In the National Football League, quarterbacks may receive too much credit when their team wins and too much blame when they lose. It is easier celebrate or criticize the person we consider the face of the franchise. Perhaps this tendency comes from our experience in business world where the success or failure of a private company often traces to the leadership of its majority owners.
Because the success of a private company is so closely linked to the actions of the majority owners, minority investors need to be closely attuned to signs of trouble. Just as importantly, minority investors should also have a plan in place if it becomes clear that the majority owners of the business are either irretrievably corrupt or hopelessly inept. Highly dysfunctional majority owners will doom their companies, and it is preferable for a minority investor to cut losses rather than waiting to experience the bitter end of a business that is locked in a death spiral.
This post is the second in a two-part series that considers how to respond effectively to, and hopefully secure a business divorce from, a highly dysfunctional business partner. Part 1 addressed this situation from the perspective of a private company majority owner who must confront a dysfunctional minority partner. Part 2 evaluates the problem from the minority investor’s perspective, and considers the business and legal avenues that may be available to a minority investor faced with a dysfunctional majority partner (or majority ownership group).
Defining Highly Dysfunctional Business Partners
In Part 1 of this series, we reviewed the definition of a highly dysfunctional partner. It is important to emphasize that mild excess or extravagance by a majority owner in the operation of the business is not cause for alarm. The passionate majority owner who is driving the company to success may also be prone to taking liberties on the expense side of the company. Further, disputes with the majority owner over the direction or the owners’ vision for the business don’t fit the dysfunctional definition. This definition only applies to someone whose character flaws and gross misjudgment will inevitably run the business into the ground. Some examples of dysfunctional conduct by majority owners are cited below:
- Rampant and material conflicts of interest/self-dealing
- Owners who stockpile excessive retained earnings and make no distributions
- Partners who routinely make large, undisclosed withdrawals or who spend recklessly on personal items
When the majority owner engages in this type of misconduct or incompetence, the minority investor needs to seriously and promptly consider seeking a business divorce.
Informal and Formal Investigation
The first step the minority investor must take upon learning that the majority owner is leading the business toward failure is to secure a full understanding of the investor’s rights as an owner of the business. The starting place is to obtain the company’s governing documents and financial records. In most cases, the governing documents and Texas law authorize minority investors to obtain books and records from the company that provide this information. In at a few instances, the investor’s request to for books and records will trigger a discussion with the majority owner that will help resolve the issues and disputes that gave rise to the request. Most of the time, however, the books and records request confirm that the minority investor’s concerns about the company are well-placed. These documents will also help provide a roadmap to guide the the business divorce the investor is seeking.
In addition to their right to secure books and records from the company, minority investors also typically have the right to call owners meetings (of shareholders or LLC members), to designate items for discussion at the owners meeting, and to call for votes on these items. While a minority investor cannot mandate that the company or majority owner take any actions desired by the investor, the investor can highlight legitimate concerns and issues that the majority may feel compelled to address.
If the majority owner refuses to resolve or even respond to any of the minority investor’s concerns, particularly about financial issues, the minority owner can request the company to conduct an audit by a third party auditor. The majority owner is certainly not compelled to implement this request, but if the majority owner rejects the request without explanation, this outright rejection of the audit request may not play well in later litigation.
The minority investor will want to consider retaining experienced outside counsel at some point to assist in the process of seeking books and records, evaluating the records produced and presenting items to be considered at owners’ meetings. Counsel can assist the minority investor in focusing the requests, determining the import of the documents and deciding what issues should be prioritized for discussion with the majority owner (and his or her counsel). Under Texas law, there are circumstances, as well, that will allow for the minority investor to recover legal fees incurred by the minority investor is seeking books and records and bringing derivative claims.
If a Contract Right Exists to Exit the Business – Exercise It
Many minority investors do not have any contract exit rights – no buy/sell provision, redemption agreement or other contract that requires the majority owner to purchase the minority investor’s stake in the business. In those cases where a contract exist right does exist that will permit the minority investor to secure a contratual buyout, however, the minority investor should trigger that right upon discovering that the majority owner has placed the company on a path of irreversible decline.
Negotiating a Business Divorce with the Majority Owner
In the more typical case where the minority investor has no contractual exit right, the investor needs to be realistic about the lack of leverage that exists in seeking to negotiate a buyout. When the majority owner has no obligation to buy the minority investor’s stake in the business, the investor has to appreciate that compromise is likely to be necessary on the value paid for the interest. In this regard, the majority owner will likely point to the fact that a minority-held interest in a private company is often subject to “minority discounts” which apply in valuing this interest. These discounts reduce the value of the minority ownership interest because the minority owner has no control over the business and there is no ready market for the sale of the minority interest.
In this situation, half a loaf is better than none is the pragmatic approach. The minority investor may be dissatisfied with the price offered by the majority owner, but the investor has to consider that this may be the best price that he/she will ever receive. If the majority owner is driving the company’s ship into the rocks, it may be best best to jump ashore with some value rather than sinking along with the majority owner when the ship finally goes under. In sum, the minority investor should consider whether it is better to continue to remain in the business with a highly dysfunctional majority owner or to accept a reduced price for the minority interest while there is still an opportunity to do so.
On the positive side of the things, the majority may be in denial about his/her failings, as well as about the true financial condition of the company. As a result, the minority investor who refrains from attacking the majority owner, may find that a respectful approach may result in an purchase offer from the majority owner that is acceptable, if not attractive.
Last Stage – Filing Claims Against The Majority Owner
When a highly dysfunctional majority owner refuses to buy the minority investor’s interest for anything other than a low ball offer unrelated to the true value of the interest, that may be the time for the investor to consider what legal recourse is available. As we have discussed in previous posts, and depending on the facts, the minority investor may have compelling legal claims to file either directly or on a derivative basis against the majority owners. Before pursuing any remedies, however, the minority investor needs to determine if the remedies are limited by the company’s governing documents.