As the Principal of a boutique business and real estate-based law firm, I have been seeing an uptick in small business start-ups and related issues that naturally occur in these environments. With the stress of Covid-19 and the ever-changing recovery and adjustments businesses are having to make in order to survive, there is one issue, in particular, that seems to be stealing the headlines so to speak: corporate freezeout claims associated with changing percentage interests.
Inevitably, in a closely held business, the company is inextricably entwined with the owners and their often vastly individualized credit worthiness. This presents an issue when a small business, especially a new one without its own creditworthiness, attempts to enter into a lease or any type of money lending agreement. This is because the lender is required to run credit on all the individual owners. However, this can come as a surprise to many business owners.
A common misconception when setting up a new entity is that the entity immediately becomes separate and distinct, therefore, it will stand alone when borrowing. But, on the contrary, many of the same reasons why a reputable lender can’t or won’t lend to a two-year old child also applies to lending to a young business. This naturally requires the lender/landlord or other types of moneylenders to look at the owners individually to assess the lending risk.
The Lending Fallout
The first step in the lending assessment process is typically to review the creditworthiness of each business owner. This, unfortunately, can often lead to owners being disappointed with their choice of “partners”; this can frequently lead to a rushed and poorly planned redistribution of ownership interests.
To further clarify, there is a guideline that seems to be followed by most lenders that anyone owning below 20% of a company does not really “count” enough to worry about when lending. Oftentimes this results in one or more members or shareholders being relegated to a tiny majority owner. Perhaps, at the time, this knee jerk reaction may seem like a suitable solution, however, it is more common to see this solution be poorly thought through. While focusing on the “ball” (getting the loan), the owners inevitably fail to appreciate the impacts of their decision!
We often hear the thought, “Well, as soon as the loan is closed, we can put everything back in place, right?” If you love white-collar crime, then sure! However, this would be a fraudulent proposition.
Then we may hear, “We have an understanding that it’s actually going to still work the same way.” However, this also does not work. If, on paper, you own 19% of the company, but you take 50% of the profits (or assume 50% of the losses) what are the I.R.S. or D.O.R. going to think about that? On the other side, what if the company is successfully sued? What percentage will you pay out? How are large expenses or debts requiring additional contributions going to be treated? Bottom line, it is important to understand how callously risky it is to have an unwritten side agreement or no agreements at all – especially when dealing with finances.
Controlling Stake
Somehow, these matters are all overshadowed by loss of control. Mysteriously, most don’t seem to realize that a 15% owner doesn’t control the company! I often use a “Google Stock” analogy when this issue arises: “What do you think Google would do if I sent an email directing the company to move its corporate headquarters? After all, as a 1% shareholder am I not entitled to move the business?” Inevitably, however, when the partner who ends up owning a vast controlling interest and who, by the way, has dutifully assumed all the financial risk makes an important decision they have the power to make it happen!
While the Massachusetts Business Corporation Act provides great flexibility to closely held businesses to tailor how their businesses will be governed, often business owners use boilerplate agreements that do not encompass their situation. When the business owners agree to change their agreement, in other words, they literally rewrite the rules. Once that happens, there’s not much the minority owner can do about changing it back.
This situation often deteriorates and eventually the minority owner wants out, however, more problems may arise. What is a minority interest worth on the open market? This issue has been litigated recently, as well, and many times the minority owner is trapped in a disadvantageous position. The most recent decisions state that the minority owner cannot even judicially force a sale without at least 40% ownership interest on top of proving essentially a management deadlock, inability to break the deadlock and irreparable injury to the corporation itself (not the owner/plaintiff, but the corporation itself).
All hope is not lost, however, if the rules of governance are properly drafted. As I alluded to earlier, the Act allows for great flexibility in decision making and in authorizing distributions, but this must be in writing. Verbal side agreements cannot be relied on! There are also separate documents that can be prepared, such as Buy-Sell Agreements, that can protect the minority owners without including the details within an Operating Agreement or Bylaws. The timing of this work is best addressed contemporaneously with either the business formation or when changes are made later as these are really the only moments in time when the minority owners have leverage. Regardless, matters of great importance – that affect the lives of the owners, and often their families – and of money should never be overlooked or underestimated. t’s my hope that this article underscores the importance of hiring capable counsel before making such important decisions.
If you are in need of agreement preparation or guidance surrounding a similar situation to those mentioned above, schedule a consultation with a member of our team.
