Just because someone may be a majority owner of a company does NOT mean the company can do whatever they please.  Minority owners have substantial rights and remedies to protect their interests.  Minority owners may not feel in control, but this does not mean they do not have power. 

 

A minority owner, in the context of business, is someone who holds less than 51{7643a07be85def2dedbecc56bad3bab67e83a7c22b809f3c7a47a1fa73b8911c} interest in the company, and this may be a group or an individual.  It’s an identification of who does not have the majority of the ownership.  The minority owner, is to some measure, the opposite of the majority owner.  Normally, the minority shareholders come to be when there is an entrepreneur who has a brilliant dream and is able to convince others to invest in him/her.  The entrepreneur than sells interest of the business to those people who want to participate, and they buy-in to a minority interest, leaving the entrepreneur “in control”.

 

In a Limited Liability Company (LLC), there are two types of structure.  One type of structure is member management and the second type is manager managed.  In a member managed LLC, everyone who owns a piece of the company gets to vote.  They get to run the business electively as members.   If there is no specification in an operating agreement that the LLC is to be managed by managers (or if there is no operating agreement) ALL members have equal rights to management of the company.  In a manager managed LLC, the operating agreement specifies that there will be managers.  The managers may, but do not have to be, members.  The members are the ones who vote to elect a manager.  Conversely, the manager managed LLC must have directors and those directors are charged with running the company.  This is important because ultimately, it is the directors or managers responsibility to run the company.

 

Corporations are set up a bit differently.  In a corporation, all management is vested in (one or more) directors.  In corporations and manager-managed LLCs, the directors/managers are elected by shareholders/members.  There are exceptions to this though.  Unless there is a contrary provision in the articles of incorporation or operating agreement, directors/managers are elected one at a time and are removed by a majority vote.  Unless there are special provisions in the Articles of Incorporation or Bylaws each share gets one vote.  Voting in a LLC is controlled by its operating agreement.  Directors and managers are charged with the operation of the company, which means they hire, fire and determine the salaries for employees (which also includes officers).

 

There are opportunities for abuse of minority owners.  Areas in which problems may occur are sometimes seen in salaries.  The directors who are representing the majority owners decide they need excessive salaries and/or benefits.  A director could also decide to withhold distributions (dividends).

 

We also see that when a business gets sold, we find that the sale price can sometimes include different types of considerations for the majority owner or for the officers of the company.  If there is a lousy manager, their dealings could fall under the Business Judgement Rule.  The Business Judgement Rule is if in good faith the manager is exercising their judgement, the fact that things didn’t quite work out as anticipated, is not exactly the type of thing that is designed to be a protection for the minority owner.  On the other hand, if the manager is advertently acting or engaging in self-indulgence, then you have a situation whereby the Business Judgement Rule factors in.  It is important who runs the company, because everyone who runs the company gets an equal vote in the company.  What is meant by this is, if you have two directors, and one director is represented by the majority, and the second director is the minority owner, they each get one vote in making decisions, so it is an indirect link between ownership, capital accounts and voting rights.  More importantly, you have to look at what the applicable documents define the role of the manager(s) or director(s).

 

There can be protection for minority owners which would be written as provisions in the bylaws or operating agreement.  All shareholder/members have the right to access, inspect, and copy business records.  These records include minutes of meetings and financial and accounting records.  The directors, managers and officers have a duty to the company and ALL owners.  Their actions must be in good faith, in reasonable belief of the director /officer to be in the best interests of the corporation, and there must be a reasonable basis for decisions being made.  Otherwise, the minority owners can sue for damages or injunctive relief if directors or officers fail to meet this level of care.  When it comes to the sale of substantially all assets or dispositive merger, the sale requires unanimous consent of the LLC members.

 

There is a different type of protection for corporations.  In a corporate setting, they have what is called a shareholder that votes against action to be taken.  Shareholders who vote against the sale or dispositive merger^[1] have the right to have their shares purchased by the corporation at “fair value” and if necessary can get their legal fees paid by the corporation.   This provides a right for the majority to buy-out a minority, but it does have to be at fair market value, whatever it may be at the time, by statute.  This is one of the differences between Corporations and Limited Liability Companies.

 

In a Samson option to dissolve a business, a court can order the dissolution under certain circumstances.  One situation is when directors/managers are deadlocked in the management of the corporate affairs, and the shareholders are unable to break and the deadlock is injurious to the corporate business affairs.  Another condition may be if the directors, managers, or those in control of the company have acted, are acting, or will act in a manner that is illegal, oppressive, or fraudulent.  A court may also dissolve a business if the company’s assets are being misapplied or wasted.

 

When a company is dissolved, it cannot carry on ANY business EXCEPT as appropriate to liquidate its business assets and activities.  After all creditors are paid, the assets are distributed to owners (pro-rata).  There are some assets, like intellectual property, that may have to be valued and distributed “in-kind” to owners.  For corporations, in lieu of a judicial dissolution, the remaining shareholders can purchase the complaining shareholder’s shares at “fair value”.

