct rights with notable differences. When a company provides the right of advancement, this enables the insider to receive advance payment of the legal expenses the insider incurs in defending against any claims that relate to that person’s services for the company. In other words, the advancement provision provides insiders with immediate interim relief from the burden of paying for the defense of a claim rather than waiting until the point at which the litigation concludes. Further, because the right to receive advanced payment of legal fees is not dependent on the right to receive indemnification, whether the company insider actually engaged in the misconduct alleged in the lawsuit is irrelevant to the insider’s right to receive advancement of legal fees.

The Scope of the Indemnity Provision Is Critical to Understand

Majority business owners who direct their companies to file suit against disloyal former insiders often assume that their company won’t be required to indemnify or advance legal expenses for the insider’s egregious or even blatant misconduct — regardless of what the company’s governing documents may say. But if the company is an LLC or GP, that assumption can be both incorrect and very costly.

This common misunderstanding may stem from the statutory scheme for indemnification and advancement for corporations. Specifically, the Texas Business Organizations Code (TBOC) codifies certain “default” rules applicable to corporations (and other Texas entities other than LLCs and GPs). For example, the TBOC specifies the circumstances under which a Texas corporation is required to indemnify a governing person, permitted to indemnify a governing person, and prohibited from indemnifying a governing person:

  • Mandatory Indemnification – First, Texas corporations are required to indemnify their current or former governing persons if they are wholly successful in defending a lawsuit to which they were a defendant because of their position in the company.
  • Permissive Indemnification – Second, a corporation is permitted, without the necessity of any enabling provision in its governing documents, to indemnify a governing person who meets certain standards. In civil proceedings, this standard requires that the governing person (1) acted in good faith and (2) reasonably believed the conduct was in the best interest of the corporation (or was not opposed to the corporation’s best interest if the conduct was outside the person’s official capacity).
  • Prohibited Indemnification – And third, corporations are statutorily prohibited from providing indemnification to a person “in relation to a proceeding in which the person has been liable for (A) [willful] or intentional misconduct in the performance of the person’s duty to the enterprise; (B) breach of the person’s duty of loyalty owed to the enterprise; or (C) an act or omission not committed in good faith that constitutes a breach of a duty owed by the person to the enterprise.”

TBOC also permits corporations to advance legal fees and other litigation-related expenses to individuals, either through their governing documents or on a case-by-case basis, as long as the individual provides the company with (1) a written affirmation that they believe they have met the standard of conduct necessary for indemnification, and (2) an undertaking, which is a promise to repay the amount advanced if there is a final determination that the person has not met the standard for indemnification.

But LLCs and GPs enjoy significantly more leeway than corporations in permitting the owners to grant or completely omit indemnification and advancement rights for managers and others. That is because, in contrast to corporations, TBOC’s indemnification and advancement provisions are not applicable to LLCs and general partnerships by default. Instead, as it relates to indemnification and advancement, the owners of LLCs and GPs may either expressly adopt the Texas statute applicable to corporations or “may contain other provisions, which will be enforceable.” In most cases, LLCs and general partnerships will choose the second option, which restricts the company’s advancement and indemnification obligations solely to those that are listed in the governing documents. If these standards and restrictions are broad (e.g., any proceeding that the individual is made a party to because of his or her employment), then the company will likely be required to indemnify and advance expenses to a former employee, regardless of how wrongful the former insider’s conduct may have been. 

In sum, owners of LLCs and general partnerships need to decide whether the indemnity provisions that protect insiders in their governance documents will protect them solely from third-party claims brought by third parties or whether they will also apply to first-party claims that are brought against them by the company. In almost all cases, the owner will want to limit the scope and protection of indemnity provisions solely to third-party claims that are filed against former insiders. 

Conclusion

Companies need to provide indemnification and advancement rights to attract and retain talented managers and employees, but the company’s governance documents need to set forth these rights in a manner that is no more expansive than the company intended. In almost all cases, the scope of the indemnity protection should be limited solely to claims made by third parties; these are claims filed against company insiders by third parties based solely on the fact that the insiders are affiliated with the company. If the company’s governance documents properly limit the scope of the indemnity provision, then, in any future suit by the company against disloyal former insiders, they will not be able to obtain any indemnity protection or advancement of their legal fees from the company. This careful drafting of indemnity provisions avoids a situation where the company is required to foot the fees for legal counsel on both sides of the lawsuit. 

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As private companies grow, they need to secure capital to support their efforts to provide more (and/or better) products and services to their clients. The need for emerging companies to obtain growth capital often leads the majority owner to consider accepting an investment in the business by a private equity (PE) firm. In this post, we share a cautionary note: Business owners need to be wary in their dealings with PE firms. If the majority owner does not thoroughly vet the PE firm, the owner may soon discover after the investment that the PE firm is imposing and carrying out a new set of business objectives, which may conflict with the majority owner’s vision for the business.

