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.

Private company business owners and investors face a host of challenges in the marketplace in their efforts to make their companies a success. As a result, they are often blindsided when they must suddenly deal with conflicts that arise with their business partners, which may be serious enough to threaten the company’s continued existence. Indeed, the Federal Bureau of Labor Statistics reports that roughly 20% of new businesses fail in their first two years with the failure rate growing to 45% in five years and 65% in 10 years.

“…roughly 20% of new businesses fail in their first two years with the failure rate growing to 45% in five years and 65% in 10 years.”

Federal Bureau of Labor Statistics

Less well known is that many the private businesses that fail do so, at least in part, because of conflicts between the company’s co-owners. Anecdotally, the conflicts among private company business partners seem to be increasing due to adverse impacts that have been caused by the COVID-19 pandemic.

Launching Bradley’s Business Divorce Blog

As business partner conflicts are on the rise, we are pleased to announce the launch of Bradley’s new Business Divorce blog. Our goal is to make the blog a valuable resource for majority owners and minority investors, as well as their legal and business advisors, in a wide variety of private businesses. We will also include information for spouses who are going through marital divorce proceedings and dealing with issues relating to the ownership of private companies and other complex property concerns in their divorce proceedings. 

Fortunately, many business partner conflicts are avoidable, or, at least, the disputes between partners may not be fatal to the company if the co-owners take reasonable precautions to arrange for an orderly partner exit in the future. Bradley’s Business Divorce team includes more than 20 attorneys with significant experience in working to head off future conflicts between business partners and, when necessary, prosecuting or defending claims by and between partners when they arise.

What to Expect

You can expect to hear from us regularly on a variety of topics related to the ownership of and investment in private companies on topics such as:

  • What are the key elements of a Buy-Sell Agreement (BSA) and why is it so important for both majority owners and minority investors to consider entering into a BSA before they accept an investment or make an investment in a private company?
  • Evaluation of key provisions included in private company governance documents.
  • What are some red flags that a potential investor should take heed of before making a minority investment in a private company?
  • When should a majority owner consider pulling the plug on a minority investor in the company based on problems and dysfunction caused by the investor?
  • What specific factors should a private company majority owner look for when considering accepting a potential significant PE investment in the company?
  • How do assignments of minority interests in LLCs take place and do minority owners continue to owe fiduciary duties following the assignment of the interest?
  • Analysis of the Texas statute that applies to derivative claims filed by shareholders or LLC members in closely held companies.
  • What concerns do spouses need to address when they transfer interests in private companies to each other in their divorce settlement?

How to Subscribe

To make sure you don’t miss updates from Bradley’s Business Divorce blog, subscribe to receive our posts via email. If you have any questions or suggestions for our blog, please contact us.

Sincerely,

Ladd Hirsch and Brian Gillett

Ladd Hirsch Brian Gillett

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

Governance/Control 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.

Anti-Dilution Provisions

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.

Conclusion

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.