It feels like a sharp punch to the stomach – a physical reaction to the sudden realization that a longtime business partner’s actions have put the business at risk. This is not a disagreement over differing approaches to business issues. It is a full-blown crisis threatening the company’s continued existence. In these situations, the best option is to secure a prompt business divorce that removes the dysfunctional partner from the company. But, is that possible, and it not, do other options exist to address the disastrous partner situation?
This Post is the first in a two-part series that considers how to respond effectively to, and ultimately secure a business divorce from, a highly dysfunctional business partner. Part 1 of the Post addresses this situation from the perspective of a private company majority owner who has to confront a highly dysfunctional minority partner. Part 2 of the Post will look at this situation from the minority investor’s perspective, who must consider what actions to take in response to discovering that the majority owner is acting in a highly dysfunctional manner.
What is a Dysfunctional Business Partner?
Conflicts between business partners are common. In fact, some would argue that conflict is necessary for a business to succeed because it forces the owners to focus on crafting a shared vision and goals. These day-to-day disagreements are not what lead to business divorce.
True dysfunction is a different story. When one partner’s actions are so destructive they put the company at risk, this defines a dysfunctional business partner.
A dysfunctional minority partner is one who engages in the following types of actions:
- Secretly conspires with other minority investors to undermine the majority owner’s leadership and management objectives;
- Steals (misappropriates) substantial funds or company property,
- Causes the company to incur large debts without the majority owner’s approval,
- Competes directly against the company using company information or assets, or
- Is so incompetent that it poses significant risks to the company and its employees.
When the minority investor engages in this type of conduct, continued co-existence is no longer possible. The continued participation of the minority partner in the business seriously jeopardizes the company’s future.
Check the Documents
The majority owner’s first step upon discovering that a minority investor is sabotaging the business is to review the governing documents. If a buy-out provision exists in a shareholder agreement with the investor, or if the company (LLC) agreement or bylaws include a buy-out option, this is the time for the majority owner to trigger and enforce the buy-out right.
If the majority owner expects the minority investor to become adversarial in the buyout process, the owner should consider retaining outside counsel to assist in securing the buyout. Outside counsel will help the majority owner implement a buyout strategy under the protection of the attorney-client privilege. One of the benefits of this privilege is that it allows the majority owner to get help with necessary due diligence in planning the buy-out, and this assistance will be shielded that information from discovery in a later lawsuit. For example, outside counsel can retain an independent valuation expert to prepare a company valuation for review solely by the majority owner. The valuation expert’s work will be shielded from discovery by the minority investor in any later legal dispute unless the majority owner decides that it is advisable to fully disclose the results of the valuation expert’s work and conclusions.
Remove Minority Investor from Company
If no buy-out provision exists, or if the buy-out cannot be promptly exercised, the majority owner needs to take steps to separate the minority investor from the company. In most cases, the minority investor will not have an employment agreement, which will permit his employment to be promptly terminated. The minority investor should also be relieved of all further management capacities, whether as a director, manager or any other type of governing role.
Even after the minority investor has been removed as an officer, employee and/or manager, the investor will continue to hold an ownership stake in the company. This will permit him/her in most cases to call meetings of shareholders or members, to designate items for discussion at the meeting, and to call for votes on these items. Given that the minority investor does not own a majority share of the equity in the company, however, the investor cannot prevail on any of the items that he/she presents at the owners’ meeting. In short, the minority investor can continue to be a thorn in the majority owner’s side, but the investor cannot require the company to take any actions that are not approved by the majority owner.
The minority investor will also continue to have the right to access and review the company’s financial books and records. In addition, the investor will likely have the right to file and pursue claims against the majority owner, including claims for breach of fiduciary duty, although these may be limited by the governing documents of the company. As a result, even after the investor is removed from employment and management, he/she will be able to continue to scrutinize and complain about the majority owner’s actions in running the business.
Issuance of Future Dividends
Given that the minority investor continues to own a stake in the business, the majority owner needs to consider whether to issue dividends/distributions that will be shared with the investor in proportion to the investor’s ownership interest. The subject of dividends requires considerable thought and business analysis, including input from the company’s accountants/tax advisors.
Most private companies are set up as pass-through entities in which the company’s owners are taxed on the company’s profits. Yet, the majority owner is not legally required in most cases to issue distributions to owners. The minority investor may feel forced to file a claim against the majority owner, however, if the investor is saddled with “phantom income.” This situation arises when the minority investor does not receive any profits distributions, and yet has to pay tax on the investor’s ownership percentage of the company’s profits. For this reason, the company’s governing documents often do require the majority owner to issue distributions that are, at a minimum, sufficient to cover the federal tax liability of all owners.
If the minority investor is removed as an employee and receives no distributions from the company other than to pay the investor’s federal income taxes, the investor has an ownership position with no economic upside unless a liquidity event takes place, such as a sale, merger or public offering (IPO) of the business. But the majority owner has sole control over whether a liquidity event will ever be approved. For these reasons, the majority owner may be able to buy the minority investor’s stake in the business for a discounted price in the future after a period of time has passed in which the investor has received no distributions (other than to pay taxes) and when the investor has no expectation of a liquidity event taking place in the foreseeable future.
Discovering that a minority investor has been destroying the business from within is a deeply unsettling event for a majority owner. It is critical for the majority owner to get over this shock quickly, however, and to take prompt action to protect the company from further harm. There may be immediate fallout from the minority partner’s exit, particularly if the departure take place in a contentious manner, but removing a dysfunctional partner often has a positive impact on the company. The departure of a corrupt or incompetent minority partner often improves the morale of remaining employees and also boosts the performance of the business going forward.
In our next blog post we will look at this issue from the perspective of a minority investor who discovers that the company’s majority owner is a highly dysfunctional partner.