Determining Whether Business Goals Align

A potential tension exists between company owners and PE firms because their goals may diverge. While the majority owner/operator is typically focused on growing the company to achieve significant appreciation in value over a lengthy timeline of 10 years or longer, PE firms more often focus on achieving a tighter window for return on investment (ROI) to provide robust returns to their investors, usually within five to seven years. The key takeaway here is that the majority owner should determine at the outset whether common ground can be reached with the PE firm on both the goals of the investment and the firm’s stated timetable for achieving those goals.

If the majority owner and the PE firm are not aligned, the PE firm may require the business to adopt timelines that accelerate the ROI, but that fundamentally alter the culture and character of the business. As just a few examples, PE firms may require the company to adopt aggressive cost-cutting measures, to expand rapidly into new markets, and to implement other operational changes with the goal of achieving short-term profitability rather than the long-term growth model the majority owner was building. The owner may value investments in the company’s culture, employee development, or in setting the stage for customer relationships, but the PE firm may view these items as inefficiencies that must be jettisoned to meet the PE firm’s financial performance targets.

For a majority owner to avoid a situation where the PE firm takes the company in an unexpected and undesired direction after investing, the owner needs to investigate the track record and method of operation of the PE firm. Specifically, the owner needs to dig in to find out how the PE firm managed previous investments in other portfolio companies to determine whether the PE firm’s approach aligns with the owner’s vision. The majority owner should be asking these questions: (i) Did the PE firm work in concert with the company’s existing management; (ii) did the PE firm exert its power to redirect the company’s operations in unexpected ways; and (iii) did the PE firm essentially treat the company as a turnaround situation to rebrand and remodel its approach or did the PE firm enhance the company’s performance without rewriting the entire script? 

Getting answers to these questions will require the majority owner to obtain specific references from the PE firm to current and former clients and the right to speak freely with them about their experiences with the PE firm. In addition, the owner should ask whether the PE firm has been involved in litigation with any former clients, and if so, it is advisable to understand what transpired regarding that dispute, i.e., what claims were made by the former client against the PE firm. Finally, the owner should ask detailed questions about what the former clients experienced in their business dealings with the PE firm, as noted above, in regard to operational changes, new timetables, and exercise of control. This type of due diligence will yield key insights about what the majority owner can expect if the courtship turns into an actual investment in the company by the PE firm.

Majority Owner Contract Protections – Preserving Control and Exit Rights

Many PE firms will not agree to make a non-controlling investment in a private company and will require the majority owner to accept being diluted to a position of holding less than a 50% ownership stake in the company.  The PE firm will insist on becoming the company’s majority owner, thereby securing the right to direct and control the business. But even if the majority owner accepts the required dilution and becomes a minority partner in the business, the owner should still insist on preserving some important rights in the investment agreement discussed below.

First, the majority owner should attempt to retain veto power over fundamental decisions that would dramatically alter the nature of the business. These are “protected decisions” that would require the PE firm to obtain the majority owner’s consent and may include the following: the sale of the company or key assets; large increases in the amount of the debt carried by the company; the addition of new investors in the business that dilute the ownership percentages of existing owners; expansion of the board/managers; large changes to executive compensation; or major operational changes such as opening an office in another state, shutting down an office or territory, or adding a stock option plan for executives. Unless the majority owner retains these veto rights, the PE firm can make whatever changes it may desire to the company without any constraints or restrictions.

Second, if the PE firm drives a hard bargain, the majority owner may permit the PE firm to override the owner’s veto and/or remove the owner from management. But if the PE firm elects to exercise these rights, the majority owner needs to secure a “put right” that the owner can trigger to demand that the PE firm purchase some or all of the majority owner’s interest in the company at that time based on a pre-determined valuation process or valuation formula. Thus, the PE firm will have the right to overrule the majority owner or even oust the owner from the company, but not without giving the owner the right to obtain a buyout at the time of exit. In short, this “put right” ensures that if the PE firm engages in actions that conflict with the majority owner’s voting rights or ownership in the company, the owner can monetize the value of its interest in the business at that point.

When to Walk Away – Red Flags Showing That Love Is Not in Bloom

The majority owner needs to approach a potential PE investment with the mindset of being willing to walk away if the PE firm’s financial goals for the investment are unrealistic, if the firm is rigid in its approach to the business, or if there are red flags that crop up during the due diligence process. Not every PE firm will be a good, collaborative partner, and for the majority owner, waiting to grow the business until the right partner comes along is a far better alternative than bringing into the fold an unyielding partner that exercises complete control over the company in a manner that defeats the majority owner’s own vision. 

