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Business Breakups: Terminating Ownership Interests in Closely Held Businesses Robert J

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Business Breakups: Terminating Ownership Interests in Closely Held Businesses Robert J Shareholder Litigation Insights Business Breakups: Terminating Ownership Interests in Closely Held Businesses Robert J. McGaughey, Esq. In the current market, liquidity is everywhere. Large banks pooled mortgages that converted illiquid mortgage notes into liquid securities. Buying and selling stocks is easier and less expensive than ever. However, one investment class that has not seen increased liquidity is investments in closely held businesses. Although these investments may provide owners with pride, a job, or above-market returns, investments in closely held businesses are among the least liquid investments available. Forensic analysts, legal counsel, business owners, and the Internal Revenue Service are often concerned with how quick, how easy, at what price, and at what cost, the owner of a noncontrolling ownership interest in closely held company can sell his or her shares? This discussion presents some of the more common methods available to both controlling owners and noncontrolling owners to sell or otherwise dispose of their investment in the closely held company. As summarized throughout this discussion, there are limited methods for noncontrolling owners to cash out of their investment in a closely held company. Most methods available to noncontrolling owners involve litigation, which can be costly and can involve an uncertain outcome. NTRODUCTION Throughout this discussion, Oregon is used to I provide illustrative examples of methods to termi- When owners of minority interests become dissatis- nate ownership interests in closely held businesses. fied with those in corporate control of a publicly trad- Every state has unique statutes and case law with ed corporation, those owners can simply sell their regard to terminating ownership interests in closely shares and immediately terminate their relationship held businesses. with the corporation. Such is not the case for owners of minority interests in closely held businesses. However, statutes and case law are often similar between states. Therefore, although this discussion The market for minority interests in closely held focuses on Oregon, the methods discussed herein businesses is negligible. Very often, the only persons may be applicable to other states. interested in acquiring a minority ownership inter- est are the majority owners of that business. The five business breakup methods presented in this discussion include the following: Likewise, when majority owners become unhap- py with minority owners, there are only a few rec- 1. Negotiated resolution ognized methods for forcing the minority owners to 2. Buy-sell agreements and other contracts relinquish their ownership interests in the business entity. 3. Squeeze-out mergers This discussion explores a few of the methods 4. Actions arising out of oppression and dead- available for terminating the relationship between lock majority owners and minority owners in closely 5. Break-ups among members in an LLC held businesses. www.willamette.com INSIGHTS • SUMMER 2011 53 EGOTIATED ESOLUTION shareholder’s shares. This provision exists primarily N R to make it virtually impossible for a shareholder to The simplest and least costly method for severing sell shares to a third party.2 A right of first refusal the business relationship is through negotiations. provision does not usually help in the event of a fall- Many of the methods discussed later in this discus- ing out between the owners. sion are very costly in terms of legal fees—as well as in terms of the time and emotional involvement of the owners themselves. Death Clauses Negotiating an acceptable deal between the par- Buy-sell agreements frequently contain a provision ties—even though the end result may not be fully that gives the corporation the right—but usually not satisfactory to either party—is often quicker and the obligation—to buy out a shareholder’s shares in less costly than resorting to litigation. There are the event in death. a number of mediators and professional organiza- Occasionally, a buy-sell agreement requires the tions (1) that deal with closely held businesses and corporation to buy out the shares of the deceased (2) that can facilitate these negotiations. shareholder. However, this provision is usually cou- Even in a negotiated resolution, there are tech- pled with a requirement that the corporation buy nical legal and accounting issues that should be life insurance on the shareholders. This provision addressed fairly early in the negotiation process. is usually not helpful in the event of shareholder Therefore, it is advisable to involve both legal and disagreement. accounting assistance early, even if the parties are negotiating directly with each other. Retirement or Disability Sometimes a buy-sell agreement contains a provi- sion giving the corporation the right—but not the BUY-SELL AGREEMENTS AND obligation—to purchase the shares of a shareholder/ OTHER CONTRACTS employee who retires or becomes disabled. Since this provision does not give the minority share- It is common for shareholders in closely held cor- holder the right to require that his/her shares be porations to negotiate and sign a buy-sell agreement purchased, it is not usually helpful in a business at formation. 