Looking back on the celebration of Independence Day this week, one of history’s most notable separations, it may be a good time for business partners who are locked in conflict to consider a business divorce. Unlike the fight to the death between the redcoats and the patriots, however, the focus of a business divorce is how to structure a separation between business partners that achieves a win-win outcome for both sides.
In its simplest terms, a business divorce refers to the process by which the owners of a private business separate from their co-owners. This Post discusses issues common to most business divorces that will be helpful for business owners to consider before they embark on this process. The perspective in the Post is from the vantage point of the minority owner seeking to negotiate favorable terms for his/her exit from the business.
One key to most successful business divorces is for both parties to approach the process with a spirit of compromise. Business divorces are not “winner take all” affairs, and a business owner determined to secure a one-sided outcome is more likely to spend time (and large sums of money) in the courthouse rather than in a conference room closing a business transaction.
The Governing Documents
As in most things, planning ahead for the negotiation of a business divorce will help in reducing the costs involved and the potential for conflicts with the majority owners. Business divorces are guided or at least, informed by the terms of the governing documents regarding the business entity at issue. Before any negotiation of a business divorce takes place the parties and their counsel need to know: (i) the ownership percentages of each of the partners, (ii) whether there are contract exit rights in any documents that govern how partners will depart from the business, (iii) if exit rights do exit, how they can or must be exercised and (iv) who controls the company’s management. These exit rights are contained in some type of agreement that is often referred to as a “corporate pre-nup.”
No two business divorces are the same, and the differences are often the result of what the governance and contract documents provide. Once the underlying documents are reviewed, counsel for the parties will need to evaluate the contract terms in light of the legal authorities that apply to business divorces. A discussion of these legal authorities is beyond the scope of this Post, but statutes and case law may impact the following issues that will be part of the business divorce: (i) the scope of documents available to minority partners when they request access to the company’s books and records, (ii) the fiduciary duties officers, managers and directors owe to the company, and (iii) the rights of partners to call for mandatory meetings of owners and to require discussion of key items at these meetings.
In sum, the governance documents and related agreements between owners will often provide a road map for the business divorce. Unfortunately, when the governance documents are silent on exit rights and no written buy-sell or other contract was agreed to at the outset between the owners dealing with exit rights, there is much greater likelihood for legal conflict. If the minority owner has no contract right to demand a buyout by the majority owner, the minority owner may begin to look for legal claims to assert against the majority owner to obtain some leverage in the settlement negotiations with the majority owner.
The Business Goals of the Parties
The goals of the business owners are critical in structuring a business divorce, and the differences in their business objectives can lead to many different paths for the minority owner’s exit from the business. Therefore, once the document review is completed, the next step for the owner and counsel is to consider the following issues before starting the negotiation process:
- Does the departing owner want to retain any continuing interest in the business
- Will the majority owner want the departing owner to provide a non-compete agreement and if so, on what terms (what scope and for how long)
- How will the payment for the purchase of the minority interest by taxed, i.e., will it be taxed as a capital gain or will it be subject to ordinary income tax rates
- Is the business close to being sold, and if so, can the minority owner secure a “true up” provision to ensure that the minority will receive an additional payment if the sale price of the business would have resulted in a larger payment for the minority interest
- Are there any other rights that the majority owner will want to purchase from the minority owner in addition to the ownership interest, e.g., patent rights or other IP rights
As the foregoing points make clear, a business divorce requires the parties to take a fully holistic approach. The co-owners must consider all aspects of their current business relationship, as well as how they will deal with each other going forward.
Valuation of the Business and Minority Stake in the Company
Valuation is one of the thorniest issues to negotiate in a business divorce if the parties have not agreed on a buyout process. At the end of the day, if the parties cannot agree on a price for the minority-held interest, a sale/purchase will not take place. There are two main points of contention regarding valuation. First, the parties must agree on the total value of the business as a going concern, and second, they must also agree on whether the minority held interest will be subject to discounts and, if so, of what amount or percentage.
The two primary discounts that apply to minority-held interests are lack of marketability and lack of control, and together they can be quite significant. Retaining a valuation expert will not resolve this issue, because the expert can calculate the discounts, but will look to the parties to decide whether the discounts should be applied or whether the minority owner will receive fair value of the minority interest without applying any discounts.
The parties may nevertheless want to retain a mutually respected business valuation expert to determine the full enterprise value of the company, along with any minority discounts that could be applied. This information will then allow them to attempt to negotiate the extent to which minority discounts will apply to the minority-held interest, if at all.
Potential Legal Claims/Defenses
As noted earlier, litigation is most often involved in business divorce situations when no corporate pre-nup exists and no process is in place to govern the departure of an owner from the business. When the minority owner does not have a contractual exit right and cannot force a sale of the minority-held interest, the minority owner will consider what legal remedies exist against the majority owner. By filing a lawsuit against the majority owner, the minority owner seeks to obtain legal leverage that will lead to a purchase of the minority owner’s interest.
In other posts, we have discussed the types of claims minority owners can assert against the majority owners on a derivative basis under Texas law. See: https://txbusinessdivorce.com/lawyer/2017/05/23/Business-Divorce-Disputes/Shareholder-Derivative-Claims–The-Sharp-Arrow-in-the-Quiver-Still-Available-to-Minority-Shareholders-In-Texas-Private-Companies_bl29995.htm. As these Posts explain, Texas law provides shareholders in close companies with a significant legal arrow when majority owners engage in self-dealing and breach their fiduciary duties to the company. The remedies available to minority owners include the right to recover legal fees. Tex. Bus. Orgs. Code § 21.561(b).
A well-structured business divorce permits co-owners to resolve their conflicts in a way that achieves an optimal result for both sides. Getting to a win-win outcome, however, requires the owners to accept that some compromise is better than remaining locked in a prolonged, and unresolved conflict. As just one example, a majority owner who staunchly refuses to purchase the minority owner’s interest at any price is keeping a disgruntled partner as a co-owner, who will continue to disrupt the business. Moreover, as the business appreciates in value over time, the minority owner will ultimately benefit from the majority owner’s devotion to the business when the business is sold or a merger takes place, but without having put in any time or made any contribution to enhance the company’s value.
In Texas parlance, for a business divorce to be successful both parties have to accept this well known fact: pigs get fat and hogs get slaughtered.