 

What is to be learned by this, is don’t cheat minority partners.  Make sure there is a clear agreement among all the parties as to what their rights are going in.  For instance, how do directors get picked, how do operating agreements get amended, who gets what and when do they.  These are important things to question and think about.

 

Contact the Kreamer Law Firm, P.C. at 515-727-0900 or info@kreamerlaw.com if you need assistance dealing with co-owners of your company from a West Des Moines lawyer who knows business law.  Kreamer Law Firm also specializes in Wills, Trusts, Estate Planning, Powers of Attorney, and Probate issues.  Give us a call today. We get things done®.

[1] Abuse could be selling on terms which wind up benefiting the majority shareholders; or refusing to sell on terms which could benefit minority shareholders. A dispositive merger is where the company owned does not survive.

[2] Iowa Code 489.407(1)(a)

[3] Iowa Code 489.407(3)(f)

[4] Iowa Code 489.407(1)

[5] Iowa Code 489.407(2)(a) and (b)

[6] Iowa Code 490.803(2)(a) Can be changed by vote of Shareholders

[7] Iowa Code 490.801(2)

[8] Iowa Code 490.803(3), Iowa Code 489.407(3)(e)

[9] Iowa Code 489.407(2)(c), Iowa Code 490.803(3), and Iowa Code 490.808

[10] Iowa Code 490.721(1)

[11] Iowa Code 489.110(1)

[12] Iowa Code 490.801(2)

[13] Iowa Code 490.1602(1) and Iowa Code 489.410

[14] Iowa Code 490.830(1), Iowa Code 490.84.(1) and Iowa Code 489.409

[15] Directors, managers, and officers have a duty to make decisions with the care that a person in a like position would reasonably believe to be appropriate. See Iowa Code 490.830(2), Iowa Code 490.831, Iowa Code 490.832(3), Iowa Code 489.409(8). This confers some responsibility to investigate the factual basis for the decisions being made.

[16] Iowa Code 490.831, Iowa Code 490.842(3) and Iowa Code 489.701(2).

[17] Iowa Code 490.1301 et. seq.

[18] Iowa Code 490.1331

[19] Iowa Code 489.407(2)(d) and (3)(d). The impact of an operating provision varying this requirement (per Iowa Code 489.110) is unclear.

[20] Iowa Code 490.1430(2) and Iowa Code 489.701(d) and (e)

 

 

 

To successfully raise capital, you must be prepared to do so, recognize the sources of capital, be aware of the costs of the funds, be in compliance with securities laws, and have a back end strategy. 

Be Prepared:

One thing investors want to make sure of is that they are going to get their investment back with a return on their investment.  They way that is going to be generated is through business operations.   Accordingly, they want some certainty that you, yourself, as the business owner, have thought through the business, have thought through its operations and activities, to the point that you can produce a business plan.  Another thing to include in your business plan is a marketing plan with a projection and a plan of what you THINK the future will bring.  Every investor realizes that a projection is just that.  It’s an assumption, it’s a possibility of what could happen.  The fact that you have projections means you have thought through what is reasonable for your business and what is reasonable for investors to expect in return for their share.

The best time to raise capital for your business is when you don’t need it, not when you are worrying about debt.  Having a track record is extremely important.  It may be easier to raise capital at the front end when there is a big promise of a business, or sometimes when you have a good track record established.

Sources of Capital:

There are several sources of capital.  One source of capital we call angel investors.  These are individuals who want to have an investment in the business, either because they like the kind of business you are in or they want to promote the type of activity the business is involved in.   These are generally people who are named individuals who many people know. The second type of investor or source of capital are out of state or out of market competitors.  If you are running a business where you have out of state competitors who want to get into the state but don’t know how to break in, sometimes you can create a strategic alliance which allows for a capital investment in your business.  This is a cheap entry into the business and they can leverage your expertise.  Another kind of investor is Venture Capital investor, sometimes called a mezzanine investor.  A venture capitalist is looking for a company that looks like it will go public soon; it’s past the startup phase.  Some people refer to them as vulture capitalists, because there are times when these types of investors swoop in and take the best part of the company.  There is a final group called heroic investors, which are generally comprised of family and friends. A family or a friend should be treated as any other investor.  They still need the same type of protections as any other investor would need, so you need to treat them as true investors.

Cost of Capital:

Something to also think about is the cost of capital.  There are many ways to compute the amount of capital in return for the amount of money, which can be more of an art than a science. Many entrepreneurs over-value their business.  One of the things you should be aware of when raising capital for your business is capital return is always going to be more expensive than borrowing, so if you can, go to a bank and borrow money.  An investor is at greater risk in the capital, because the debts get paid before the return on investments.  Another thing to be aware of is who is putting the money in.  Different types of investors require and demand different types of returns.  For instance, an angel investor is probably someone who is an economic investor who is saying they would like a reasonable amount of rate of return and wants to look forward to some kind of back end profit.  A venture capitalist is looking for a big score when the company goes public.  There is no money more expensive than family money.  It’s expensive, in part, because of the emotional cost that this money has.  If you borrow capital from a multi-millionaire, they want a return on their investment.  You know where they stand.  If you get are loaned money from a relative, that person may want to know why you are going out to eat, why are you driving that type of car, why are you vacationing so long, what are the hours of the store, etc. and they are going to be more emotional.  Most of our clients find that when they are raising capital, and where it comes from, may not be as important as the fact that it is available because of the business needs and its operations.

