Minority Share Interests: The Good, the Bad and the Ugly

A company is an entity, being or thing that exists separately and distinctly. It operates, even lives, apart from its owners and officers. It can enter into relationships, transact, borrow or lend, earn and spend, sue and be sued. It has a personality, a reputation, and it may flourish or fail. It even has superpowers – it can live forever. But like all superheroes, it has an Achilles’ heel – it can’t think or act for itself. Someone must “pull the strings,” and the role of puppeteer is coveted. This is because the role offers meaningful perquisites. Yes, as the old saying goes, “uneasy lies the head that wears a crown” – but there’s no shortage of applicants.

Perquisites can include salary, insurance, retirement benefits, expense account, company car, travel, ability to hire and fire others, and all the power and prestige of controlling and managing the assets and activities of a business. And the owners have much at stake in who manages their company. The value of their ownership interest will rise and fall, in part, on who is manager.

So the big question is: What determines who manages a private company?

Answer: Whomever the board of directors chooses.

Question: Who chooses the board of directors?

Answer: The shareholders.

Question: How do the shareholders choose the directors?

Answer: That’s dictated by what is written in:

a.    Documents that govern the company, such as the articles of incorporation, bylaws and shareholder’s agreement

b.    Statutes (laws) of the state under which the company was organized

Every shareholder in a private company should have these documents and know what they contain. They are unique for every private company.

If you own 100%, you’ll want to know some things before you gift or sell shares. Based on what you find, you may want to change some things in the governing documents before you bring on co-owners. Maybe to enhance your control, power or protection.

If you own less than 100% but a controlling interest, you’ll want to know whether your control is absolute or limited. If limited, where and how? Do you have any rights or powers to control who becomes an owner by the sale of stock owned by others? Is your ability to sell shares limited by an anti-dilution clause? Will you have to get approval to sell the company? What obligations do you have to your shareholders? What risk do you bear if you do not uphold these obligations? Under which scenarios could you lose control or expose yourself to personal liability?

If you own a non-controlling interest in a private company, you’re weak but not powerless. To manage your interests properly, you need to know what’s in the documents that stipulate how the company is managed. You also should know pertinent laws of the state under which it was organized. It’s not prohibitively complex; and it’s only in knowing your rights and limitations to the rights of the other shareholders, directors and managers that you’ll be able to protect your investment. By doing so, you can do your part to ensure that your weaknesses do not invite abuse.

The Corporate Form: Most businesses are organized as a corporation – C, S, LLC or professional. Corporations may be private or public and may be for-profit or not-for-profit. The corporate form is so popular because – unlike the sole proprietorship and partnership – it offers its owners a shield from personal liability. This means as long as the owners, directors and managers adhere to some basic requirements, the owners will not be liable for the corporation’s debts. Shareholders are obligated to pay only for shares acquired – whether to the company itself (when the company issues shares) or to a secondary seller (whoever owned and sold the shares). The corporate form is also popular because it may continue to exist in perpetuity, meaning it may survive despite the passing of its owner(s).

Herein we’ll use the terms company and corporation synonymously, meaning a business organized as a corporation(C, S, LLC, professional).

A corporation is an entity of the state. This means that when a company is formed it is under the laws of a particular state. State law dictates how a corporation is formed, what is required and how it may operate. Corporate laws tend to be similar from state to state because most have modeled their laws after a template called the Model Business Corporation Act (MBCA).

A corporation is a legal entity separate and apart from its shareholders, with its own separate and distinct rights and liabilities. Even when a single individual owns 100% of the corporation’s stock, the shareholder and the corporation are not the same but have a separate and distinct existence.

Organizing Documents: When a corporation is created, certain persons (“incorporators”) execute and deliver to the Secretary of State (of the state in which they wish to incorporate) articles of incorporation. This filing contains very little information, typically just the name selected for the corporation, purpose of the corporation, number of authorized shares of stock, classifications of stock (if more than one), any special restrictions on the stock, the names of the incorporators, and the name and address of the primary representative. If it is approved, the state will issue a certificate of incorporation and then the incorporators meet to adopt bylaws, elect officers, and transact any other business.

Almost every corporation has bylaws, which contain the rules and regulations for how the company is to be managed. The bylaws may not contain anything contrary to or inconsistent with the state statutes (laws) or the articles of incorporation. Bylaws do not have to be publicly filed, and many states allow the board to amend the bylaws. Generally, bylaws must contain:

• Requirements for annual meetings of stockholders; provisions for special meetings of stockholders; and selection, number, duties and terms of directors.
• When and how directors are to meet; selection and duties of officers; rights or prohibitions on making loans and borrowing, issuance of capital stock, distribution of earnings, amendments of bylaws, rights and obligations of members or stockholders.

