Shareholder Deadlock Part 2- Contract Terms To Consider (Including Buy/Sell Provisions) To Resolve Future Conflicts

Shareholder deadlocks in private companies often result in protracted legal fights to break the impasse that are expensive and also highly disruptive to the business.  In some cases, these business conflicts can even lead to the forced dissolution of the company.  Just as importantly, these ownership battles are destructive to personal relationships because closely held businesses are frequently owned by family members or longtime friends.

Private companies are prone to shareholder deadlocks when there is no single owner (or no ownership group) who owns a large enough stake in the company to exercise control over the company’s business operations.  Shareholder deadlocks are readily avoidable, however, through advance planning.  Ben Franklin’s famous quote was never more apt than in the private company context:  “An ounce of prevention is worth a pound of cure.”

With just a modest amount of forethought, shareholders can evaluate and adopt contract terms at or near the time of their investment that provide them with a means for resolving future conflicts.  These contract terms also promote harmony and are therefore more likely to preserve the relationship between the owners.  There are a number of different methods for resolving shareholder conflicts, which are reviewed below. 

Advance Planning to Resolve Future Owner Conflicts

It is always better to resolve brewing conflicts, if possible, before the dispute escalates.  Contract terms that provide for this type of early conflict resolution can require one or more of the following: (1) the owners can require disagreements to be presented to the company’s board or to an advisory board for resolution, (2) the owners can agree in advance to retain an outside consultant to issue a report on financial matters that will control the decision on items such as executive compensation levels, stock option plans for key employees and the amount of retained earnings to be distributed to the owners, (3) the owners can mandate that a mediation take place before any legal action is take or (4) if mediation is not successful, the owners can decide that some their disputes must be resolved solely through a “fast track” arbitration that is narrow in both scope and duration.

On this last point, a fast-track arbitration can be conducted rapidly because the business owners agree in advance to a set of limiting procedures.  Specifically, the owners can determine all of the following before the dispute arises: (1) what matters, issues and claims will be subject to arbitration, (2) who will serve as the arbitrators (identifying a group from whom the arbitrators must be chosen), (3) what discovery will be permitted, if any, (4) how quickly the arbitration hearing must be held after a claim is made and (5) the amount of time allowed for the arbitration hearing.  This type of fast-track arbitration allows the shareholders to secure a prompt result for a low cost in comparison to other, far pricier legal alternatives.

Resolution Of Substantial Owner Conflicts

Shareholder conflicts about fundamental business issues may require the owners to adopt a different set of procedures to resolve an impasse between them.  For example, whether to sell the business and for what amount are among the most serious issues that the owners will face in their business.  To resolve these issues, the owners may want to designate a provisional director (“PD”) as someone in whom both deadlocked owners (or owner groups) have great trust.

The PD essentially acts as a referee to decide issues on which the owners cannot agree after considering input from both sides.  The owners must agree to immunize the PD so that the non-prevailing owner will have no legal recourse against the PD.  The owners may want to list several potential PD’s in their agreement (or they may wish to define the process for selecting a PD in the future) so that they can be sure that the PD they choose will be available to serve in this role when a conflict arises.

Resolution Of Irreconcilable Conflicts

Despite the best efforts of private company shareholders to avoid deadlocks between them in the operation of their business, it is possible that future conflicts will arise that result in an impasse.  The shareholders may conclude that they have become so divided in the direction, goals or value of the business that the only way to resolve their differences is for one of the owners to leave the business.

There are number of contractual ways for the shareholders to provide for the exit of an owner from the business.   This type of contract is often referred to as a buy-sell or a redemption agreement.   We discussed buy-sell agreements in a previous Post, but will summarize a number of the different buy-sell/exit provisions that exist below. 

Russian Roulette

In this scenario, one of the shareholder triggers the buy/sell provision by serving notice on the shareholder to buy or sell the other owner’s interest based on a set value for the business.   The triggering owner unilaterally sets a value that does not have to be based on any valuation method or formula.  The owner receiving the notice of the offer cannot contest the value and has to decide whether to buy the other owner’s interest based on that value or to sell his/her interest for that same company value. 

Texas Shoot-out

This type of provision requires each owner to submit a sealed bid setting forth the owner’s stated value for the entire business.  The owner who submits the highest bid then has the obligation to buy out the other owner’s interest in the business based on the value of the high bid that was submitted in the sealed bid.

Dutch Auction

Once again, both owners will submit a sealed bid, but this time the owner submits a number that reflects the lowest value at which the owner would be willing to sell his/her interest in the business.  The owner who submits the higher price is then obligated to buy out the other owner’s interest at the lower price submitted.

Buy-Sell with Third Party Valuation

This contract formula involves retaining an outside, independent business valuation expert.  The valuation expert determines the fair market value of the business and the owner who triggers the buy-sell will either buy the other owner’s interest or sell his/her interest to the other owner for that value or for that value with a set additional premium added (e.g.15%). 

As we emphasized in our earlier Post, negotiating and securing a contract exit right is strongly recommended, but the owners will also want to address a number of related issues as part of this process.  These issues include the following:  (1) how quickly can the buy-sell be triggered after the company begins (should the owners have to wait a minimum period before triggering the buy-sell, (2) does the buy-sell require a sale of all shares or can the owner trigger the buy-sell to dispose of a portion of his/her interest, (3) what date should be used for valuing the company – how close in time to the date the buyout is triggered, (4) what terms apply to the buyout, i.e., how long should the purchasing owner have to pay the buy-out amount so that a large cash payment is not due immediately, and (5) how long should the buyout take – should the buyer owner be given time to raise capital to fund the purchase of the other owner’s interest.

A shareholder deadlock can be devastating to a business, but it can be avoided if the owners agree to adopt one or more of the contract terms reviewed above, which provide a means for resolving conflicts.  No one size fits all, but if the shareholders implement procedures that fit their situation, they will avoid or at least limit future headache, heartache and legal expense.