Don’t Wait to Jump Off the Bandwagon: Cutting Ties With a Bad Business Partner (Part 2)
As we have noted in previous posts, it can become critical for the majority owner of a private company to remove a business partner who holds a minority ownership stake in the business and who is causing major dysfunction in the company. See “The Devil You Know: Pick Business Partners Wisely and Plan For Problems Ahead” By the same token, a minority investor may desire to exit the business when the majority owner is taking actions that benefit himself to the detriment of the company. This is the second of two posts that discusses issues involved in separating from bad business partners, and it reflects the perspective of both majority owners and minority investors. (Read Part 1)
Act Promptly To Obtain Business Divorce
Before considering any Business Divorce strategies, it is important to emphasize the critical importance of taking prompt action. Putting off the steps needed to cut ties with a bad business partner is only likely to make the situation worse. An entrepreneur who writes about startup companies has noted:
The longer you wait, the harder it becomes.
The longer you wait, the longer it’ll take to right the ship.
The longer you wait, the more frustrated you’ll grow. That’s not healthy.
The longer you wait, the less likely your business will succeed.
The Majority Owner Perspective
A. When A Buy-Sell Agreement Exits
We have strongly advocated for both majority owners and investors to negotiate and enter into a Buy/Sell Agreement (“BSA”) before the minority investor acquires an interest in the company. When a BSA exists, it provides the majority owner with a defined path for removing the minority owner who has become a problem in the business. Specifically, the BSA will set forth the manner in which to trigger the buyout, the valuation of the minority investor’s ownership interest in the business and the specific terms under which the minority interest will be redeemed (Read more, here).
B. When No Buy-Sell Agreement Exists
In the absence of a BSA, however, the majority owner has problem when seeking to oust a disruptive minority investor from the business. With a BSA in place between the parties, the majority owner cannot require the minority investor to sell his/her interest in the company. In the absence of a BSA, the minority investor has no contractual duty to sell his/her ownership interest to the majority owner at any price. The options available to the majority owner are reviewed separately below.
1) Voluntary Buyout of Minority Interest
Even in the absence of a BSA, the majority owner and the minority investor may be able to reach agreement on a voluntary buyout, which can involve creative terms. For example, the buyout can be for an agreed value paid over time, or it can involve a hybrid arrangement where the minority investor receives some amount as a stipulated payment together with a royalty that is tied to the company’s future performance. This type of royalty provides the investor with the potential for significant upside if the company performs well in the future.
When the minority investor refuses to negotiate with the majority owner or declines to accept reasonable buyout terms, however, the majority owner may need to take actions designed to create leverage. The goal is to bring the investor back to the table and in a mindset of being more willing to consider the majority owner’s buyout proposals.
2) Squeeze Out or Freeze Out Tactics to Accomplish Buy-Out
In a squeeze out scenario, the company’s majority owner engages in one or more of the actions noted below with the ultimate goal of securing a buyout of the minority investor on more favorable terms. These actions are permissible, provided that they arguably benefit the company and are therefore consistent with the majority owner’s fiduciary duties to the company as an officer, director or manager. Freeze out tactics include, but are not limited to: (i) terminating the minority investor as an employee, (ii) removing the minority investor from all management positions as an officer, manager or director and (iii) refusing to declare profits distributions to owners and, instead, retaining earnings and paying bonuses to officers, and (iv) issuing K-1s that create tax liability (phantom income) for the investor and other owners but without making any profits distributions that can be used to pay for the tax liability.
Squeeze out techniques available to majority owners seeking a Business Divorce are discussed here.
3) Freeze Out Merger
One way for the majority owner to remove one or more minority investors from the business is to engage in what is known as a freeze-out or squeeze-out merger. This transaction is one in which a merger takes place of two or more business entities with the result that at least one owner from one or more of the pre-merger entities will be cashed out in the merger, i.e., they will receive a cash payment for their interest but will not own any equity in the post-merger company that survives. Under state corporate law, mergers typically must be authorized and approved by both the equity holders and the directors or managers of each entity participating in the merger. We have discussed the details of these mergers in a previous post shown here.
