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A Piece of the Pie: The Tribulations of a Minority Owner

July 2012

Published in The Daily Journal of Commerce

For many employees, becoming a partner or buying into the company is a significant career milestone. When someone is offered an equity interest in the business – a piece of the pie – it's a sign that the employee has 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 of the 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. That's fine if cash is distributed from the company to help pay the tax, but the company won't necessarily 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 and leave 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 don't typically declare dividends. They aren't deductible by the company for tax purposes, and small businesses usually will retain available cash to pay for 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 owner. Those provisions are fairly complicated and may require disclosure of more of the owner's tax return than might be comfortable. Consider instead using a percentage of the company's taxable income.

The bylaws or operating agreement might require that 40 percent of the company's taxable income be distributed to the owners if the company has available cash. That might not be sufficient to completely cover the tax obligation (especially in Oregon, which has a high income tax rate), but should go a long way toward offsetting 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.

Moreover, preferred stock is usually convertible to common stock at the option of the shareholder or in the event of a liquidity event, 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 some limitations on the majority owners, several mechanisms are available to help protect minority owners. Sometimes the bylaws or operating agreement will establish a supermajority – perhaps 75 percent of the ownership interest – for specific actions such as mergers and acquisitions. Use of nonvoting common shares can help separate equity ownership from control, so a minority owner 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 of them 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's 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. For example, a buy-sell agreement might require the company to redeem an employee's shares or units in the event of death, disability, or termination of employment without cause. This provides the minority owner at least some assurance of ability to recover 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.

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