Texas Business Dispute Blog

Monday, August 24, 2015

Employee Ownership 101: Pitfalls for Employees as Minority Owners in Private Companies

By:  Ladd Hirsch (Dallas)

On the face of it, the grant of minority ownership interests to key employees in private companies should be a win-win for both emerging companies and also for key employees of the business.  The company offers an equity stake to key employees, but pays them modest, below-market compensation to help launch and grow the business.  The employees agree to accept the low level of compensation, but they are incentivized by the minority ownership interest they receive in the business in hopes of obtaining significant financial rewards in the future when the company is ultimately sold, merged or goes public.  Drilling down a bit, however, problems may arise here, particularly for the employees who are granted a minority ownership interest in the business, but have no employment contract and no provisions to protect them in regard to their minority ownership stake in the company.

At Will Employment Status

Employees who help start a new business may consider themselves founders and believe this status insulates them from being fired by the majority owners.  If minority owners hold this belief, however, it is misplaced.  Even when minority owners are, in fact, co-founders, they are still considered employees at will unless they have an employment contract.  At will employees can be fired by majority ownersat any time as long as the firing is not for a discriminatory reason that is protected by federal law (e.g., age, sex or religion).

To protect against being fired without cause, employees need to secure an employment agreement that assures them they will be employed for a specific term of years along with a “for cause” termination provision.  This for cause provision will require the majority owner to show that the employee engaged in in illegal or serious misconduct before the employee can be fired.

Employment agreements became even more important last summer after the Texas Supreme Court’s decision in Ritchie v. Rupe.  Before Richie, minority owner/employees could argue that being fired without cause was an “act of oppression” that supported a court-ordered buyout of the minority’s interest under a claim for shareholder oppression.  In Ritchie, however, the Court held that oppressive conduct by the majority owner would – at most – authorize the court to appoint a receiver.  More specifically, the Court held that trial courts have no authority under statute or common law to order a buyout of the minority’s interest even if the majority owners engaged in oppressive conduct. Ritchie v. Rupe, 443 S.W.3rd 856 (Tex. 2014).

Vesting Period for Ownership

Another problem the employee/minority owners face is that there may be a vesting period that takes place before the employee receives/earns the ownership interest in the business.  In this situation, the employee will have to work for a period of years before becoming an actual owner.This is referred to the “you have to be present to win” rule.  An employee can be fired without cause before his/her ownership in the company becomes vested and, therefore, the employee will not obtain some or all of the anticipated ownership stake in the company.

The employee can protect against the vesting problem in several different ways, but all of them require the employee to obtain a contract up front.  Specifically, the employee can bargain for one or more of the following:  (i) a shorter vesting period, (ii) a vesting period based on time worked by months rather than by years, and/or (iii) full vesting that will take place immediately if the employee is terminated without cause.

The Exit Strategy

A critically important issue faced by employee owners is their need to obtain some type of exit strategy – in writing – at the time they receive their minority ownership interest.  Unless the minority owner secures a “corporate pre-nup” – a buy-sell provision or some other type of contractual redemption right, he/she will be locked into holding his/her minority interest with no way to monetize it.  This difficult situation results because a minority stake in a private company is typically illiquid and is not marketable to third parties, and the only buyers for the minority owner’s interest are the company or the other owners of the company.  Therefore, unless the minority owner obtains a redemption agreement that requires the company and/or other owners to buy out the minority owner’s interest in the company, the minority owner will be stuck hoping for a future liquidity event that permits him/her to cash out.

Valuation Methods – Minority Discounts

 The final concern for employees receiving an ownership interest in the company is how their interest will be valued when they sell it, typically at the time they leave the business.  Under most valuation models used for private companies, discounts apply to the value of minority-held interests based on two factors:  lack of control by the minority owners and lack of marketability of the minority interest.  These are known as “minority discounts” and they can be used to deduct a large amount from the value of the minority interest – a wide range from 20-60%.  

To avoid being hit with these steep discounts when the employee ultimately sells his/her minority interest to the company or to the other owners, it is critical for the employee to obtain the corporate pre-nup previously noted.  These provisions will be set forth in the LLC company agreement, in a limited partnership agreement or in separate agreement among the owners of the business.  In brief, the provision will state that minority discounts do not apply to the value of the minority interest and that the employee/minority owner will receive a full pro rata share of the company’s value based on the employee’s specific percentage of ownership in the company.

Conclusion

The grant of a minority ownership interest to employees can be a win-win for both sides, but only if the minority owner is pro-active and takes steps to ensure that the minority ownership provides benefits and not just burdens.  In this regard, the employee/minority owner needs to address in writing and up front the following issues: (i) the employee’s status during the vesting period, (ii) how any vesting period will apply, (iii) the existence of an exit strategy that allows the minority owner to monetize his/her interest in the business in the future and (iv) the method for valuation of the minority interest to preclude the application of steep minority discounts to the value of the minority-held interest.

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