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Majority owners of private companies are empowered to exercise control over their businesses, but if they disregard the valid concerns of their minority partners, they may sow the seeds for a divisive business divorce in the future. The typical business owner is focused, decisive and driven to succeed. These characteristics are admirable, and they work best when paired with an approach to company governance that provides minority partners with transparency and some participation in decision-making. This post identifies three governance controls that are designed to help majority owners maintain goodwill with their business partners while keeping the company on track for continued success.

Adopt Governance Controls That Strike a Reasonable Balance

The majority owner’s gut instinct is to preserve unfettered power over the company, but insisting on this all-powerful, exclusive approach may undermine the owner’s goals and needlessly create conflict with and distrust by co-owners. Fortunately, adopting a more balanced approach to governance will not unduly tie the majority owner’s hands, and it will provide transparency and protections that are desired by the company’s minority partners. 

The governance controls that strike this balance will be set forth in corporate bylaws, in the LLC company agreement, or in written procedures adopted by the company’s board of directors or managers. These controls will provide for limits on the majority owner’s authority as explained below.

  • The governance controls will specify limits on the majority owner’s power to act in the capacity as CEO or president without obtaining approval from the board or managers.  For example, with approval, the majority owner may not be able to: (i) direct the company to enter into the sale or purchase of assets above a certain dollar limit, (ii) enter into any self-interested transactions with the company for loans, sales, or purchases, or (iii) enter into contracts to sell or issue any stock of the company. Ultimately, given the owner’s majority ownership, the owner should be able to overcome opposition to these proposed actions from the board or managers, but it will first require a discussion with these other participants in the management of the business.  
  • Similarly, to limit conflicts and dissension, the majority owner should not seek authority to set his or her own compensation, bonuses or the issuance of any additional interests in the company.  All of these should require the involvement and vote of the board or managers, and in some cases, a vote of the other owners. The board and managers may also decide that the majority owner is not permitted to set the compensation or bonuses of any other officers and that these compensation decisions need to be a topic of discussion and vote by the full board/managers.
  • Finally, the decisions regarding the hiring and firing of employees may also need to be subject to approval by the board/managers. If the majority owner is hiring family/friends and firing all naysayers who express any opposition to the majority owner’s views, this will lead to morale issues and may well create disputing factions within the company.  The better practice is to require the majority owner to seek/obtain input from the board or managers regarding employment decisions.

Create a Culture of Transparency in Management

Providing transparency has been referred to as the key antidote for partner conflicts. Keeping significant owners in the business informed of major decisions by management will go a long way toward building trust, and it will also help all the co-owners feel connected to and supportive of the company’s direction under the majority owner’s leadership.

To achieve this type of internal transparency, the majority owner will want the company’s governance documents to provide for the following:

  • A well-run company will hold regular meetings of boards/managers, as well as and owners (shareholders or members). The minimum would be annual meetings, but boards/managers in particular should meet more often to provide consistent management oversight and to avoid allowing major problems to fester. Owners’ meetings could be held semi-annually if having quarterly meetings is viewed as too burdensome. 
  • In addition to holding regular meetings, the company will also want to provide financial reports to owners on a consistent periodic basis. The bare minimum would be to issue these reports annually, but to achieve the goal of healthy transparency, it is advisable to issue these reports on a quarterly basis, if not more frequently. 
  • The final transparency point is to provide prompt notice to owners when major variances or problems arise. For example, most private companies issue dividends or distributions each year to all the owners to cover their “pass through” income tax liability. If there are problems that will require the company to retain an unusual amount of earnings and issue a smaller amount of dividends/distributions than is customary, notice of this reduced payment should be provided as soon as possible. This will alleviate the problem of a sudden, unwelcome development for the owners that is presented to them with no advance notice.

Provide for Meaningful Participation in Governance

The last governance control procedure for majority owners to put in place is to provide co-owners with the opportunity to participate in the company’s governance in a way that is not perfunctory. This is a due process concern, because minority partners will never have the right to direct or control the management of the company, but they should have participation rights.

More specifically, minority partners should be able to bring items up for the full board or managers to consider, and they should have the opportunity to vote on matters of substance. This will require that certain procedures are established before and during governance meetings to ensure that all owners can exercise these rights. These procedures are reviewed below.