Some red flags may include PE firms (i) that insist the company can meet aggressive growth and revenue projections well above industry norms; (ii) that demand the company meet unrealistic timelines; or (iii) that reduce capital expenditures and insist on making sharp spending cuts and requiring immediate and substantial employee layoffs, which are not tailored to minimize the impact on the company’s culture. A final red flag is a PE firm that declines to explain how setbacks will be handled if the company misses a deadline, fails to meet a revenue projection, or has other problems. If the PE firm cannot engage in a problem-solving exercise before issues arise that is a major concern, because challenges are inevitable and business partners need to be able to work together in an effective manner to meet and overcome them.

Conclusion

Successful private companies need capital as fuel to power their growth. But majority owners need to engage in the process of securing capital from PE firms with care if they want to avoid becoming roadkill the PE firm churns through without slowing down. This requires a majority owner to assess whether the PE firm’s goals, approach to the business, and timetable closely align with the owner’s long-term vision.

At the outset, the majority owner needs to develop a clear, specific statement of the owner’s own goals, to conduct detailed due diligence on the PE firm’s track record, and to adopt contract terms that protect the owner’s ongoing rights to ensure that the company will continue to operate in a manner that aligns with the owner’s vision. The majority owner must also maintain discipline, if necessary, to end discussions with PE firms when that alignment does not exist or when the PE firm insists on contract terms that give the firm the right to kick the owner to the curb with no recourse after investing. Sometimes the right response for the majority owner to the PE firm is to “Just Say No.”

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When a married couple enters into a divorce proceeding, they generally expect to end things in a final decree that fully divides all of their marital assets. But when they fully own or have a large interest in a closely held, private business, for a number of reasons they may find that it benefits them to continue co-owning all or a portion of the company for some time period after their divorce becomes final. It is not surprising that a business partnership entered into between divorcing spouses can be rife with problems. This post therefore focuses on steps that each of the spouses can take to protect their interests while also continuing to maximize the value of the company in which they have a shared ownership interest.

There are a number of reasons why it may be beneficial for ex-spouses to continue in a business partnership after their divorce, including (i) to achieve the most favorable tax treatment, (ii) because the value of one of the individual interest held in the business cannot be fully realized at the time of the divorce, (iii) because the sale of an interest in the business by one spouse could lead to a substantial downturn in the business, or (iv) because both ex-spouses like the business and they do not want to relinquish their continued ownership in the company.

Once the ex-spouses decide to continue co-owning an interest in a business together, for this partnership to have any hope of working well, they should consider the following steps to put a workable structure in place. Specifically, the ex-spouses will want to (i) require the company to adopt a clear governance structure, (ii) specify a compensation strategy that determines how each of them will be paid, including dividends and distributions, and (iii) negotiate and implement a buy-sell agreement that sets forth a defined contract governing a future partner exit. Placing a set of rules and mutual safeguards in place will permit both parties to protect their investment and also minimize the potential for future conflict.​​​​​​​​​​​​​​​​

The Control Dilemma in Post-Divorce Partnerships

When a couple considers becoming business partners after their divorce, the most basic issue they need to confront is who will control the company after the divorce is final. It will be a recipe for disaster for them to adopt a joint management approach where they must agree on all business decisions on a 50-50 basis. Divorcing spouses likely have a low level of trust between them and requiring them to exercise joint authority will very likely lead to an impasse putting the company into stagnation or chaos. By the same token, allowing just one of them to make all of the business decisions for the company exposes the non-decision maker to an unacceptable level of risk in regard to the operation of the business.

The practical solution to the issue of control is to provide one partner with control over the day-to-day operations and routine decisions made on behalf of the business, but with an important set of exceptions. Specifically, the parties need to negotiate a clear set of veto rights by the non-controlling ex-spouse on matters that would impact the company’s long-term value. These are what can be referred to as “protected decisions,” and they are typically included in the governance documents for companies that are owned on a 50-50 basis. The protected decisions that may be subject to veto rights may include (i) the sale of the entire company or a sale of the company’s major assets, (ii) any large purchases made by the company above a certain amount, (iii) bringing new partners into the business that would cause a dilution of ownership rights, (iv) taking on substantial new debt by the company, (v) changes to the compensation paid to either of the parties, (vi) whether to issue any dividends or not and in what amount, and (vii) the hiring or firing of key personnel at the business. All of these specific veto rights are subject to negotiation during the divorce and before the couple actually become business partners.  

