When business partners start a company, they often fail to plan for the possibility of a dispute years down the line due to irreconcilable differences. They fail to plan on how assets will be distributed, and fail to discuss how this should happen (see an interesting discussion here).
The discussion should, however, happen early, at the moment of formation, and should be memorialized in a written agreement. The agreement that governs such scenarios can be analogized to a pre-nuptial agreement; a business divorce is often no different than a regular divorce (see another interesting discussion here).
A key provision in such an agreement is language governing “deadlock.” A closely held corporation’s distinguishing features make them particularly vulnerable to deadlock. Deadlock can arise when business partners have a fundamental disagreement as to an issue that requires a majority or unanimous vote. Potentially severe problems may arise from deadlock in business entities with an even number of owners, especially those entities with just two owners. While much discussion surrounding deadlock resolution has involved judicial and legislative remedies, a well-drafted shareholders or operating agreement is critical in preventing shareholder deadlock in closely held corporations. This is especially so in light of the fact that courts are ill-equipped to tackle disputes relating to business decisions, as opposed to a purely legal dispute (e.g. breach of fiduciary duty).
The Closely Held Corporation
Generally, closely held corporations are composed of a small number of shareholders who invested monies into the business, control management, and hold restricted shares. Shareholders in closely held corporations often contribute much of their time, energy, and money to make the corporation a successful enterprise; their sole return on their investment may be in the form of a salary they receive as active managers of the company. Id. If dissension develops among the shareholders of a closely held company, shareholders that wish to exit may be unable to do so. Unless otherwise provided in an agreement, shareholders of a closely held corporation cannot dissolve the company at will, nor can they freely transfer their shares on an open market as in a publicly traded corporation.
Deadlock, or “an impasse in corporate decisional processes” can generally occur at two levels. First, shareholders are unable to unable to come to an agreement to elect directors, and second, they are unable to make management decisions. Shareholders and directors may become deadlocked on a number of issues, and if not resolved, a corporation’s business may suffer impairment and commercial loss.
While courts, in some instances, have the authority to dissolve corporations that can no longer operate effectively due to deadlock, other less extreme measures may be available in the form planning and contractual resolutions. Discussed below, while not exhaustive, are some provisions that may be contained or addressed in shareholder, operating, or other agreements to help avoid conflict and deadlock in closely held corporations.
Voting Rights and Management.Generally, unless set forth in a shareholders agreement, shareholders controlling more than 50 percent of the shares control the vote in a closely held corporation. Shareholders agreements often provide certain fundamental decisions that require unanimous consent from all of the company’s shareholders. These fundamental decisions vary from business to business, but generally pertain to issues such as sale or liquidation of the company, mergers and acquisitions, hiring or firing employees, and commencing or settling lawsuits. One way of streamlining the management process in a closely held corporation is to have shareholders approve in advance an annual operating and expenditure budget. The shareholders then appoint one shareholder involved in the management of the company to handle the day to day operations of the company within the confines of the agreements’ provisions. This position can rotate on an annual basis. As a result, shareholder consent will only be needed for actions falling outside of the approved budgets.
Buy-Sell Agreements.A buy-sell agreement may provide minority shareholders an “exit” in the event of deadlock. A buy-sell agreement typically obligates the corporation or remaining shareholders to purchase the minority’s stock in certain events, such as voluntary resignation or termination. The negotiation and drafting of buy-sell agreements, however, may prove difficult as they must address issues such as the price of the stock and how and when it is to be paid, which may require a pre-negotiated formula price, or independent appraiser. There are several types of buy-sell agreements that may be considered. (For more interesting articles on this topic, see 22 Michigan Bus. L.J. 14, 18 (2002)).
Transfer Restrictions.Because the shareholders of a closely held corporation, unlike large corporations, are likely to be active in the operations of the company, it is common to have in place restrictions on shareholders’ ability to transfer shares. Typically, shareholders agreements may allow shareholders to transfer their shares subject to a “right of first refusal.” This requires a selling shareholder to obtain a third party offer for his or her shares. Once a third party has been obtained, the selling shareholder is required to provide all non-selling shareholders the right to purchase the selling shares on the same terms and conditions offered to the third party. If the non-selling shareholders do not accept the offer, the selling shareholder may sell his or her shares to the third party.
Shotgun Provisions.In a company with only two shareholders, an option would be to include a provision that triggers a mandatory sale in the event of disagreement and deadlock. Referred to as a “shotgun” provision, this provides that when the shareholders are deadlocked over a fundamental matter concerning the company, either shareholder can trigger a buy-out. For more on shotgun provisions, see Landeo&Spier, supra.
Dissolution Provisions.A dissolution provision may be included in a company’s articles of incorporation or operating agreement stating the company “will be dissolved if any of the founding shareholders (or some other designated group) ceases to be employed by the corporation, either for any reason or if a founding shareholder is discharged from employment without cause.” (See 14 Fordham J. Corp. & Fin. L. 491 (2008-2009)). A dissolution provision may also be triggered by certain events, such as deadlock.
Employment Agreements. An issue that may arise in disagreement and deadlock is a minority shareholder’s denial of employment. As discussed earlier, a salary is often the only “return” a minority owner receives from his or her investment in the company. Unless a minority shareholder has an employment agreement, majority shareholders may “ire him with few obstacles. The “at will” employment law rule prevails in the United States, meaning “an employer may freely fire an employee for any reason or no reason, outside a few limitations such as discrimination statutes. Consequently, a minority shareholder that is an employee would be well advised to have an employment agreement, providing cause for termination. While this would not prevent termination altogether, a firing without “cause” would constitute a breach of contract. Id. at 521.
Third Party Alternatives. When dissolution or having a shareholder leave the business are not options, arbitration may provide a way or resolving disputes by engaging a neutral third party to review a dispute and render a legally binding judgment. Shareholders may outline within the scope of the agreement, certain issues or triggering events, such as deadlock, that would cause the parties to proceed to arbitration. Other third party alternatives include mediation, the hybrid mediation-arbitration, the appointment by a court of a provisional director, a neutral third-party who acts as a tie-breaking director, or a custodian or temporary receiver, a neutral third party that is vested with the power of the board of directors and may maintain a company’s operations until parties reach agreement.
Shareholder conflicts that result in deadlock pose challenges for corporations and corporate law. Careful, advance planning and drafting, and the use of provisions and alternative remedies such as those discussed above may lessen the likelihood of shareholders in a closely held corporation becoming deadlocked, and in the event of disagreement, provide an orderly resolution.