A person holding a majority of a closely held business (let’s call her “Ms. Big”) generally gets to make all the major decisions concerning the business. Fiduciary duties and other restrictions prevent Ms. Big from running roughshod over other owners, but within fairly broad parameters, Ms. Big can rule the day. A person owning a non-controlling or minority interest (let’s call him “Mr. Small”), on the other hand, is frequently just along for the ride. However, with proper planning and negotiation, Mr. Small may be able to assure a certain level of participation in management and other rights he would not otherwise have.
These concepts apply equally in the context of a corporation, limited liability company, or other business organization. Most of them also apply whether the controlling interest is held by a single owner or a group of owners.
One of the first devices to consider is a supermajority voting requirement. For example, if Mr. Small holds 25% of the business, the entity can be structured so certain actions require the approval of 80% of the ownership interests, instead of the usual 50%. This essentially gives a veto power. In a situation where there are multiple minority owners, the voting threshold might be set so that no one shareholder can veto a proposed action. Typically, this voting requirement would be limited to specific major items such as a merger or other acquisition, dissolution, sale of substantial assets, etc.
Participation in Management
Mr. Small could insist that the business be structured to assure his participation in management. In the corporate context, cumulative voting can give a minority shareholder the right to elect a member of the board of directors. Stock can also be organized in different classes, each having the right to elect one or more members of the board of directors. While this does not assure the outcome of any particular vote, it at least can assure Mr. Small a seat at the table, an opportunity to persuade others of his point of view, and a way to keep abreast of the decisions which are being made.
Similar results can be accomplished in the organizational documents of other types of entities, or in a separate agreement.
Rights to Distributions
As a minority shareholder, Mr. Small will have very limited ability, if any, to compel the business to distribute any profits. Particularly if the business is a pass-through entity for tax purposes (a limited liability company, partnership, or S-corporation), Mr. Small will be subject to tax liability for profits whether or not they are distributed. Accordingly, he may want formal assurance that at least a certain percentage of the profits taxable to owners will be distributed to provide the cash flow to pay those taxes.
Buy and Sell Issues
Mr. Small presumably knows Ms. Big and any other co-owners when the business is organized. He might want to have some protection against transfers to strangers. A buy and sell agreement might require that an interest first be offered to the other owners before it can be sold to a third party. Similarly, an agreement might provide that one or more controlling shareholders cannot sell their interests in the company to a third party unless they also arrange for the sale of the interests of the minority owners (sometimes referred to as “tag along” rights).
What should happen to Mr. Small’s ownership interest if he dies, quits, gets fired, or becomes disabled? A properly drafted buy and sell agreement can provide protection for Mr. Small and his family on all of these points.
Without advance planning, the owner of a minority interest may find that he or she has made an investment for life (or perhaps longer). Mr. Small might consider a “put” right or similar arrangement under which he could force the company to purchase his interest. Perhaps this put right would be exercisable only in certain events. For the put right to be meaningful, the agreement must spell out all of the material terms of the buy-out.
Another exit strategy is to include a “Dutch auction” or similar arrangement. Such an arrangement might permit any shareholder to initiate a bidding process that leads to a mandatory purchase by the high bidders of the interests of the low bidder or bidders. Variations are numerous but one common alternative would permit Mr. Small to name a price per share, with Ms. Big then being required to chose between selling her interest to Mr. Small or buying his interest at the same price.
A simple, albeit more extreme alternative is for the noncontrolling owner to have the right to force dissolution of the company. While the actual exercise of this right might be somewhat clumsy, the possession of this power can help Mr. Small negotiate a favorable buyout with Ms. Big.
Instead of being at the complete mercy of controlling owners, the holders of lesser interests can take steps to protect themselves with proper advance planning. While controlling shareholders might not always agree to the various protections discussed above, the holder of a minority interest should at least consider these before ending up like Mr. Small.
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Bruce C. Young is a partner in the Grand Rapids office of Warner Norcross & Judd LLP. He focuses his practice on general corporate representation and tax and estate planning for business and their owners. Bruce may be reached at 616.752.2144. Because each business situation is different, this information is intended for general information purposes only and is not intended to provide legal advice.