Texas Business Dispute Blog

Monday, October 5, 2015

Red Flags for Minority Investors in Private Companies 101: Smoke v. Fire

By Ladd Hirsch

Minority investors in private companies accept significant risks in making non-control investments, including both business risk and management risk.  Examples of business risk are many and include increased competition, changes in government regulations and gaining or losing patent protection.  The focus of this Post, however, is on the risks minority investors are exposed to from majority owners who exploit their control over the company.  Specifically, this Post reviews red flags indicating that the company’s management is acting other than in the best interests of the company and its investors.

Phantom Income – Failure to Distribute Funds to Pay Taxes on Company Profits

In most instances, private companies are “pass through” entities which means that, for tax purposes, the company’s profits are attributable to the owners who must pay the taxes on these profits.  This status does not mean, however, that the company will distribute the funds necessary for the owners to pay their taxes on the company’s profits.  When the company makes no distributions or when the distributions the company does make are insufficient to cover the owners’ tax liability, the profits are referred to as “phantom income.” In this situation, the company’s profits are reflected on the owners’ tax returns (their K-1s), but the company has not distributed funds sufficient to pay the owners’ taxes based on the company’s declared profits.

In our experience, the biggest red flag indicating there are serious problems for minority investors is phantom income --- when no (or insufficient) distributions are issued to the owners to pay the taxes resulting from their ownership interest in the company.  There is no statute or regulation that requires private companies to make distributions sufficient to cover their owners’ tax liability, but most investors expect a profitable company to issue distributions that are, at a minimum, enough to pay their taxes on the company’s profits.  Further, given that all company owners pay taxes, and majority owners will have the largest tax bill, the majority owners’ self-interest typically causes them to distribute enough funds to cover the taxes owed by all owners.

Therefore, when minority investors receive K-1’s that reflect tax liability resulting from the company’s recorded profits, but do not receive a distribution from the company sufficient to pay the taxes on those profits, they should investigate promptly.   The majority owners should be required to explain what the company did with the profits it generated and also explain why no distribution was made to pay for the owners’ tax liability. 

Failure to Provide Information:  No News is NOT Good News

The old adage of no news being good news does not apply to companies in which minority investors have made a substantial investment.  Small, closely-held companies are less formal than large businesses and they have significantly fewer policies.  The informality with which small companies operate, however, does not permit them to refuse to provide material information to their owners/investors.  When the management of the company (majority owners or those under their control) fails to provide any reports regarding the company’s financial and business operations, this is a definite red flag. 

Fortunately, whether the management’s failure to provide financial/business reports to the minority investors is a cause for serious concern can be quickly determined.  The minority investor can issue a books and records request to the company’s management, which is almost always authorized by the governance documents and also mandated by Texas statutes.  Upon receipt of a books and request, the company’s management is obligated to provide the investor with prompt access and opportunity to review the company’s financial and business records. 

Capital Calls:  Dilution of Minority Interest

Most companies do not require minority investors to provide any additional capital to the company after they have made their initial investment.   When the company needs additional funds for growth or for continued operations, it may request the investors to provide another capital infusion, but the investors typically make this decision voluntarily and are not obligated to do so.  If the investors decline to provide any additional capital, however, the percentage of their ownership interest can be diluted when other investors step up to cover the shortfall and provide the additional capital the company has requested.

A company’s issuance of repeated capital calls is obviously a sign of problems. Before a minority investor makes any further capital investment in the company, he/she will want to request that management explain, in detail, the company’s proposed use of the additional funds, the future plans for the business and the impact of the investor’s decision not to provide additional capital on the percentage of the investor’s ownership interest. 

Interested Party Transactions:  Self-Dealing by Majority Owners

It is not uncommon for the majority owners of closely-held companies to do business with the company.  Majority owners often help their companies by providing loans, making goods and services available from other companies and leasing buildings and other property needed by the company.  All of these transactions may provide necessary and substantial benefits to the company.  When the majority owner’s loans and other transactions with the company become extensive, however, the minority investor should evaluate these business arrangements to ensure that the majority owner is not unfairly exploiting his/her control over the company. 

In all of these transactions, the majority owner has the opportunity to take advantage of the fact that the majority owner is on both sides of the transaction.  The interest rate the majority owner is charging on the loans could be much greater than the interest or bank would charge, the company may be charged substantially higher than market rates for goods and services provided by the majority owner, and the property leased by the majority owner could be for excessive rates, as well.  The minority investor should review the terms of these transactions to confirm that the majority owner’s dealings with the company are in its best financial interests.

Conclusion

Minority investors will inevitably be exposed to risks associated with their private company investment, but these risks should be limited to those that flow from the business and not from self-dealing by majority owners who have exploited their control over the company.  To mitigate these risks, minority investors need to monitor both the company’s financial performance and the conduct by majority owners in their business dealings with the company. 


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