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Why is a minority interest in owning a business complicated?

Question

I was approached by a buyer who proposed that I retain a minority interest. What factors should I consider before deciding if I should do this?


 

Answer

Retaining a minority interest in a business involves a number of key decisions that must be made regarding how the business will operate after the closing. What follows here are a few factors you should consider before deciding to retain a minority position.

What liability does a minority partner have? What happens if the entity the minority partner holds an interest in is sued?

Assuming the business is in corporate form, the minority shareholder is liable only to the extent of their shareholding. However, as an exception, the minority shareholder could be made liable to whatever extent it could be proven the minority partner knowingly participated in any misconduct or negligence of the business. There is an increased degree of risk if the buyer intends to use the seller’s continued involvement in the business as a marketing tool. This makes it relatively difficult for the minority shareholder to disclaim knowledge of the specifics of the buyer’s management of the business.

If the business is not incorporated as an entity, the minority owner has the same liability as the majority owner with respect to third parties. Co-owners of an unincorporated business can arguably bind one another with respect to legal obligations. In the absence of a legal entity, third parties could treat each co-owner as fully representing the whole co-ownership.

How complicated would it be to document a sale of 80% of the business with the owner retaining 20%? What additional documents would be required, such as a buy-sell agreement, etc.?

Setting up this sort of arrangement is more complicated if the business is not already in a corporate form since the sellers first have to incorporate the entity. The assets of the business have to be transferred from the co-ownership of the individuals to a corporation. There may be certain tax incentives with respect to the transfer, depending on the state.

Once the business is in corporate form, the sellers can execute a deed of sale for 80% of their shares, and the corporation can issue stock certificates to the buyer and seller accordingly.

The buy-sell agreement can also be called a “put option.” The seller can “put” their remaining shares before the buyer during a specified period, or upon a specified event, and the buyer must buy such shares.

As a shortcut, the seller could choose not to incorporate the business, and just sell 80% of their ownership interest via contract. However, as a 20% co-owner of an unincorporated business, they would be exposed to much greater liability than as a 20% shareholder of an entity, for the reasons discussed above.

How would you structure this to protect the seller?

Aside from a put option, we suggest an indemnity agreement where the buyer acknowledges that they will manage the business and will indemnify the seller from any damage arising from the buyer’s mismanagement or other misconduct.

Would you recommend the seller hold common stock?

If the seller wishes to benefit from the future growth of the company, common stock would be ideal.

On the other hand, if the seller wishes to have a fixed return that will be paid before any profits go to the common stock, preferred stock would be a better option.

Would it be reasonable for the seller or minority partner to expect to receive dividends? If so, would it be easy for the buyer to find a workaround to avoid paying a dividend, such as by paying themselves a higher salary?

Yes, it’s reasonable to expect that the minority owner should receive dividends as long as the business earns a profit. A shareholders’ agreement can protect the minority owner by establishing criteria as to when dividends should be paid (e.g., net profits of a certain percentage) and the amount allocated to dividends. The agreement can also specify that the minority shareholder has audit rights and ongoing access to the business’s financial information.

Wouldn’t the buyer essentially have complete control if they own 80% of the business? Would this work in the real world? I understand how control works in larger companies with a board, shareholders, etc., but how does a minority interest work in the real world for a small company like this?

Generally, the minority owner has the right of access to the business’s financial records, and the right to be notified of, and participate in, all board meetings or board decisions. If in the course of reviewing the financial records, or participating in board meetings or actions, the minority owner encounters the misconduct or neglect of the majority owner, the minority owner may file suit. Alternatively, if the majority owner unreasonably denies access, or fails to notify the minority owner of board meetings or proposed corporate actions, the minority owner can also sue. In general, the majority owner may be held liable for any oppressive actions toward the minority owner.


Summary

Retaining a minority interest in a small business is not a wise course of action for most business owners if the buyer is an individual. The only scenario in which we recommend retaining a minority interest is if the buyer is a larger corporation or private equity group, as long as the seller has a strong shareholders’ agreement to protect their ongoing rights in the business.

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