If given the opportunity, should you purchase a partial ownership (i.e., some of the outstanding shares) in a small business? What benefits do the shares confer? This article explores the benefits and power of majority and minority shareholders of a corporation. A similar (albeit different) analysis applies for members of a limited liability company.
When Ownership Confers Power
In general, the benefits of ownership hinge on whether you have sufficient shares to control the actions of the corporation, such as hiring employees, fixing compensation, declaring dividends, borrowing money, selling the corporation’s assets, acquiring other companies, etc. In general, these decisions are made by the corporation’s directors, normally by majority vote. (Occasionally, bylaws require a supermajority (e.g., 2/3) for certain decisions.) Thus, if you have sufficient shares to elect a majority of the directors, you alone control these fundamental decisions. An owner whose shares are insufficient to elect a majority of the directors is commonly known as a “minority shareholder,” and a shareholder controlling sufficient shares to elect a majority of the directors is often referred to as a “majority shareholder” or “controlling shareholder.”
Ownership ≠ More Compensation
Intuitively, one would think that purchasing shares of a small business will directly or directly create an income stream. It doesn’t — unless you are a majority shareholder. If you don’t control a majority of the shares, either through your own ownership or alliances with other owners, your shares are nearly irrelevant to your compensation. Your business skills (sales, management, technical) may be sufficient to confer control over your compensation (by threatening to leave), but not your minority block of shares.
Ownership ≠ Guaranteed Employment
Does owning shares guarantee a job? Not if you are a minority owner. Instead, the majority shareholder (through the directors he controls) is usually free to terminate your employment at any time. And this frequently occurs when there are disputes between minority and majority shareholders. Without a job, a minority shareholder has no means of generating an income stream. Unless the corporation pays dividends (which the directors will usually resist), the minority shareholder has funds tied up in an investment that generates no return.
Selling the shares to an outsider is seldom an option. A minority block of shares is nearly impossible to sell to anyone other than an existing owner. (Why would anyone pay money to be in your shoes?) Further, if the shares are covered by a buy-sell agreement, sales to outsiders are usually prohibited. This means that a minority shareholder is usually “stuck.” Buy sell agreements frequently give the corporation or majority shareholder the option, but do not create an obligation, to purchase the shares of a minority shareholder whose employment has terminated. The price is usually discounted and payable over a period of time.
Rights of Minority Shareholders
Even if you are a minority shareholder, you still have some leverage to liquidate your investment at a fair price. A sophisticated majority shareholder is always pondering “exit strategies,” meaning the ultimate disposition of the business. Perhaps the owner wants to build the business and eventually sell it. If so, the owner’s efforts will partially inure to the benefit of a passive investor, assuming the minority owner’s employment has terminated. This may be sufficient motivation to the majority owner to buy out the minority owner.
An uncooperative minority owner may also have the ability to frustrate corporate operations by refusing to guarantee leases and lines of credit. Most banks and landlords require a personal guarantee from all shareholders owning, say, 15% or more of the shares. Thus, a minority owner’s refusal to provide a personal guarantee may be sufficient leverage to compel a buyout.
When Should You Purchase Shares?
A 50-50 ownership arrangement may couple the benefits of ownership without the risk of being forced out through termination of employment. Neither owner has the right to change the arrangement existing when the ownership began. For example, an owner can’t unilaterally terminate the other’s employment, remove him or her as a director, or adjust salaries. (Sometimes this is addressed by “voting agreements” whereby each shareholder agrees to vote for the other as director, and not to take action to terminate the other’s employment.) The key disadvantage to equal ownership is that disputes may create a stalemate paralyzing the business. There may be no remedy if a disgruntled owner reduces his effort or hours, or just quits coming to work.
Before you buy a minority block of shares, you should identify your objectives. If compensation is the prime objective, you might consider limiting your participation to employment. Another alternative is to insist on a voting agreement that prevents the majority shareholder from terminating your employment or reducing your salary. Another angle might be to insist on a buy sell agreement that compels the corporation to purchase your shares on favorable terms if your employment is terminated. If your objective is to participate in the growth of the company and its eventual sale, guaranteed employment is less important. This might be the case if you believe the company is a candidate for an IPO.
Purchasing shares of a business is similar to starting a marriage. Getting in is much easier than getting out. Even if you are best friends with the other owner when you join the business, things may change down the road. Be cautious. Obtain references for your future business partners. Suppress the romantic euphoria of owning a business, and instead focus on practicalities.
Finally, hiring an experienced business lawyer before you invest is usually money well spent.