  • All board/manager meetings should be scheduled in advance, and agendas for each meeting also should be circulated listing the items for discussion and vote by the members at the meeting.
  • The board/managers should outline company goals, review the progress that has been made in achieving the goals and provide an overview of the current challenges the company is facing.  
  • When minority partners request that items be included for discussion at the meeting, they should be added to the agenda as appropriate.
  • Minutes should be prepared of each meeting and circulated before or at the meeting for approval by the board, managers or owners.

Conclusion

Companies that create and maintain a strong management consensus are built to last, and they will weather the storms that inevitably come their way. By contrast, a majority owner who wields governing power by giving short shift to the interests of the company’s other co-owners is setting the stage for discord that may lead to a business divorce. While a business divorce that results in the removal of minority partners from the business is rarely fatal to the company, it is likely to create a significant internal distraction, and it may also be negative for the company in its dealings with clients, vendors and others outside the company.

In sum, going through a business divorce is rarely a positive for majority owners, but this distracting conflict is less likely if minority partners remain focused on the company’s long-term success. This goal is achievable when majority owners adopt a governance structure designed to provide minority partners with transparency, predictability and the opportunity to participate to some extent in management.  Further, none of the procedures discussed in this post will deprive the majority owner of ultimate power over the company, and instead, they are intended to assist the owner in building a strong, lasting consensus with all of the company’s owners.

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Money talks when the majority owners of private companies add new business partners who contribute additional capital. When these investors are high-powered PE firms or high-profile companies, with large balance sheets and impressive portfolio companies, they may seem too good to be true. That may be the case, as well, with high-net-worth individual investors who promise to meet all of the capital needs of the business. 

Majority owners need to be wary, however, as they bring additional partners into the fold — these new investors may seem exciting, but they may believe their money shouldn’t just talk but scream. There is no fail-safe formula for choosing good business partners, but this post identifies potential red flags to help avoid business partners who may create problems in the future, including by seeking to exert control over the business. In all cases, majority owners should secure a redemption right (a business prenup) from their new partners to ensure that if conflicts do arise in the future, the disagreements will not derail the business.

The Due Diligence Process for New Investors

Potential new investors should be subject to a vetting process, which is critical to identify potential red flags. One of the best ways to gain insights about new investors is to speak with others who have firsthand experience with them. This is basic due diligence and a check on the investor’s track record. In the case of PE firms, these will be members of portfolio companies in whom the PE firm invested. Questions may include: Did the firm live up to the promises it made before investing? What was the firm’s approach to management? How did the firm resolve conflicts that arose?

In these interviews of members of portfolio companies, the goal is to determine whether the PE firm was a good partner, was helpful to the growth of the business, played a constructive role in the company’s management, and was collaborative in finding resolutions when conflicts arose. On the downside, red flags will be raised if the reports indicate that the firm sought to dominate the leadership meetings, take control over the business, and showed a lack of respect for and no deference to the company’s existing management. 

The PE firm typically provides a list of references for vetting, but the majority owner should go beyond the listed references and, instead, request that the firm provide a list of all investments it made during the past 10 years. There are likely to be some problem investments included on that list, and the interviews should therefore include people who were members of successful portfolio companies in which the PE firm invested, as well as people who experienced challenges during the period of the PE firm’s investment.

Setting Mutual Expectations

One way to determine if potential new investors will be good long-term partners is to gauge whether their interests are aligned with the majority owner’s vision for the company. In making this assessment, the majority owner will want to focus on these questions to the investor: What is the potential new partner’s investment horizon? What approval rights is the investor is seeking to include over management decisions in the investment documents? Is the investor open to some dilution in connection with potential future rounds of investment?

As just one example where alignment with the investor may not exist, if the majority owner does not expect a liquidity event (sale, merger, IPO) to take place for more than five years, that is likely to be a problem if the investor has a shorter time horizon and desires to monetize its investment in five years or less. Another example is if the investor is insisting that its interest will never be subject to dilution of any amount. This position is likely to make it more difficult for the majority owner to raise additional rounds of financing.  

In addition, this approach is a bit formal, but it is generally a good idea to require the investor to describe its expectations in writing to confirm the alignment between the majority owner and the new investor. In fairness, the investor will want to maintain flexibility and retain the right to adapt to changing situations at the company. But, if the investor declines to describe its expected role at the company and to share details of its vision in any written form, that is a red flag. This refusal signals that the investor is saying, in effect, you just have to trust me. In light of this intransigence, the investor’s reluctance to provide any written statement about its role and vision signals that this trust may be misplaced. 