Another practical suggestion is for the couple to consider appointing either an entirely independent board for the company or to appoint a designated arbitrator to resolve disputes. They could then turn to the board or the arbitrator to address any conflicts arising between them that relate to the operation of the business. These outside parties then serve the role of preventing the parties from experiencing a conflict between them that could lead to litigation. For example, if the non-managing partner exercises a veto right over a business decision the managing partner party believes would seriously harm the business, the managing partner  could require that the exercise of the veto be subject to a prompt arbitration.  

Establishing Reasonable Compensation and Distributions

Once the couple have resolved control issues in managing the business, their next major challenge is to determine the financial returns that they will each receive from the company. The spouse who is actively managing the company will rightfully expect to receive compensation for these services, but the non-manager may also desire to receive distributions or dividends issued by the company on a current basis if the business is generating profits. If the compensation paid to the managing partner is too large, that will likely reduce the amount of distributions, so there is definite potential for tension here between the ex-spouses. 

The way to resolve this conflict is similar to the previous management discussion, with a pragmatic approach to the problem. More specifically, the parties’ divorce settlement will need to document not just their co-ownership of the business after the divorce, but it will also need to present negotiated formulas for executive compensation and for future dividends/distributions. The compensation levels will be tied to the company’s future financial performance taking into account both revenues and profits, and experts can assist the parties in developing formulas for the total amount of compensation that is reasonable to pay to the managing spouse.

Similarly, experts can also propose dividend/distribution formulas based on the earnings of the business earnings (EBITDA) taking into account the amounts that the company will need to retain for working capital and potential future expansion. At a minimum, the company should be making distributions sufficient to cover the income tax liability of both co-owners – neither one should have to pay taxes on income that is not distributed. But a dividend/distribution formula will call for the company to distribute some additional amount above the tax distribution based on a formula that includes working retaining capital and expansion capital – perhaps 15% to 25% of the company’s total profits can be distributed to the ex-spouses on an annual basis, without causing any negative impact to the company. 

Establishing these clear parameters on compensation and distributions/dividends in the divorce documents will help to avoid future conflicts and meet the financial objectives of both co-owners. These negotiated boundaries achieve the necessary balance that allows the company to continue to flourish and the ex-spouses to continue to coexist as business partners.

As a necessary corollary to the contract parameters set forth that govern compensation and distributions, the divorce documents need to provide for financial transparency to the non-manager. To ensure that the compensation level and dividends are based on information that is both accurate and up to date, the divorce settlement will need to require the company to provide the non-manager with consistent financial reports, likely on a quarterly basis.

The Final Lap: The Divorce Settlement Should Include a Partner Exit Plan

Even with all of the careful planning in place, most post-divorce business partnerships are temporary arrangements that are in place for a limited period of years until one or both of them wants to separate. At that point, a business divorce will become necessary, and the ex-spouses therefore need to anticipate and plan for the business divorce in the future when they are completing their marital divorce and creating their post-divorce business partnership.

The situations calling for a business divorce can arise when the business does poorly, when one of the ex-spouses wants to retire, becomes ill or remarries, or when the managing individual wants to grow the business requiring major reinvestment and the non-manager is content with the current situation and blocks the company from taking steps needed to grow. But if there is no partner exit plan in place, the non-manager who desires to depart from the company will be stuck holding what amounts to an illiquid, unmarketable interest — it has considerable value, but it cannot be monetized. On the other side of the ownership, the manager may desire to redeem the interest held by the non-manager, but if no contract right exists that permits the manager to require a redemption, the partners remain together unwillingly.

The partner exit plan should be set forth in a buy-sell agreement (BSA) that provides the ex-spouses with a defined path for them to exit the business. The agreement will therefore provide for all of the following: (1) the specific circumstances under which either ex-spouse can trigger the BSA, (2) the manner for determining the value of the departing individual’s interest once the BSA has been triggered, and (3) the terms for payment of the departing partner’s interest because the purchase price typically involves payment being made over a period of years and there may be collateral provided to protect the departing co-owner in the event of a monetary default. The payment terms have to be realistic and not cause undue economic stress to the company.

The mechanism for triggering the BSA will be the subject of negotiation at the time the divorce is finalized. The agreement may include a “shotgun” provision that enables either side to trigger the buyout but allowing the ex-spouse receiving the purchase offer to either offer to accept it or, instead, to purchase the interest held by the other party. This type of provision is designed to achieve fair pricing because the party making the offer must be willing to accept the same price in return for his or her own interest in the business.

Conclusion

When divorcing couples consider the possibility of continuing as partners in a company after their divorce, they need to take steps to head off potential conflicts as business partners. They can avoid disputes by creating a clear governance structure, by addressing the amount of compensation and distributions to be issued in the future, and by negotiating and signing off on a buy-sell agreement that provides a path to exit in the future. When these provisions are put in place at the time of divorce, the couple are positioned to meet their business objectives with reasonable hope for success as they embark on a post-divorce partnership.