There is another cost in addition to an economic cost.  That’s a managerial cost.  Some clients think they can raise money for the business and continue to run it just as they were running it before.  That is not normally the case.  What generally happens, is the investor will want to have a say in how things are run with the business.  They will want information annually, if not quarterly.  They will especially want financial, operational and background data.  The investors want communication.  Investors who are receiving a return in their investment usually need a lot less information when things are working well.  When things aren’t going so well, suddenly, everyone wants to know what’s going on with everything.  If people make a large investment, relative to their portfolio, they want a lot more information than somebody who doesn’t have a substantial proportional risk.

Investors commonly want to be a part of a Board of Directors or a Manager.  It is extremely important to have by-laws and operating agreements to define the rights.  Some issues may be resolved and decided by a majority vote and other issues may require unanimous consent.  How votes are counted is extremely important.  Normally, each manager/director has an equal vote.  Sometimes, voting is based on capital account (investment) or the number of shares or units.  There may be times when a deadlock occurs.

 

Securities Laws:

There are security laws to keep in mind.  The shares or units of your company will probably be considered a “security” like stocks on the New York Stock Exchange.  Your company would be considered the “issuer”.  If or when it comes to selling part of your business, you may or not have to register.  There are both state and federal securities laws which require issuers fo securities to make extensive disclosures to buyers who will not be actively involved in investigating the issuer’s company and industry prior to investing.  These disclosures are in writing, are designed to protect buyers from dishonest sellers, and MAY have to be filed with governmental agencies.  They are fundamentally designed to protect investors from unscrupulous issuers of securities.  They are also designed so that if the deal is memorialized in some type of writing.

There are exceptions to the need for filing full disclosure documents.  There is a small offering exemption, inter-state offerings, private placements, and “good deal” exemptions.  Generally, you will need either a prospectus or private placement memorandum or some type of circular offering for larger offerings (not for friends who may want to invest).  Whether or not you are going to do one of these securities registrations, you need to provide written documentation of what your business and marketing plan is, financial statements and a FULL DISCUSSION OF POTENTIAL RISKS Of LOSS OF INVESTMENT. Make sure you put EVERYTHING in writing.

Back End Strategy:

One type of back end is where you have a buy/sell agreement which specifies how and in what circumstances an investor can or must sell back their investment.  When certain events occur, the company may buy out the investor, the company may go public, or there is some other kind of planned back-end.  These buy/sell agreements are extremely important because otherwise, there is no way for a company to get rid of an investor (i.e. for the entrepreneur who started the business) and to really gain control of the business again.  A buy/sell agreement may be either mandatory (must buy/must sell) or permissive.  In either one, you should establish a pricing formula and terms of payment.  If you fail to plan, you plan to fail. When you begin to plan on raising capital, you should look at what you think the end result will be and how it’s going to play out.

Raising capital is more of a process than an event.  It’s something that takes many steps.  You’ve got to be ready, you have to recognize the sources of capital, be aware of who’s providing the capital, look at the legal constructs around it, and finally, you have to have a back end plan.

When your business is ready to raise capital, contact Kreamer Law Firm, P.C. at 515-727-0900 or via e-mail at info@kreamerlaw.com for experienced legal assistance.

 

 

 

 

 

Recently I was able to record a short video explaining what it is we do at Kreamer Law firm and how we can help you with legal assistance in your Business, Corporate, Estate Planning, and Probate needs.

Click the link below to watch our video, then head over to our Practice Areas tab for more information!
If we can help you in any of our various practice areas, feel free to call us at (515)727-0900, or email us at info@kreamerlaw.com.

This blog is part of a series of blogs on buying a business. We are first exploring the qualities you need when deciding to whether or not you are should buy a business. I encourage you to go back and read the previous blogs.

This week we are discussing access to commitment.

Commitment. The one indispensable characteristic of a successful Buyer is commitment. By this I mean that although a Buyer will not succeed simply because they ARE committed to the business; it is certain that the business will fail if they are not.  Business commitment takes many forms. Business ownership can take a toll on the Buyer’s social and family life in addition to their financial situation. Accordingly, a Buyer, and to some extent their family and friends, must be willing to make some short term sacrifices to reap long term benefits. Among the commitments successful Buyers make is to be “life long learners.” There are many good business books and courses. Four books that we strongly recommend are: “Getting to Yes” by Roger Fisher and William Ury; “Guerilla Marketing” by Jay Conrad Levinson; “From Good to Great” by James Collins and “E-Myth Revisited” by Michael Gerber.

If you would like assistance in regards to the purchase/sale of a business, please contact me at www.kreamerlaw.com.