By Gerald P. (“Jerry”) Burleson
© 2014 by Gerald P. Burleson, all rights reserved
My law practice is devoted primarily to representation of minority shareholders* of privately held companies who have been “oppressed” by those in control of the company, usually a majority shareholder or a group of shareholders who have the power to control the corporation. In this context, I use the term “shareholder oppression” to refer to the denial of any realistic benefit to a shareholder for their investment in the company. So, how do the people in control of a privately held company oppress minority shareholders? I will discuss that in this article.
In a privately held company, the majority shareholder will typically serve as the company’s CEO, but not always. For example, the majority shareholder may have reached an age where she wants to be less active in the day to day management of the company and if the company has been successful and can afford it, she may transition to a position such as Chairperson of the Board while an experienced manager is hired as the CEO. Oftentimes such a hired business executive will receive stock in the company as part of their compensation. There will be plenty of strings, however, and you can bet that the majority shareholder will remain in control of the company. In addition to employee shareholders who acquire minority interests in the company as part of their compensation package, there are often minority shareholders who invest in the company, perhaps in the expectation that the company will eventually be taken public and their investment will be cashed out at a premium when that happens. For all kinds of reasons, there are usually minority shareholders in most privately held companies.
Most privately held companies do not regularly pay dividends to the shareholders, if they ever do so. So, why do people make minority investments in privately held companies? Well, there are a number of possible reasons. The investor may believe in the company and see his or her investment as an opportunity to “get in on the ground floor”, with the expectation that somewhere down the line there will be a cash-out event or perhaps that the stock might be worth millions in the future. Sometimes in a smaller company the investor will essentially be buying a job. Whatever the motivation for their investment, it is fairly universally accepted by minority stockholders that they will have little or no control over the company and that the fate of their investment is largely in the hands of the majority stockholder. Which means that the integrity of the majority stockholder or of the group of stockholders who control the corporation is paramount to the value of the investments of the minority stockholders? An investment of any kind always involves risk. Investors know and generally accept that the business might fail for reasons beyond the control of the founder or even because of poor business decisions made by the founder, or by those in control of the company. One thing that most investors will not readily accept is being connived out of their investment.
So, how does it happen that stockholders are denied the benefit of their investments by those in control of a company? In my experience, there are countless ways, only limited by the ingenuity of the person or persons in control. I will mention a few of the schemes to oppress shareholders that I have observed in my law practice.
Probably the most common way to deny shareholders the benefit of their investment is simply to ignore the shareholders and deliver all of the fruits of a company’s success to the officers, particularly the CEO! After all, the people in control of a company will usually be wearing several hats: they are shareholders, officers and even directors of the company. If all of the company’s money is being paid out in excessive salaries, bonuses and other forms of compensation to the CEO and the other key officers, there will not be anything left to distribute to the rest of the shareholders! And this may go on for years and even indefinitely. The minority shareholders in this situation are sucking wind!
A variation on delivering all of the fruits of the company’s success to the officers is for the CEO/majority shareholder to put all of his family on the company payroll in high paying jobs. Perhaps the company needs somebody doing most of those jobs, but in reality, they could be done by hired professionals who might do a better job at a much lower cost. (Why not put some of the minority shareholders on the job, since that is apparently how the company’s profits are being distributed?)
Another method seen too frequently is for the majority shareholder to set up a separate entity which she uses to conduct business with the corporation, and make a killing! For example, valuable assets of the corporation used to perform some necessary function might be transferred to the separate entity in exchange for inadequate compensation and then the separate entity takes over that function and is paid for the work. All of the company’s employees who had been doing that work are terminated (cutting the overhead and outsourcing the work!) and then hired by the separate entity. This is progress? In reality, this is nothing more than a means to divert more money into the CEO’s pocket.
How much are your shares worth if somebody else can get the corporation to loan them money to purchase the stock of the founder/majority shareholder, and then payoff the debt with the high compensation package they are granted as the company’s new CEO? This has happened, and oftentimes it is the board appointees of the new majority shareholder/CEO who approved the transaction. As a minority shareholder of a company like this, don’t expect to see dividends anytime soon!
Minority stockholders in subchapter S corporations can find themselves in an unenviable situation if the corporation begins making a lot of money and the company does not make a distribution sufficient to cover each stockholder’s income tax liability on pass-through income. I have seen a situation where a highly profitable subchapter S corporation had a fairly regular custom and practice of distributing profits annually to the shareholders to cover their distributive shares of the company’s pass-through income tax liability. Then, the CEO/majority shareholder decided that he wanted to buy-out the other shareholders and so he made them a low-ball offer. Around the same time, the company’s board, which was controlled by the majority shareholder, announced that the company would be using its substantial pot of cash on hand “for other business purposes” and so the company would not be making a distribution to the shareholders that year. The tax liability each shareholder would be facing that year was enormous. The credible threat of driving a stockholder into personal bankruptcy will cause just about anybody to sellout their stock on the cheap, and they did sellout!
Most of the stock issued by privately held companies will be subject to some kind of a buy-sell agreement, and the unfriendly terms of such agreements to the shareholder can be a means of shareholder oppression from the get-go. Frequently an investor will sign a buy-sell agreement without reading it or having the agreement reviewed by an attorney. That is almost universally a mistake that will be very costly down the line to the stockholder. If you are an employee of the company and you acquired your minority shares as part of your compensation package, you may find the value of your stock to be somewhat illusory, even in a highly successful and profitable company, in light of terms in the buy-sell agreement that force an employee who is exiting the company, whether voluntarily or involuntarily, to sell her stock back at a bargain price determined by some formula or metric specified in the agreement. Another common scenario that I encounter is the minority stockholder who invests hard-earned cash or borrowed funds in a privately held company and goes to work there as an employee. Essentially, they have bought a job. It is not unusual for such a shareholder-employee to later be terminated when business slows down, only to learn that under the terms of the buy-sell agreement she signed, the stockholder is forced to accept a pay-back of her investment in installments bearing little or no interest over a period of up to five years, or even longer.
Any investor should do their due-diligence before investing in a privately held company, just as they should with any other kind of an investment, and they should consult legal counsel before signing a buy-sell agreement or any other binding obligation in connection with the deal. Employees who are offered stock as part of their compensation package may not have as much flexibility as investors paying hard cash, however, if the stock is a significant part of the compensation package, employees too should be extremely vigilant in examining the terms of the deal to make sure that it is not illusory, which includes having the buy-sell agreement reviewed by their own legal counsel. In the end, the integrity of the majority stockholder or the people in control of the company may be the only thing that determines whether their stock represents real and valuable rights or merely an illusion.