Small businesses often operate like families; in fact, many involve actual family members. Because there are few people involved, everyone has to work together and interact constantly. They are also like families because fighting and personality conflicts can become a serious issue. When it gets bad enough, a large company has the ability to move people around so they don’t have to work together anymore. But in a small business, when the family becomes “dysfunctional,” this is usually not an option. Sometimes, it gets to the point where someone has to go.
When a small business needs to get rid of a problem employee, the answer is simple: you fire the employee. But what does a small company do when the problem employee is also one of the owners?
Owners (called “shareholders” if the company is a corporation, and “members” if it is a limited liability company) have significantly more rights than employees, who can be fired at will. In Ohio, and many other states, majority owners (i.e. those who own more than 50%, either alone or together) owe fiduciary duties to minority owners. These duties create a bundle of legal rights that the minority owners may be able to enforce in court. Also, there are legal formalities that have to be undertaken to buy back the minority owner’s interest in the company.
The exact legal formalities will vary based on the shareholder/member agreements, the type of business, and other factors. A good attorney will craft a strategy based on the available options. Unfortunately, any route that the majority may take could lead to litigation. Often, the minority shareholder thinks their interest was worth more than the buyout. Or some may fight the transaction on principle, hoping to work something out in the process that allows them to stay on as an owner. Because of the close working history of the parties involved, there are often hurt feelings and emotional issues that come out in the process as well. In fact, as a business attorney, these kinds of breakups are the closest thing I have ever had to working on a divorce.
The prospect of litigation is why an attorney needs to craft a strategy early on and make sure that every step is done properly, and every letter written with the idea that it could someday wind up as an exhibit in court. It needs to be clear that the majority is respecting the minority’s rights and taking lawful steps to resolve a business dispute. In court, the minority will certainly try to paint the picture that the majority was simply taking advantage of their position and unfairly squeezing out the minority for a fraction of what should be owed. The main issue often becomes: how much is the minority’s interest worth? The answer to that question is the amount that a hypothetical buyer would pay for the interest.
This is also why it is important to get a good accountant involved. Not simply a generalist, but a CPA who specializes in evaluating business interests. This is because the evaluation is critical in determining whether or not the majority acted properly. This area is ripe for disagreement because not only will there be an argument as to the value of the whole company, but also about the minority’s interest. Take, for example a three member LLC, where each owns 1/3 of a company that is worth $1 million. It is not so simple as multiplying the 1/3 by the $1 million and saying the minority’s interest is worth $333k. Ohio generally allows the inclusion of a “minority discount,” based on the logic that owning 1/3 of a company is not as valuable because of the minority status (i.e. the owner of that interest may have business decisions thrust upon them against their will). Likewise, a 51% stake in a company may be worth more than 51% of the total value, because that owner will normally be able to make decisions many on their own (depending on the relevant agreements). Also, a “marketability discount” may be taken, depending on the industry, which reflects the fact that it may be difficult to locate qualifying buyers.
On the other hand, the minority shareholder also needs to consult a good attorney early on. This is because majorities do sometimes take advantage of the situation to bully out the shareholder. Sometimes, the motivation is actually just a financial power grab, and not because of anything the minority has done. In either case, it is important that the valuation process be fair. If the majority is using a friendly accountant, they could persuade the person to value the minority interest at a ridiculously low amount.
In summary, people who are in a small business as partners have to be careful in severing the relationship. It is a lot like a divorce proceeding, where both sides are trying to make sure they walk away with as much as possible. Unlike a divorce proceeding, there are not very many attorneys who have the knowledge of both corporate law and trial practice sufficient to protect their interests throughout the process. A word to the wise is: choose carefully.