How to protect a closely held business when owners disagree

Why it’s a good idea to anticipate a breakdown in communication

The owners of closely held corporations sometimes disagree as to the plans for the company’s future, the relative worth of their contributions and a host of other matters, large and small. When those disagreements result in an irretrievable breakdown in communication, and no owner can outvote the others, things can go badly for the company.

The law in most states attempts to address these difficult dynamics in a way that preserves both the ownership stakes of the disputing parties and the underlying business of the company. This is not a perfect process, however, and it behooves business partners to anticipate the potential for disagreement and plan accordingly.

The law allows one or more of the deadlocked parties to petition the court to dissolve the company. Before a court will let an owner or ownership group “pick up their marbles and go home,” however, the owner seeking dissolution must establish:

 • The directors are deadlocked in the management of the company’s affairs

 • The shareholders are unable to break the deadlock

 • The company is threatened with irreparable harm

The court can also order dissolution when the company’s affairs can no longer be conducted to the advantage of the shareholders. It also can order dissolution when it finds that the directors or those in control of the corporation acted, are acting, or will act in a manner that is illegal or fraudulent.

Even when the court determines that the company can be dissolved, there is still room for the shareholders who want to perpetuate the company to do so. To be precise, they can buy out the dissenter.

This election must be made within 90 days of the request for dissolution. The law makes irrevocable an election to purchase the dissenter’s shares. The parties then have 60 days after the election to purchase to agree on a price for the departing shareholder’s shares.

If the parties cannot reach agreement on a price, the court can determine the fair value of the petitioner’s shares.

Fair value does not mean “fair market value,” but rather means what the dissenter’s shares are fairly worth – a determination potentially subject to significant debate.

Once the court determines the fair value of shares, it orders their purchase for that price, upon such terms and conditions it deems appropriate.

The terms of purchase can include provisions such as installment payments and/or security for installment payments. The court can also allocate the fees and costs associated with the valuation proceeding.

Room for controversy

The problem with the law is that the parties can wrangle over the fair value of a dissenter’s shares only to have the result unwound, if within 10 days of the court’s final determination of the terms of purchase, the company votes to dissolve rather than buy the dissenter’s shares according to the terms established by the court.

The vote to dissolve puts the company right back where it was when the petitioning shareholder first went to court seeking dissolution. The only difference is that by the time the court valuation process is completed, the litigation has usually gone on for years, with all the costs associated with that process.

While it helpful that the law allows the owners of a deadlocked corporation to get their investment back, there is lots of room for controversy.

For example, the meaning of “fair value” is not fixed by the “market,” as is “fair market value.” Even “fair market value” is debatable when applied to the valuation of an asset without a ready market.

Of course, where there is ambiguity, the time and money it costs to reach resolution can escalate. Likewise, finding capital or diverting operating income to buy out a significant stakeholder can be challenging in the best circumstances.

It is also unnerving for the petitioning shareholder to know that the company could vote to dissolve after a costly valuation process and the passage of time that may further erode the company’s value.

Owners in closely held business may therefore want to anticipate the potential for disagreement in fashioning their business agreements.

They should, for instance, have a clear understanding on issues like how and when they will be called upon to contribute additional capital, the expectations for the ongoing commitment of time and attention to the business, and how leadership of the company will change over time.

They can also agree to procedures for resolution in the event of a deadlock.

For example, they might agree to a mechanism for valuing their interests, as by using a multiple of the company’s revenue averaged out over the prior three years.

They might also stipulate that in the event of litigation over the value of a dissenting shareholder’s interest in the company, the loser will pay the attorneys’ fees and costs of the winner – a powerful incentive to be reasonable and avoid litigation.

Scott Harris, a director in the Litigation Department of McLane, Graf, Raulerson & Middleton, can be reached at 628-1459 or scott.harris@mclane.com.