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.

One of the goals in a business divorce is finality – ending a business relationship once and for all. But what if the end isn’t really the end?

When members of limited liability companies (LLCs) sell their interests in the LLCs to a third party, they may assume that the sale provides the desired end of their rights and obligations related to the company. But that may not be the case. It is possible that even after selling and assigning an LLC interest, the assignor may continue to owe fiduciary duties to the LLC and its members. This post reviews some of the pitfalls of assigning an LLC interest and discusses strategies that may help to avoid those problems.

The Texas LLC Act – Provisions Governing Assignments of LLC Interests

Chapter 101 of the Texas Business Organizations Code (the “LLC Act”) governs LLCs. The LLC Act provides that a member of an LLC may transfer his or her membership interest to another party in whole or in part. But the assignment of an LLC interest is different from the transfer of membership in the company. The assignment of the LLC interest does not give the assignee the rights to (1) participate in the management and affairs of the company; (2) become a member of the company; or (3) exercise any rights of a member of the company. The assignment of the LLC interest provides the assignee with the right to receive distributions issued by the company and information about the company’s finances, but that’s about it.

The LLC Act spells out these rights of the assignee: “An assignor of a membership interest in a limited liability company continues to be a member of the company until the assignee becomes a member of the company.” Further, the assignor does not have the right under the LLC Act to withdraw as a member from the company. (An LLC member also cannot be expelled from the company.) The result is that even after assignors assign the LLC interest and are enjoying “life on the beach,” they may still owe fiduciary duties as a member of the company.

As a side note, this discussion has assumed that there are fiduciary duties owed within the LLC at issue. But that is not always the case. The LLC Act permits the members to agree in the  company’s certificate of formation or operating agreement to modify or even eliminate all fiduciary duties that are owed to the company and its members by the managers of the LLC. Tex. Bus. Org. Code § 7.001(d)(3). While including such a provision would certainly make it safer for a member to assign an LLC interest, doing so poses its own set of risks while the company is operating.

A Case Study: Villareal v. Saenz

The problem of fiduciary duties persisting after an assignment may sound far-fetched, but it is a real concern. In Villareal v. Saenz, the co-owners of an LLC agreed to a business divorce in which Saenz assigned the entirety of his interest in the company to Villareal. 5:20-cv-571, 2021 WL 1986831, at *2 (W.D. Tex. May 18, 2021). The assignment was part of a broad release of claims, both known and unknown. Villareal later filed suit, alleging that before signing the release, Saenz had engaged in various acts of misconduct, including misappropriating company trade secrets and embezzling funds, and that after the release, Saenz had taken over the company’s web and email domain, pulled down the website, and offered to sell it back to Villareal for $7,000.

A magistrate judge in the Western District of Texas recommended that all claims based on alleged acts arising before the release should be dismissed for failure to state a claim. But the magistrate judge also recommended that the claims against Saenz based on actions that allegedly took place after the release – including those for breach of fiduciary duty – should proceed. The court concluded that Saenz had not demonstrated that his fiduciary duties ended when he assigned his interest in the company to Villareal, and he may have breached those fiduciary duties by maintaining dominion and control over the company’s email server and website.

Conclusion and Recommendations

The key takeaway from Villareal v. Saenz is that disputes between owners regarding the fiduciary duties that exist after an assignment can be avoided by more clearly wording the company agreement or assignment. The following are specific steps that potential assignors can take before their assign their LLC interests to another party:

  • First, assignors can make sure that the assignment provides an end to their membership in the company by agreement of all members, along with a mechanism set forth for the assignee to assume the membership interest.
  • Second, assignors can include an express written release and waiver of any post-assignment duties to the company or its members (fiduciary or otherwise). This should be signed by the company and all of its members to be certain it is effective.
  • Third, and most importantly, assignors can make sure at the outset, when forming the company, that the operating agreement provides a mechanism for transfer of the membership interest in connection with an assignment, specifying what happens to the member’s duties (fiduciary or otherwise) when the transfer takes place.

The bottom line is that when assignor is trying to exit the company, he or she does not want to have any continuing duties to the company. To ensure this takes place, the assignment documents and the terms of the LLC Agreement should confirm that these duties no longer exist after the assignment takes place.