Stockholder Disputes: Why Sometimes Breaking Up is Hard?
There’s a reason that contentious disputes among stockholders in closely held corporations are referred to as ‘business divorces’. Even where relationships among the founders and other principals have not yet soured, a stockholder’s exit can easily prompt a range of damaging, even ugly, quarrels among formerly cordial colleagues
Here Euripides Dalmanieras, Partner at Foley Hoag, argues that once the parties mobilise to protect their own interests (whether prompted by one stockholder’s desire to move on or, worse, the dissolution of the entity itself), the threat of litigation will cloud their negotiations, exacerbating already frayed relations among family and colleagues and damaging once profitable businesses.
At the heart of all too many, such disagreements will be the valuation of each party’s interest in the money and property at stake, just as it is in the case of most disputed divorces. The struggle to value equity holdings for which there is no public market can wreak havoc among stockholders, much like a heated clash over marital assets can generate acrimony.
A lawyer’s effectiveness in resolving a business divorce will depend in part on their ability to understand the people at the centre of the dispute (often family members and friends), the anxiety and stress suffered by all parties, and the longstanding damage to relationships and business prospects that a protracted litigation will cause.
A seller may not have any better options than what the insider is offering, and that engenders resentment.
At the root of every valuation, dispute is the inherent illiquidity of closely held stock. The classic definition of fair market value is the price that an informed buyer will pay to a willing seller. But this basic economic principle may not have any bearing on the price of stock in a closely held corporation. While there may well be a market for an entire closely held business, it’s unlikely that potential buyers will be lining up to acquire a portion of the stock in such an enterprise. As a result, stockholders in close corporations, especially minority stockholders, face serious obstacles in monetising their interests for a price consistent with their expectations of the stock’s value.
There are several reasons for these obstacles:
- Even if organised as a corporation or limited liability company, a closely held company is almost like a partnership with only a few owners. A stockholder seeking to sell their stake must find a buyer who is willing not only to assume the risk of owning a piece of a business but will do so by partnering with people they may not even know; much less trust.
- Corporate stock may be subject to the corporation’s right of first offer or right of first refusal. This will further dampen the market for the stock.
- Close corporations frequently operate without the financial transparency required of public companies. This makes it difficult for an outsider to ascertain the value of the business and, by extension, its stock.
- Finally, the goodwill of a close corporation is often tied up with the reputations of and relationships nurtured by its founders. Their exit (or potential exit) from the business is a risk that negatively affects price.
So, who then might comprise the market for a closely held company’s stock? Usually, the pool of possible buyers will be limited to insiders, e.g., existing stockholders. The lack of competitive bids from outside parties gives insiders a lot of negotiating leverage, especially vis-à-vis minority stockholders. If the insiders are already receiving substantial financial benefits from the business (salaries and benefits, dividends, and perks), they may not leap at the chance of a larger stake, unless it would materially increase those benefits or come with full control of the business. In other words, the insider’s perception of the stock’s desirability and value will be driven by the potential incremental benefits of owning the additional stock. A seller may not have any better options than what the insider is offering, and that engenders resentment.
There are ways to resolve these disputes short of civil litigation if the parties are willing to compromise, in writing, as early in the life of the company or in their stock ownership, as possible. Founders and later stage equity holders alike are well advised to sort out their valuation options before any party has started to think about an exit plan by, among other things, crafting creative buyout agreements and stock valuation mandates in the corporation’s articles and bylaws. While they do not eliminate all litigation risk – bylaws and other agreements providing a stock valuation process are subject to interpretation by lawyers and appraisers – they do mitigate that risk and provide for a faster resolution. And at the end of the day, they may just save your personal relationships.