Thinking About a Minority Ownership in a Business? Watch Out!

September 18, 2008

What's the most important fact in common among the following?

· A friend, who owns 100% of a consulting firm company, approaches you about investing $50,000 in the company to bring new software to market in return for a 30% interest in the company;

· A 100% owner of a firm you've been consulting for on an hourly basis offers you 20% of the equity in the firm in return for working at 25% of your usual hourly rate;

· You have accumulated a 10% stake in your current employer, but you want to go out on your own, possibly competing with your current employer. The principal of the firm owns a 60% stake in the company.

Since professionals are reading this article, I assume you have all figured out which numbers are the most important. The most important fact common to all these scenarios is that you will have a minority stake in a company where one person owns a majority interest. Do you understand the consequences of such a distribution of ownership?

Rights of a Minority Owner

In the absence of an agreement to the contrary, what rights do you have as a minority shareholder, assuming that there is no written shareholder or operating agreement addressing these issues? In the absence of an agreement to the contrary, you basically have the following rights as a minority owner:

· If the company is sold or dissolved, you get your proportionate share of the proceeds remaining after all debts are paid;

· If there is a distribution of profits, you are entitled to a share of the distribution;

· You have the right to demand an accounting, which is a limited right to examine the books and financial records of the company; and

· You have the right to sue for breach of fiduciary duty if the majority owner engages in bad misconduct.

This article will not address the last situation, involving issues tantamount to fraud. If you believe the majority owner is defrauding you, see a lawyer immediately, and be prepared to spend some real money. Nor will this article address issues involving several people going into business together with equal interests when all the owners will work for the company, which I've addressed in several prior articles. This article deals with the more quotidian issues that confront a minority owner when someone else has majority control.

What Issues Do Minority Owners Confront?

What are the consequences of your bundle of rights as a minority owner when addressing day-to-day business issues?

· As a practical matter, your right to demand current distributions from an operating business is limited. A majority owner, if she is committed to avoiding any distributions to a minority owner, can usually avoid making any distributions of profits. By establishing generous reserves for future expenses, paying a salary to herself or her relatives at the high range of what is reasonable, pre-paying expenses, investing in new business or new equipment, leasing expensive cars, etc., a majority owner can spend enough that there are rarely any profits to be distributed. So long as the expenses are not grossly unreasonable, you probably won't be able to force the company to allow you to share in any of the current income of the company.

· You have no right to participate in any management decisions of the company. The majority owner may make a decision that you think is bad and puts your interest in the company at risk. You may see the majority owner running the company into the ground. You can try to convince him that it is the wrong decision, but he doesn't have to take your calls.

· You have limited rights, if any, to have your interest bought out. You may want to cash out your interest and do other things with the money. State law may give you the right to force the company to buy you out, but these rights are limited.

· While you would be entitled to a share of any profits on sale of the entire business, a sale can be structured in a way to avoid any payout to minority owners, such as a sale of assets over time with the proceeds reinvested in another business.

How Can You Owner Protect Yourself?

The law of corporations and limited liability companies gives owners almost unlimited discretion in deciding how a company will be run and what rights any of the owners, majority or minority, may have. To address the three scenarios I discussed at the beginning of the article:

· The investor may want to contribute only $10,000 in equity for his 30% interest, and have the other $40,000 be a loan secured by the assets of the business and a personal guarantee of the majority owner.

· The consultant working at a discount rate may require that he have a personal ownership interest in the software.

· The employee leaving the company would be in better shape if the agreement provided for some mandatory buyout. He would, however, have to expect to take a sharp discount from the proportionate value of the interest in the company.

The provisions regarding management of a company and protection of minority owners are limited only by the creativity of the owners and their counsel, and a complete discussion of the possibilities is beyond the scope of the article. When considering a minority stake in a company, think carefully about your expectations regarding the following:

· Involvement in day-to-day management;

· Involvement in decisions about fundamental corporate changes such as sale of the company;

· Payments on your equity from current operations;

· When you will be able to sell or be bought out; and

· Distributions on sale or dissolution of the company.

Discuss these with your prospective business partners to make sure everyone shares basically the same expectations. Then, you can go to a lawyer to have this understanding reduced to writing.

While going to a lawyer to get an agreement will cost some money, it will be much less money that litigating problems once they arise. For instance, I ask for a $500 - $1,000 retainer to draft an operating agreement; I require a minimum $10,000 retainer to start a lawsuit among partners. One last issue to consider in hiring a lawyer to draft an agreement is whether each partner should have their own lawyer, or if one lawyer can draft the agreement for everyone. If all the partners will be equal owners, are equally sophisticated, and are bringing in roughly equivalent business, one lawyer should be able to draft the agreement. The more unequal the partners, though, the more you should consider having more than one lawyer participate in negotiation of the agreement.

Conclusion: Think First.

Many times, a minority interest is worthwhile and valuable, particularly when a business is sold. A minority stake certainly does not mean that you inevitably will be shut out from any financial gain. If, however, the majority owner is not cooperative and no written shareholder or operating agreement exists, your minority interest in the company may not be worth much in any practical sense. In the absence of an agreement, you should realize that your ability to financially benefit from a minority interest depends to a great degree on the good faith of the majority owner. Before you invest time and money in a minority stake in a business, think about whether trusting the majority owner is enough, or do you want to get your agreement in writing to make sure that everyone's expectations are fulfilled.