business builder law
Take these steps
before adding
new shareholders
Selling shares to employees or others closely related to the business raises capital for the company, but those shares are not readily marketable to investors outside the business.
For these reasons, shareholders in such businesses are generally treated as partners. As partners, the shareholders are required to treat each other in a different manner than they would in a standard employer/employee setting.
Under the law, they owe each other the duty to act with the utmost honesty, loyalty and good faith. They must also respect and honor the “reasonable expectations” of each one of the shareholders at the time they become shareholders and as the business and relationship develops over time.
Describing these duties may seem easy enough in the abstract. Determining precisely what they mean in a specific setting, however, can often prove quite difficult.
Dissenters’ rights
Because shareholders in closely held corporations are treated like partners, each shareholder is entitled to a say in the operation of the business. Minnesota courts protect those rights in a variety of ways. One of the laws enacted to try to balance the power between the shareholders is known as the Dissenters’ Rights Act.
The Dissenters’ Rights Act generally comes into play when a minority shareholder has been treated in a manner that results in a loss to the shareholder of one of his or her fundamental shareholder rights. For example, if the company decides to unilaterally sell, lease or dispose of substantially all its assets, enter into a merger or other large transaction, or exclude or limit the right of the shareholder to vote on a matter, such action may trigger dissenters’ rights. Those rights allow a shareholder who disagrees with the action to demand a buyout of his shares at a “fair value” price.
As discussed below, “fair value” is a term of art that can result in the shareholder receiving a substantially higher price for his shares than might otherwise be expected. Once a majority shareholder sells shares to minority shareholders, any act that triggers dissenters’ rights may result in a large and otherwise unplanned-for expense to the company.
In addition to dissenter’s rights, minority shareholders also possess the statutory right to be treated fairly or, in the parlance of the law, to not be treated in an “unfairly prejudicial manner.”
Such rights, commonly known as “751 rights” (named after the Minnesota statue that creates them) provide minority shareholders with the right to make claims whenever the shareholder believes she has been treated in an unfairly prejudicial manner.
Not surprisingly, what constitutes an “unfairly prejudicial act” (like what constitutes “reasonable expectations”) is often difficult to determine and will vary under the circumstances. Based on the case law, however, “unfairly prejudicial acts” may include such things as physical and verbal abuse toward the shareholder, depriving the shareholder of notice or information concerning important corporate matters, firing the shareholder without cause or even failing to offer the shareholder reasonable compensation for her shares during buyout negotiations.
Once triggered by the acts of the majority or those in control of the company, the minority shareholder may claim a variety of damages under a 751 claim, including the right to be bought out at fair value, the right to “lifetime” employment damages, the right to require that the corporation be dissolved, and the right to demand that the company pay for all attorneys’ fees and other expenses associated with the action.
Interestingly, when awarding damages under 751, courts have often held the majority shareholder personally liable, along with the corporation, for any damages awarded. As may be obvious, 751 claims have the potential to be very destructive, and great care should be taken to avoid them if at all possible.
What’s fair value?
Under both the dissenters’ rights act and 751, courts have the authority to order a buyout by the corporation of all the shareholder’s stock at “fair value.” The statute allows the court to determine the fair value of the shares by “taking into account any and all factors the court finds relevant, computed by any method or combination of methods that the court, in its discretion, sees fit to use whether or not used by the corporation or by the dissenter.”
Courts have generally held that it is improper when calculating “fair value” to apply a minority discount, and have also determined that even “marketability discounts” are inappropriate in all but the most extraordinary cases.
As a result, “fair value” calculations often involve a battle of the experts with the values suggested by the minority shareholder’s experts often dwarfing those of the majority.
In the end, if the parties are unable to reach a settlement on their own, the court will be required to make a decision on value. Since most judges, by their own admission, are not experts in the economic concepts underlying business valuation methods, the risks associated with allowing a valuation decision to be made by the court are substantial.
How to protect yourself
Courts are required by statute to rely on written agreements among or between shareholders and the corporation in order to ascertain what those reasonable expectations are.
One type of written agreement that can be used is a shareholder control and voting agreement. These agreements can cover any issue on which a shareholder is entitled to vote and can even go so far as to bind a shareholder in advance to vote shares in a particular way. In this manner a person signing a shareholder agreement can often be limited in his argument regarding reasonable expectations.
Buy/sell agreements are also invaluable in defining rights and obligations. Buy/sell agreements address the circumstances under which a shareholder’s stock will be purchased, the price of the stock and the payment terms. The agreements may also provide for a manner to fund the company’s re-purchase of the stock, i.e., life insurance.
As discussed above, one of the most difficult issues courts deal with in shareholder cases is the question of valuation of shares. Through a buy/sell agreement, the parties can define, up front, both the conditions under which a buy-back of shares will be required, as well as the price and terms at which the buy-back will occur.
Employment agreements can also be used to eliminate or refine an employee/minority shareholder’s “expectation” with respect to employment matters. With a written employment agreement setting forth the expectations of both the employee/shareholder and the majority shareholder, many troublesome employment-related issues can be avoided.
[contact] Patrick Rooney is a partner in the litigation department of Rider Bennett law firm in Minneapolis: 612.340.7996; prooney@riderlaw.com; www.riderlaw.com