What if the corporation was not set up properly, or managed properly? The shareholders, and potentially the officers and directors, may be held liable for the debts of the corporation.

Management of the Corporation: Shareholders of the corporation elect the board of directors (“directors”), sometimes called trustees, who manage the corporation’s affairs. The board appoints officers to run the day-to-day operations of the business. Directors and officers (collectively referred to as “management”) need not be shareholders. But in most closely held private companies the majority shareholder will appoint himself as the sole board member and then, using his board authority, appoint himself to fill the officer roles.

Shareholder Rights and Duties: Shares are a method of describing a proportionate interest in a corporation. Shareholders enjoy three rights:

1.    To participate in control (as stipulated on the articles of incorporation, bylaws and state statutes)

2.    To a proportionate share of the corporation’s earnings

3.    To a proportionate share of the corporation’s net assets upon dissolution

So that shareholders may enforce their rights, law also grants to shareholders the right to information; to sue the corporation; to sue a director or officer on behalf of the corporation; and to dissent.

Shareholders control the business by their right to elect directors to manage the ordinary business matters of the corporation, and by approving all extraordinary matters. Ordinary business matters include things regularly dealt with, such as hiring and firing of officers, borrowing and paying back money, and setting dividend levels. Items not considered ordinary that must be approved by the shareholders include changes to the articles of incorporation, sale or lease of all or substantially all corporate assets, and most mergers, consolidations, sale or dissolution of the business.

Rights and Duties of Directors and Officers: Directors, as the shareholders’ elected representatives, are delegated the power to manage the corporation’s business. Directors are not expected to devote full time to corporate affairs. They have broad authority to delegate power to persons who will run the business’ day-to-day activities. They do so by appointing officers such as president, vice president, secretary and treasurer. These officers, in turn, can hire additional employees to carry out the business’ necessary tasks.

Directors and officers owe certain duties to the corporate entity and shareholders – obedience and loyalty to the company and all shareholders, and reasonable diligence in protecting the interests of same.

Directors, properly elected, have broad power to select and remove officers, determine capital structure, declare dividends and set management and officer compensation. Directors and officers shall not be held liable for poor performance but could be held liable if found to breach their fiduciary duties.

Preemptive Rights: A shareholder’s proportionate interest in the corporation can be lowered by a non-proportionate issuance of additional shares or a non-proportionate purchase of shares. Preemptive rights give shareholders some protection and may be found in state statutes or company bylaws.

Transferability of Shares: In the absence of a specific agreement, shares of stock are freely transferable. But stockholders of closely held companies (i.e., private companies with few shareholders) often prefer to limit who may own shares and total number of shareholders. The former is to keep shareholders “friendly” and the latter is to keep the number below the threshold that would disqualify them for closely held corporation status. Such status enables corporate affairs to be managed in a more relaxed and less burdensome manner.

Most states allow transfer restrictions to be placed on shares of stock by provisions placed in the articles of incorporation, bylaws, or a separate shareholder or stockholder agreement. But most state statutes hold that such a restriction will be binding only if a notice is placed conspicuously on each stock certificate. If the corporation elects not to issue certificates as evidence of ownership, then a notice should be included in an information statement sent to purchasers and holders of stock.

Fundamental Changes: The board of directors has very broad powers to select persons who manage the company, set corporate policy, establish compensation for officers and managers, etc. But some actions would have such a substantial impact that shareholder approval is required. Such actions include charter amendment (i.e., amendment of articles of incorporation and bylaws), sale or lease of all or substantially all assets of the business, mergers, consolidations, compulsory share exchanges, and dissolution. But approval typically requires a simple majority, or possibly a super majority.

Dissenters’ Rights: Shareholders in a dissenting minority may not be able to block fundamental changes from taking place. But in some instances, shareholders may be able to dissent and recover the fair value of their shares. To do so, they must comply with the dissenter’s-rights statutes of the state in which the corporation is organized, which typically stipulate that the dissenter must:

• Notify the corporation in writing of the objection to the proposed corporate action before the shareholder vote
• Refrain from voting in favor of the proposed corporate action
• Make a written demand on the corporation, on a form provided by the corporation, within the time period set by the corporation, which may be no less than 30 days after the corporation mails the form

The dissenting shareholder who complies in full is entitled to an appraisal remedy, which results in payment by the corporation of the fair value of the shares immediately before the disputed corporation action was approved, plus interest.