Secure a Business Prenup

Even with the best of intentions, majority owners and investors may find themselves in conflict over the company’s direction at some point in the future. When frank dialogue between the majority owner and investor does not resolve these conflicts, both sides will be glad that they negotiated and adopted a buy-sell agreement (BSA) at the time of the investment. The BSA provides the majority owner with a “call option” that allows the owner to redeem the investor’s interest in the company if the owner decides the investor’s continued involvement in the business has become too disruptive. By the same token, the BSA provides the investor with a “put option” that authorizes the investor to secure a buyout of its ownership interest if the investor becomes dissatisfied with the majority owner’s conduct.

The critical elements of a BSA have been covered in our previous posts, which address how the BSA can be triggered by either party, how the investor’s interest in the company will be valued when the option is triggered, and how the company’s payment for the investor’s interest in the business will be structured. If the parties reach an impasse in their conflict, they should have a clear, prompt method for securing a buyout of the investor’s interest that avoids a protracted, expensive legal battle.

Conclusion

Majority owners of private companies often need additional capital for their business, which they cannot obtain from traditional lending sources. And if the current company owners do not wish to to invest any more capital in the business, the majority owner will need to seek investment from outside sources. At this stage, when majority owners are considering adding new partners who will provide growth capital for the business, the owners need to be cautious or they risk finding out that bringing these new partners on board was a case of the expected cure for the company being worse than the disease.

No one has a crystal ball to know if a new business partner will be a positive, long-term addition to the company. But there are red flags that are likely to surface if the majority owner conducts a thorough vetting process regarding potential new investors, including by interviewing people who have had direct, firsthand experience with the potential investors. Finally, the fail-safe option is for majority owners to obtain a buy-sell agreement from all their new investors. This agreement will provide the owner with a redemption/repurchase right if things do go off the rails with the investors in the future.

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Business divorces take place in all types of private companies, including those owned and operated by family members. But families that are willing to engage in thoughtful planning can head off some of the internal conflicts that lead to business divorces, and if the exit of a family member from the company does becomes unavoidable in the future, the proactive steps discussed here can limit the negative impacts the business and the family may otherwise have to confront. The effort by the family to avoid or limit the downsides of a business divorce begins by adopting a clear governance structure and also requires all owners to sign off on a business prenup that controls when a family member/owner departs from the business. 

Adopting a Clear Governance Structure: Start with an Experienced Board

Achieving success in a new business is a daunting challenge. As a result, the owners of new and emerging companies, including family businesses, tend to focus their attention on the steps to succeed in the marketplace and much less on steps to govern their company. This simple focus on launching the business may work for a time, but as the company grows, the family members will need to put a clear governance structure in place to avoid chaos and/or major conflicts that would otherwise derail their success.

There are two aspects to governance. First is the creation of a board and, second, is to appoint officers and then define their roles. For corporations and LLCs, the governance structure requires the owners to install a governing board or group of managers (we refer to this as a board for both types of entities). In creating the board, the business owners need to consider these critical components for effective governance: (1) the best boards bring solid experience in the industry to the table; (2) board meetings should be held both regularly and consistently to review the company’s performance; and (3) the board must be empowered to take the steps necessary to successfully manage the business. 

Regarding the last point – the scope of authority – the board needs to have clear authority to make the final, “buck stops here” type of decisions for the company, including (i) hiring and firing each of the company’s officers and determining how they are compensated; (ii) approving the company’s annual budget forecast; (iii) determining what amount of profits each quarter to distribute, if any, to the owners of the business; (iv) evaluating whether to approve extraordinary expenses not included in the annual budget; and, finally, (v) developing a succession plan for the company’s executive leadership in the future. The board should fully disclose its work and the results of its decisions to the board members in written minutes and resolutions. These board actions also need to be sent to all non-board members at least in a summary format.

In a family business, the board typically includes multiple family members, but having non-family members also serve on the board should be considered, provided that they are truly independent, i.e., the non-family member(s) on the board should not have business or family ties to other members of the board. More specifically, it is generally best not to include the in-laws of family members on the board as this defeats the purpose of seeking independence.

The Roles of Officers Must Be Clearly Defined

The second aspect of governing is to appoint officers of the company and to ensure that they know their expected roles in some detail. Failing to provide clear definition of leadership roles has created many conflicts in business, and not just in family-owned companies. The board should lead this effort because it is not just assigning duties by appointing people to serve as officers of the company, but it is also defining the scope of authority that is being granted to these officers to achieve their specific business objectives. 

