Like fish need water in which to swim, private company owners need to secure capital on an almost continuous basis.  Capital is necessary to develop the company’s products and services, to retain top talent and to market and promote the business.  But securing capital from outside investors can cause headaches for company founders when conflicts later arise with new investors who have discordant views about the company’s strategy and business plans.  For this reason, business owners are wise to accept investments from third parties only when specific conditions are in place designed to prevent and/or resolve later conflicts that threaten the company’s continued existence. This post reviews key terms company owners should consider including in their governance documents or in separate agreements with the new investors to ensure that the majority owners maintain full control over the company.

Secure Buy-Sell Agreement With Investors

If relationships with new investors turn south and the minority investors become a thorn in the side of the company’s majority owners, they will want to have the right to remove these new investors by redeeming all of their ownership interests in the business.  This redemption right to exit minority investors will be available to the company’s owners, however, only if they secure a signed written agreement from the new investors at the time they make their investment in the company.  If the majority owners fail to secure this redemption right from new investors when the investment that is made in the business, the owners may find themselves stuck with unwelcome investors.  Without a redemption right in place, the majority owners have no ability to remove from these co-owners from the business.

Include Specify Valuation Formula in Buy-Sell Agreement

 A key aspect of the Buy-Sell agreement is the amount to be paid for the purchase of the investor’s minority interest in the company.  If the manner in which the buyout price is to be determined is not clear, it may well lead to disputes and litigation.  There is no “one size fits all” approach to the valuation calculation and there are a number of different approaches available to majority owners. What is critical is for majority owners to discuss this issue with their counsel and their accounting professionals to determine what best meets their business objectives.

Broad Management Discretion

 Following a capital investment, majority owners need to maintain broad discretion to manage the business, including right to determine whether any distributions will be declared, and if so, in what amount.  For example, new investors may want to secure a current return and press for distributions while the majority owners want to reinvest profits in the continued growth of the business.  To avoid this conflict, the majority owners will want the governance documents of the company to make it clear the majority owners have sole discretion to determine distributions. In this regard, one common exception is for the governance documents to provide that the company will make distributions sufficient to cover the tax liability of all owners.  The broad discretion that majority owners want to maintain extends to other management items, as well, including handling of personnel issues, development of business strategy and the nature and amount that the company invests in pursuing growth opportunities.

Preserve Amendment Power

 The Texas Business Organizations Code (“TBOC”) requires that unanimous consent be obtained from all owners before any amendments are made to company bylaws or the operating agreement. This unanimity requirement, however, can be changed by agreement of the owners, and it is common for the company’s documents to permit amendment by a simple majority or, perhaps, by a super-majority requirement of 60% or 75% of the shareholders or members.  The majority owners will want to carefully consider what the impact will be when new shares or units are issued to new investors, because this new equity issuance may change the ability of majority owners to amend the bylaws or company agreement.  In short, if the majority owners do not attend to this issue, they may unknowingly provide the new investors with a veto right over all future amendments.

Eliminate or Limit Fiduciary Duties

If the company’s majority owners have not already addressed this issue in the original version of the governance documents, they will want to make sure to limit the scope of fiduciary duties of officers, managers and directors solely to those required by TBOC.  More specifically, TBOC permits companies to limit or eliminate the duty of care (for negligence, acts in good faith).  The provisions of TBOC will not permit companies, however, to remove or limit the duty of loyalty that is owed by governing persons.  See TBOC 7.001 – 7.006.  By limiting fiduciary duties in this manner, company owners will significantly limit their potential liability for their actions as managers to instances in which they have failed to act in good faith.

Require Mandatory Fast Track Arbitration to Resolve Disputes

A final important issue majority owners will want to address before they issue ownership interests to new investors will be the method for resolving disputes with these co-owners of the business.   In this regard, the company’s owners will want to consider adopting a fast-track set of arbitration procedures.  No dispute resolution process is perfect, and arbitration does have flaws, arbitration does provide the following significant benefits:

• Arbitration can resolve disputes much faster, particularly if the final hearing must take place in 90 days under the fast-track process
• Discovery is limited to the specific parameters set forth in the arbitration provision
• The dispute is handled in a confidential manner without public disclosure,
• The prevailing party (including respondent) recovers all legal fees incurred
• Arbitration result is final, without potential appeals that will drag on for years.

Conclusion

Most business owners would prefer to take on debt rather than bring new partners into their business.  The risk is clear—the potential loss of control.  As an article from last year in Forbes stated in discussing the pros and cons of debt versus equity:

The primary fear of giving up equity is loss of control.  Partners can mean giving up decision making control.  That can affect every micro-factor in your business.  It can even lead to you being replaced by your partners if you don’t retain enough board seats and voting power. (Read full article here)

Even if debt is preferred, there are times when debt is not available, or where the terms under which the debt would be issued are onerous.  In those situations, securing capital through the issuance of equity to new investors is the only viable alternative.  When the best option for the company is taking on new business partners, addressing each of the key items discussed in this post will help majority owners avoid future headaches and heartaches.