For many employees, making partner or buying into the company is a significant career milestone. Being offered an equity interest in the business, getting their piece of the pie, is a sign of having arrived. For outside investors, owning part of a privately held business might seem like an attractive alternative to the public investment markets.
But minority owners are vulnerable. The majority owner, or owners, will have the controlling power for most purposes. At least some risks of minority ownership can be addressed at the outset with appropriate protective provisions.
Most service businesses and many small companies are pass-through entities for income tax purposes. The taxable income of S corporations and limited liability companies pass through to the company’s owners in proportion to their ownership interests. The owners are personally responsible for paying the taxes. That’s fine if cash is distributed from the company to help pay the tax, but the company won’t necessary be required to distribute the cash, and may not have cash available for distribution. For an outside investor in pass-through entities, the situation may be even more difficult. Employee-owners might increase their compensation from the company sufficiently to cover tax obligations, while leaving the outside investors with a tax bill and no cash for payment.
If the company is a C corporation, pass-through tax obligations won’t be an issue, but small corporations frequently don’t declare dividends. They aren’t deductible by the company for tax, so small businesses often will retain cash to fund growth instead.
For pass-through entities (S corporations and LLCs), consider adding a provision to the bylaws or the operating agreement requiring a portion of the taxable income to be distributed in cash to help address the owners’ tax obligations. Sometimes tax distribution provisions are tied to the highest marginal income tax rate of any of the owners. Those provisions can be complicated, and may require disclosure of more of the owner’s tax return than might be comfortable. Consider instead a percentage of the company’s taxable income. The bylaws or operating agreement might call for 40% of the company’s taxable income to be distributed to the owners if the company has available cash. That might not be sufficient to cover all the tax obligation, especially in a high income tax rate state such as Oregon, but should offsetting most of the tax effect of pass-through income.
For C corporations, outside investors, especially venture capitalists, will usually invest in preferred stock. The investor is assured of payment, or at least accrual, of the coupon dividend on the preferred stock. Preferred stock is usually convertible to common stock at the option of the shareholder or if a liquidity event occurs, such as sale of the company. Finally, the preferred stock investors will have priority over common stockholders if the company is liquidated.
Although common law and statute both impose limitations on the majority owners, several mechanisms are also available to help protect minority owners. Sometimes the bylaws or operating agreement will establish a supermajority 75% of the ownership interests for specific actions such as mergers and acquisitions. Use of nonvoting common shares can help separate equity ownership from control, so an owner of a minority of the equity might still own a significant portion of the voting securities and, therefore, voting power disproportional to ownership.
Another common minority protection approach is the use of classes of stock or ownership units. If Tom, Dick, and Harry each own one-third of their company, any two might vote the third off the board. If instead ownership is divided into three classes of shares or units, each can each be assured of a seat on the board. All of Tom’s shares could be A shares, Dick’s could be B shares, and Harry could be C shares. One director is elected by the A shares, one by the B shares, and one by the C shares. In this way, Tom, Dick, and Harry are all assured of having a seat on the board.
Buy-sell agreements can also provide significant protections for minority owners. A buy-sell agreement might require the company to redeem an employee’s shares or units if death occurs, disability, or termination of employment without cause. That way, the minority owner has assurance of recovering the capital invested in the business.
A piece of the small business pie can bring tremendous benefits to both the company and the minority owner, but a minority owner is often at risk of being treated unfairly by the majority owner or block of owners. Building protective provisions into the company’s governance documents at the outset can help protect the minority and maintain harmony among the owners.