The Darker Side of Exit Planning: Achieving a Business Divorce
When business owners think about exit planning, they usually think in terms of a voluntary sale of the assets or equity interests of the company by a willing seller to a willing buyer, a transfer upon death, a gift or some other form of amicable transaction. These types of transactions usually are planned out well in advance. Few people imagine a situation where they become involved in a dispute (or even litigation) with their fellow owners, and as a result, one or more owners is forced out, or some other resolution of the underlying disagreement is forced upon the parties. A business divorce can be a messy, bitter transaction to manage, referee or experience. It can be as emotionally charged as a divorce between spouses (and sometimes the two events overlap). Few people shake hands and congratulate each other when the business divorce is ultimately completed.
As a business attorney and commercial litigator, I am involved in many disputes among business owners. Although it is difficult to anticipate every possible scenario, proper planning can mitigate the damage inevitably cause by unresolved disputes among owners, which can, if left to fester, cause severe damage to the parties’ shared asset—the company. Many tools are available that favor the majority owners over those who lack voting control. For example, I often incorporate “call” provisions into limited liability company operating agreements and shareholders agreements. These require certain owners (usually the minority owners) to sell, and either the company or the remaining owner(s) to buy, the seller’s equity interests upon the occurrence of certain events--such as the termination of the seller’s employment with the company that he or she partially owns. The sale price may be set at fair market value, book value, or some other agreed amount that may be more favorable to one party or the other. If the minority owner is not protected by an employment agreement limiting the grounds for his termination, his employment and his interest in the company may depend entirely on the goodwill of the majority owner(s).
Persuading a Minority Owner to Sell
Similarly, a functional divorce can be achieved in some cases, even when there is no contractual provision to force the minority owner to sell or redeem his or her interest in the company. Unless the minority owner is adequately protected by agreement, his employment (and livelihood) could be summarily terminated, he could be stripped of all title and position, and then voted off the company’s board of directors or management committee. Unless the company makes substantial distributions of profits or pays substantial dividends, the minority owner’s equity interest may thereafter have little practical value, and he would have no effective means to participate in the management of the business and affairs of the company. Without a “put” option that requires the company to redeem his interest and includes a fair valuation method and payment terms, the minority owner may have little choice but to redeem his interest at less than full value (i.e. at whatever discounted price he may be offered) in order to realize any value for his interest in the company.
Such an undesirable result (at least from the minority owner’s perspective) highlights the advantages in planning for an exit from the outset. The prudent minority owner should always seek an emergency exit plan to implement in the event his relationship with the majority owners sours. The emergency exit plan should clearly set forth (i) the circumstance under which it can be implemented, (ii) valuation methods and procedures, and (iii) payment terms in order to ensure that the minority owner receives fair value for his interest in the company.
Mechanisms for Achieving a Business Divorce
If control of a company is evenly split, so that there is no majority owner, planning for a divorce can be more complicated. But when a deadlock exists between the owners that can jeopardize the health and/or value of the company, it is prudent to create a mechanism for divorce. A number of variants exist that are intended to eliminate one or more of the disputants from the company. One mechanism is called Russian roulette, whereby one party suggests a value for the company. The other party then has the option to either buy out the party offering the suggested value at the proffered price per share or unit of membership interest, or sell his interest to the offering party at the same value. Another variant involves both parties submitting sealed bids, and the party submitting the highest bid must buy the other party at the high bid price. A third option is to provide that the initiating party will have the company valued by an independent appraiser, following which that party can either sell his interest to the other for an agreed percentage below appraised value, or he can elect to buy the other party for an agreed percentage in excess of appraised value. There are variations of these mechanisms, but the final result is always a business divorce.
If, due to lack of planning or agreement, none of these tools are available to the parties, there may still be other options available. In some situations, the majority owners may be able to engineer a “reverse stock split” and thereby leave the minority owner with a fractional share of the company. For example, if a party owns five shares of stock, and there is a reverse stock split of one share for ten, the minority owner would be left with only half a share of stock. Under the Maryland General Corporation Law, for example, a corporation is authorized to pay cash for the fair value of fractional shares. Thus, following the reverse stock split, the minority owner can be forced (even in the absence of call right) to sell his fractional share to the company—a process we have used in the past to push out an unwanted shareholder.
When a Court Dissolves the Company
Finally, where a company has become so dysfunctional due to the owners’ inability to come to agreement on its management, grounds may exist to petition a court to dissolve the company and liquidate its assets. Upon a judicial dissolution, the owners receive their pro rata share of the proceeds from the sale of the company’s assets. Using the Maryland Code as an example, a court may dissolve a corporation when “the directors are so divided respecting the management of the corporation’s affairs that the votes required for action by the board cannot be obtained,” or when “the stockholders are so divided that directors cannot be elected.” Similarly, a court can order the dissolution of a Maryland limited liability company “whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or the operating agreement” of the company. Although none of the equity owners of the company may want to liquidate its assets were other choices available, such a scenario may be the only available exit strategy.
Proper planning is always preferred to anticipate and accommodate changed circumstances. However, notwithstanding the best laid plans, business owners can sometimes find themselves locked into business arrangements that are no longer desirable, and in those cases they should consult professionals who are knowledgeable about business ownership disputes and the tools needed to resolve them.
Theodore Goldstock is a business and litigation attorney at Lerch, Early & Brewer, Chtd. in Bethesda, Maryland. He counsels businesses on a broad range of corporate and commercial law matters and represents clients in business-related disputes and commercial litigation. He also advises family-owned businesses on succession planning, governance and other issues. For more information about exit planning, contact Ted at email@example.com or (301) 347-1274.
This article originally appeared on the Exit Planning Exchange.