This article describes the types of provisions that should be considered when preparing Operating Agreements, Shareholder Agreements, and Partnership Agreements, to protect the interests of both minority owners and majority owners, streamline management and reduce the likelihood of future litigation.
Management Control Provisions
The mechanisms described below can help streamline management, ensure that minority owners have a voice in management, and reduce the adverse impact of management disputes.
Director/Manager Appointment Rights. A voting agreement to appoint one or more directors or managers designated by specified minority owners, allows minority owners to maintain representation in the management of the Company, even though they may not hold a sufficient number of votes necessary to elect a director or appoint a manager.
Special Approval Rights. Approval rights for various corporation actions, such as the incurrence of debt in excess of a specified amount, certain capital expenditures, and officer compensation over a specified threshold, provide management the flexibility to effectively operate the business while providing minority owners with the right to approve major decisions and corporate actions.
Dispute Resolution Provisions. Disputes between owners can deadlock the operation of a business and sometimes drive a company out of business. Companies with two equal owners are especially susceptible. Shareholder Agreements and Operating Agreements often have mandatory arbitration or complicated dispute resolution procedures, which can be costly and time-consuming, and therefore, impractical when resolving important issues that could stifle the operation of a business. A simple method of resolution is to agree in advance upon, and designate, a neutral third party, such as the company’s accounting firm, to resolve such a dispute.
Protections Related to the Transfer and Issuance of Securities.
The provisions below restrict and, in certain circumstances, compel, the transfer or issuance of a company’s securities. As discussed below, such provisions can protect the interests of both minority owners and majority owners.
Right of First Refusal. Right of first refusal provisions allows owners to prevent being forced into co-ownership with an unwanted or unknown third party. A well-crafted right of first refusal provision, by requiring an owner to offer his or her partners the first right to purchase their ownership interest on the terms and at the price offered.
Tag Along Rights. Tag-along rights provide minority owners with the right to participate in the sale of a company’s securities by the majority owners, in the same proportion and on the same terms as offered to the majority owners. In addition to preventing minority owners from being left behind in a liquidity event, tag-along rights protect minority owners from being forced into co-ownership with unknown or undesirable third parties.
Drag Along Rights. Drag-along rights allow majority owners to compel minority owners to participate in the sale of a company’s equity on the same terms and conditions offered to the majority owners. Without drag-along rights, minority owners may be able to block a sale, and/or leverage their minority position to negotiate a disproportionate share of the purchase price.
Buyout Provisions. Buyout provisions allow owners to compel other owners or the company itself, to purchase such owner’s equity, and are useful to keep equity from falling into the hands of an unknown or undesirable third party upon the death, divorce, or bankruptcy of an owner. Buyout provisions can also be used if an unresolvable dispute arises between the owners. A well-crafted buyout provision provides a clear and simple method for setting the purchase price for the equity and the payment terms of the buyout. Typical methods of setting the purchase price include creating a pre-set formula based on revenues, earnings, or some other financial metric, having a pre-selected third-party appraiser conduct an independent valuation, or setting a pre-determined purchase price. Key man life insurance policies are often used to finance the buyout of an owner upon his or her death. In addition, a portion of the buyout price is often paid by a promissory note which can be secured by a pledge of the ownership interests being purchased.
Transfer restrictions imposed by securities laws, which are not discussed in this article, should also be considered and incorporated into shareholder agreements, operating agreements, and partnership agreements.