The exercise of defining roles is so important to the business and to the people involved that it may be helpful to obtain input from outside management consultants. This is money well-spent, because leaders in business are best positioned to flourish when they know and understand the role they are expected to perform and have clear guidelines regarding their authority. When the roles of leaders are not clearly defined, however, turf battles will invariably break out, which will cause discord and dysfunction in the business that can lead to a business divorce.

The board should also be devising a succession plan for senior officers. Putting this plan in place provides the business with continuity, stability and a sense of purpose both internally and externally to customers and others. If the board fails to develop a leadership succession plan, that may lead to internal conflicts, lack of focus and a sense of instability. If employees, customers and third parties sense that the business has lost focus because a leadership change is coming, but there is no clear plan for the future, it can lead to employee turnover, loss of clients, and loss of prestige in the marketplace.  

Adopting a Business Pre-Nup for All Owners

We have written extensively about buy-sell agreements in previous posts, and this type of agreement is an important part of partner exit planning that is even more critical for family businesses. In short, all family members with a stake in the business should consider entering into a buy-sell agreement as part of the governance document that is reflected in a separate shareholder/owner agreement. This agreement protects the interests of both those with a majority interest in the company, as well as those who are minority owners.

For those with a majority interest in the business, it allows them to purchase the interests that are held by a minority owner based on the fair market value of the interest. For those with a minority interest in the company, it enables them to to secure a buyout of their ownership interest if they do decide to depart from the business. Thus, minority owners are not “stuck” and unable to sell what amounts to an illiquid interest they hold in the business, and they will have a contractual right to require that their interest be purchased by the company or by the majority owner of the business, and for a price based on its fair market value.

There are some issues that are particular to family businesses in regard to a buy-sell agreement, and these can be addressed in the shareholder agreement. For example, the minority owners may fear that they will be removed from the business against their will when they want to continue to maintain their interest in the company. This valid concern can be addressed by requiring that a minority interest can be redeemed only with “super-majority” vote, i.e., the minority interest can only be redeemed by a high percentage vote taken of the total ownership of the business and not by a bare majority. In the family business, this will require a high percentage of the family to vote to oust another family member from the business.

Similarly, minority owners may also fear they will be bought out and then a transaction will take place in a short time at a much more favorable valuation, i.e., they will miss out on a large upside. This concern can be mitigated by including what is called a “look back” provision in the shareholder agreement. This term provides that the minority owner will receive additional consideration if a sale of the company or even another stock sale takes place for a higher price within an agreed period of time (usually within a year) after the minority owner’s interest was redeemed. This provision permits the minority owner to receive the full increased sales price if another transaction takes place during the restricted period after the redemption.

On the other side of the equation, majority owners may be concerned that a group of family members who are minority owners may all chose to exit at the same time and demand a payout of their interest. This situation can also be addressed by limiting the amount that will be paid out in redemptions to minority owners in any single year based on the company’s available finances. In short, minority owner redemptions will not be permitted to cash strap the company. 

In sum, the benefit of a buy-sell agreement is that it provides a defined process for the exit of a partner from the business. The buy-sell agreement governs when a buyout can be triggered, how the interest will be valued, how the payment will be structured, and finally, how any disputes relating to the buyout will be resolved. The parties can choose to arbitrate any disputes, which will permit them to resolve their conflict more quickly and in a confidential manner. 

Conclusion

Business divorces may be a fact of life, but in the context of a family business, they can do harm to the business as well as to family relationships. Fortunately, some conflicts may be avoided and relationships may be preserved if the family members engage in advance planning.  If the family will install an experienced board, clearly define the roles of company officers, and actively participate in the governance of the company, they may be able to work through the challenges that arise in operating the business and avoid a business divorce entirely.

In the event that a family member wants to depart or is asked to depart by a majority of the other owners, this type of partner exit should not result in a harsh impact to the business or a major conflict in family dynamics. Instead, if the parties sign a buy-sell agreement, they will be able to chart a path setting forth when and how the partner’s exit will take place, which will include the method for determining the fair market value of the departing partner’s interest and the terms for the paying that value. Buy-sell agreements are not easily negotiated, but when the family goes through the hard work of putting them in place, everyone knows the rules that will govern if a business divorce does take place in the future. This will avoid a host of conflicts that might otherwise create problems for the business and fray family relationships.