Although the Eagles hit song “Hotel California” is over 40 years old, most people have probably heard it numerous times. The song could be a good metaphor for owning a minority investment in a privately held company because it is very difficult to leave the company when you want: “You can check out any time you want, but you can never leave.”
As a minority owner, it is very difficult to leave a privately held company primarily because there is no liquid market for such a company’s stock. Unlike publicly held stock, one cannot simply go online and sell stock of a privately held company. Moreover, stockholders cannot force the company or other stockholders to buy their shares when they want to leave the company. To the extent that owners consider these issues in advance, they typically cover them in a contract, often called a “Stockholders Agreement.”
A Stockholders Agreement is a document that outlines the stockholders’ rights and obligations with respect to a particular company. It is very similar to a prenuptial agreement in that it is not legally required, but it saves the parties from uncertainties as to their rights if some contingencies materialize in the future. A Stockholders Agreement typically restricts transfers of stock to persons or entities that are not current stockholders but generally does not give stockholders the right to sell their shares—a “put”—to the company or the other stockholders.
When it comes to disposing of privately held stock, there are two big hurdles. First, there is no statutory right that requires the company or other stockholders to buy the shares of the departing stockholder. However, there are many ways to provide for such a right in a Stockholders Agreement.
The second hurdle is determining the price at which the shares must be bought if a put does exist. Due to the complexity involved with valuation, we will cover this issue in a future post.
Not being able to freely sell shares and exit the company is a common problem for small companies that have two or more co-founders. To illustrate this issue, we return to our previously used Pasta Delite hypothetical. Mary and Marty co-founded the Italian restaurant, which they operate through a corporation, in State College, Pennsylvania. The restaurant has been a success and has been getting a lot of attention on social media. Several prominent magazines have also reviewed the restaurant.
Melissa Kay, a famous New York City restaurateur, read about Pasta Delite in Bon Appétit magazine and was very impressed by how quickly it had become Central Pennsylvania’s top Italian restaurant. Melissa is opening a new Italian bistro in New York and now wants Mary, a graduate of Penn State’s hospitality school, to manage the bistro. She called Mary and offered her the manager position. Mary was so excited to receive Melissa’s offer that she instantly accepted it.
Mary is thrilled to start the next phase of her career in New York but realizes that she will have to leave Pasta Delite. Mary contacted the Entrepreneur Assistance Clinic to inquire if she can require Marty to buy her shares and completely withdraw from her investment in their company.
If a founder wants to retire, dies, or just leave the company, the founder often wants to “cash out” his or her shares. This can be a major problem when a deceased founder’s shares represent most of his or her estate at the time of death—the family may be desperate to convert some or all of the decedent’s shares into cash, but there is no right to liquidity in a privately held company unless the parties have contractually provided for this situation. Similarly, illiquidity can pose a problem when a founder bequeaths his or her shares to family members, such as the next generation, and one or more of the founder’s children wants to get cash for the shares and move on. The illiquidity issue also arises when a top executive invests in an employer and wants to leave for another job years down the road, as was the case with Mary in the above example.
Even if the company or its other stockholders are willing to buy the departing co-owner’s shares, they may not have the cash or borrowing capacity to buy the shares. Further, if the company has enough cash to buy back shares, it would probably prefer to use its working capital for a purpose that advances the company’s business, rather than to restructure the company’s ownership.
There are a few different ways a company can resolve the buy-back of a departing stockholder’s shares. In order to cover the death of a co-founder, the company could purchase life insurance that would provide funds for redeeming shares if a stockholder dies. Another option is to pay the purchase price for the departing stockholder’s shares over time under a promissory note. In this case, it is common to link the required payments to the company’s income rather than have a fixed payment schedule. With such an arrangement, the company often secures payment of the note with a pledge of the shares being purchased.
The issue of selling privately held stock may also arise when there is an irreconcilable dispute between two big stockholders in a company. There are various contractual ways to deal with such a deadlock. In cases where the deadlock is between two stockholders that own equal or substantially equal shares in the company, a “Russian roulette” clause can be useful. Under this type of clause, one stockholder decides to “trigger” the clause by making an offer to the other stockholder that includes valuation of the shares, and then the “receiving” stockholder must decide either to (1) buy the shares of the “offering” stockholder at the specified price or (2) sell his or her shares to the offering shareholder at the same price. Because an offering stockholder cannot be sure whether the specified price would be the price at which the offering stockholder would buy or sell shares, it is reasonable to expect that the offering stockholder will choose a fair price.
A Stockholders Agreement could also give any major stockholder the right to invoke a “nuclear option” if the company or another stockholder is unwilling to purchase the major stockholder’s shares: put the entire company up for sale. Similar to the “mutual assured destruction” principle that keeps nuclear powers from starting a nuclear war, the possibility of such a Draconian contractual provision should encourage the parties to negotiate a solution.
Some Stockholders Agreements provide for mediation or arbitration, or both, as a means of resolving disputes, including disputes with respect to a sale of stock and valuation. With mediation, an independent party facilitates discussions among the stockholders with the goal of reaching a compromise. Arbitration is different in that an independent party makes a decision that it is typically binding on all parties.
This post uses a corporation as an example. but for the most part, the ownership of a minority interest in an LLC would involve the same considerations. An LLC is similar to a corporation, but different from a partnership, in that it is possible to resign from active involvement in the entity but still retain an economic interest. Having the right to withdraw, or “dissociate” as it is called in the statute, and keep an economic interest still does not accomplish the goal of cashing out an investment if that is what is sought.
The Clinic is available to help small businesses in developing their exit strategies and drafting founder agreements that would solidify any rights to which the founders agree. Startup and early-stage businesses based in Pennsylvania can request assistance by filling out an intake form here: https://launchbox.psu.edu/advisor/penn-state-law-entrepreneurial-assistance-clinic/.
This post was written by Riya Anchi and Tom Sharbaugh.