Selling equity in your business to fuel expansion

Problems with Minority Partners

BY JAY WINSTON, WINSTON & WINSTON, P.C.

 

Selling equity in your business to fuel expansion: The risks may outweigh the benefits

Small Business owners of closely held corporations should carefully assess the advantages and risks before taking on minority owners to provide a cash infusion to their business. Picking a business partner is one of the most important decisions that a small business owner will make during his/her life. The decision, is almost as important as choosing a spouse, because you are just as accountable to your minority partner(s).  Make sure your partner(s) share similar short term and long term goals. When the goals diverge, litigation is always a risk.

A majority owner owes every minority owner a fiduciary duty of loyalty. This duty imposes a higher level higher level of responsibility, than is required in most day-to-day transactions. A diligent minority owner is entitled to carefully scrutinize every action or in-action by the majority owner. This power is real and may interfere with your ability to run the business as you wish. This interference may range from the sincerely questioning your decisions to intentionally hindering your ability to act, or even force you to sell your business.

If bad blood develops between the parties, a minority owner may institute suit by merely alleging that the controlling party breached its fiduciary duty, engaged in bad faith and unfair dealing, as well as other contractual breaches. The purpose of the suit may merely be to extort a settlement, to avoid attorneys fees. The suits indirectly affect the profitability of the business as it diverts your attention away from operating the business and marketing. In addition, if this internal conflict becomes public, customers may leave until the lawsuit is resolved which may be years.

While the majority owner’s decisions are protected by the business judgment rule which holds that the majority’s good faith decisions regarding management of the company can not be questioned. Actions with respect to self-dealing, disloyalty or self-preference shifts the burden onto the majority to prove fairness. Often this issue is an issue of fact that cannot be resolved without a trial.

Disputes often arises in the following areas: Information Rights, Participation Rights, Distributions of excess cash vs. reinvestment, Sale of the business, Focus of the Business, Future Opportunity Rights, Need for Additional Capital, and Redemption Rights. The sources of the disputes often occur, because the minority partner(s) insists on taking on a large rule than anticipated, or because the minority partner(s) believes the controlling partner has unfairly benefited.

For example, the minority partner may demand access to all financial or business information. The additional reporting requirements can become burdensome and will distract you from running your business. Likewise, an older minority partner, who wishes to retire, may want to sell the business at it peak to maximize his investment, while you consider the business part of your life. If you refuse, he may start a lawsuit based on a breach of your fiduciary duty. The majority partner may not have the resources to defend the lawsuit. Thus, consultation with an attorney is strongly recommended. From past experience, minority owners generally have unrealistic expectations, and the judicial system has been receptive to creative arguments set forth by attorneys. In summary, if merely additional financing is required, other alternatives should be considered first, before bringing in additional partners.

The decision to sell or not to sell the business is often a source of litigation. The allegation is the Majority owner sold to cheaply or in the alternative unreasonably refused an offer to sell.

 

Copyright © 2001, 2002 Winston & Winston P.C. All rights reserved.
Revised: July 29, 2003

 

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