Posted On May 12, 2016
When entrepreneurs start a business, they are long on optimism and short on contingency plans. That faith in free enterprise and the willingness to take risks has made America great. But businesses do hit speed bumps and the best-business-friends who worked so well together at the beginning of the enterprise sometimes find that their relationship unravels. When that happens, it can be frustrating if you’re a minority owner of the business.
As a dissenting minority shareholder, you can find yourself with no voice in a business where you invested money or sweat equity. That can include operations, hiring and firing, how profits are distributed, and mergers and acquisitions. While people often have honest disagreements over business strategy, the majority also can embark on a deliberate strategy to devalue a minority shareholder’s interest or shut him out of a fair share of profits.
As in most things, you often can avert headaches in a business relationship by assuming the best and planning for the worst.
Don’t invest without a shareholder agreement
New businesses, particularly if they are started among family members or friends, tend to have informal governance. There’s so much to do in the business; who has time for bylaws?
Do it right from the start with a shareholder agreement that lays down rules that will carry you into a future that includes more investors, bigger sales, expanded operations or a merger. At the same time, you can include specific protections for minority shareholders.
Your lawyer and accountant will have specific advice on what an agreement for your business should include, but here are some of the areas that most such should agreements cover.
Leaving the business – by choice or otherwise
A buy-sell agreement – which may be part of the shareholder agreement or a separate document – outlines the terms for recouping your investment if you leave the business. Some of the considerations are:
Valuation. In many cases, there will be no public market for your interest in a small business, making this an area ripe for disagreement. Buyers may say a business isn’t worth any more than its assets if there are no profits. Sellers are more apt to look at market share, revenue, innovative products and all the goodwill factors that suggest the potential of the business. There are varied approaches to determining value of the shares of the corporation, ranging from data-driven formulas to using the average of multiple outside appraisals.
Buy-out triggers. Your minority interest is worthless if you can’t sell it. Agree in advance to situations that require the majority to buy minority shares. Examples include forcing the minority out of management or employment or even just the minority shareholder’s desire to do something else. If a minority shareholder dies, the majority may want a clause that gives them the option of buying the minority interest, rather than have it pass to a family member.
Employment terms. You may work for the company you partly own, but the majority can fire you. What happens then? Are you stuck with a passive investment?
When all the love is gone
While there is plenty of room for honest disagreement among shareholders, it’s also possible for all-out war. The majority can steal the company from minority shareholders using various maneuvers. Assets can be moved to another company, majority shareholders can pay themselves exorbitant salaries, refuse to issue dividends, shut minority shareholders out of meetings or double-deal with insider transactions.
The courts call this shareholder oppression and South Carolina law provides remedies that include, in a worst-case scenario, a forced sale or liquidation of the business. The law does not define oppression, however, leaving each judge to look at the totality of the circumstances and then determine if the majority’s conduct departed from fair dealing. One test is the business judgment rule, which holds that the court should defer to the majority’s right to make decisions for a business as long as they do so in good faith and are honest and competent.
That’s a high bar to meet, and a short-changed minority shareholder will fare much better litigating a breached shareholder agreement. Don’t trust your investment and hard work in a business to the good intentions of your business associates. Get everything in writing at the beginning.
Julie Jeffords Moose is a shareholder in Turner Padget’s Florence, S.C. office. She represents clients in complex accounting, financial and business issues, and provides counsel in drafting corporate and organizational documents, including contracts, operating agreements employment contracts and other business agreements. She was a Licensed Certified Public Accountant in South Carolina from 1987 to 2005. She may be reached at (843) 656-4418 or by email at firstname.lastname@example.org.