4) Sell the Company
A final, but drastic option that may be available to the majority owner is to sell the business, which will then make the minority owner the problem of the new owner acquiring the company. A sale of the business may not be an option the majority owner can pursue, however, if the company’s governance documents require that any sale of the business be approved by all owners. Therefore, a majority owner will want to be sure that the governing provisions provide him or her with the right to sell the business and do not require a unanimous vote of all owners.
The Minority Owner Perspective
A. When a Buy-Sell Agreement (BSA) Exists
Similar to the majority owner, when a BSA exists, it provides for the minority investor to secure a buyout of his/her ownership interest in the business. This is of vital importance to a minority investor because, without a BSA in place, the investor is likely to remain stuck holding an unmarketable, illiquid investment that provides no current return. The minority investor will then remain in this state of limbo hoping for a liquidity event at some point in the future that will permit the investor to finally monetize his/her interest in the company.
B. When No BSA Exists
1) Voluntary Buyout of Minority Interest
As with the majority owner, even in the absence of a BSA, the minority investor can agree to a voluntary sale of his/her interest to the majority owner on terms the investor considers acceptable. If the majority owner is offering unreasonable terms for the purchase of the minority interest, however, the investor can decline to accept them as there is no contract that obligates the investor to accept the majority owner’s low ball purchase offer.
2) Availability of Derivative Actions Against Majority Owners
As noted above, if the minority investor rejects the majority owner’s buyout offer, the majority owner may begin to exercise freeze out/squeeze out tactics. In response to these aggressive maneuvers by the majority owner, or if the minority investor is seeking an exit based on improper conduct by the majority owner, the investor can consider engaging in a strategy that amounts to becoming a thorn in the side of the majority owner.
The arsenal of options available to minority investors is limited, however, in seeking to become a squeaky wheel in efforts to secure a buyout from the majority owner. The tactics that minority investors can pursue include demanding access to books and records, calling special shareholder or members meetings to discuss changes needed at the company and filing derivative claims against the majority owner for breach of his/her fiduciary duties. When there is evidence the majority owner has breached duties owed to the company in his/her capacity as an officer, director or manager, these claims can only be pursued on a derivative basis. The prosecution of derivative claims by private company investors against majority owners for their breach of fiduciary duties is discussed in a previous blog post shown here.
3) Sale of Minority Interest to Third Party
The minority investor may be able to sell his/her ownership interest in the business to a third party, although the transfer of a minority held interest is generally subject to restriction in the company’s governance documents and will require the majority owner’s approval. These restrictions on transferability may not be the real impediment, however, as the majority owner may be happy to substitute a new owner for the existing minority investor. The more likely problem is that there are no third party buyers available who want to step into the shoes of the minority investor, who has no BSA in place and no history of receiving distributions.
4) Create An After-the-Fact BSA
One remaining option that may be available to minority investors to secure an exit from the business in some cases is the potential for creating a new BSA with the majority owner that did not exist at the time the investment was made. The majority owner in some cases may agree to create a new BSA if it provides him/her with the right to redeem the interest currently held by the minority investor in the company. When this type of after-the-fact type of BSA is created, it generally precludes either the majority owner or the minority investor from exercising the right to trigger a redemption or a buyout for some period, at least one year. Once the initial waiting period has elapsed, either side can then trigger the buyout clause. The creation of a new BSA after-the-fact is discussed in this post shown here.
Once a majority owner or a minority investor concludes that they are in business with a bad business partner, it is rare for this problem to be resolved in a way that will preserve their business relationship. Most business advisors therefore strongly recommend that the majority owner or minority investor act promptly to terminate their relationship with a dysfunctional business partner.
A Business Divorce is most efficiently achieved when a Buy/Sell Agreement exists between the partners, which prescribes the specific steps they are required to follow to achieve the divorce. When a BSA has not been agreed to between the parties, the potential for conflicts between them escalates dramatically in conducting a Business Divorce. The distraction and the significant legal expense the parties may be required to endure in achieving a Business Divorce are nevertheless better than the alternative of remaining tethered to a bad business partner whose actions will hinder or even ultimately destroy a successful business.