1 dissolution. In a limited liability company, the operating Likewise, the definitions of “retirement” and agreement often includes a mechanism for terminat- “disability” in the buy-sell agreement usually restrict ing the relationship between the members. this provision to a true retirement or disability. Sometimes a buy-sell agreement provides that the corporation’s board of directors will periodically set a buyout price. It has been this author’s experi- Termination of Employment ence that the board often forgets to set a new price Sometimes a buy-sell agreement contains a provi- each year. sion that provides for the purchase of a minority Therefore, when the falling out occurs, the last shareholder’s shares in the event that employment board pronouncement on “value” has often occurred is terminated. Often, distinctions are made for many years prior to the proposed buyout. The last termination by the corporation “for cause” and value set by the board may bear little relationship to “without cause,” and for terminations initiated by the current value of the company. the employee. Obviously, the specific wording in the buy-sell agreement will control. It is very important for the board of directors to revisit the issue of value each and every year, or to In these circumstances, a buy-sell agreement revise the buy-sell agreement to have the value set frequently includes a formula for valuing the shares in a manner that does not require periodic reviews of the departing shareholder. If such a provision of this value by the board (such as having the value exists, it is very important to periodically revisit of the shares determined by independent appraisal). that formula to make sure that the formula still makes sense for the business at its current level of development and in current economic conditions. Right of First Refusal A buy-sell agreement usually contains a provision that gives the corporation (and sometimes other Forced Buy-Outs Clauses shareholders) a “right of first refusal.” A right of first Occasionally when a corporation has two equal refusal is a provision that gives the corporation the owners, a buy-sell agreement may contain a provi- right to match any third-party offers to purchase the sion that either shareholder can cause a buyout by 54 INSIGHTS • SUMMER 2011 www.willamette.com (1) naming a price and (2) giving the other share- holder a short period in which to decide whether to become the buyer or seller at that price. Such a provision works best in corporations with two equal owners. It can sometimes be used when the ownership is close, but not exactly equal—for example, when there are 51 percent/49 percent owners. But in such a situation, it is important to address the issue of whether or not a control price premium or discount for lack of ownership control is appli- cable. This forced buy-out mechanism does not work well if the two owners own substantially different percentages of the stock or where there are multiple owners. making it important to having an idea going in as to Summary what that purchase price will likely be. In the event of a falling out between business own- These types of reorganization plans give rise to ers, contracts between those business owners—such “dissenter’s rights,” and a process covered by stat- as buy-sell agreements, operating agreements, and ute. occasionally the bylaws—should be reviewed to see if there is a contractual mechanism for resolving the Steps Required by Oregon Statute dispute, or for giving one owner the right to force In Oregon,4 if a corporation proposes a squeeze-out the other owner to buy or sell his/her ownership merger or similar reorganization, the corporation interest. must notify its shareholders of the right to dissent before the shareholder meeting when the vote to merge will occur. In order to dissent under such cir- SQUEEZE-OUT MERGERS cumstances, a dissenting shareholder must deliver If the majority owners wish to force the minor- a written notice to the corporation before the vote ity owners to sell their shares, there are forms of is taken. corporate reorganization that can accomplish this The written notice must include a demand for goal. The most common of these reorganizations is payment in exchange for the shareholder’s shares known as a “squeeze-out merger.”3 in the event the action is effectuated at the share- In a classic squeeze-out merger, the major- holder meeting. ity owners contribute their shares in the company If the shareholders fail to take the proposed (OldCo) to a new corporation (NewCo). After this action, the corporation need do nothing more with transfer, NewCo becomes the majority owner of regard to any dissenting shareholder.
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