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Don’t Take Sides When Counseling Start-Ups

June 6, 2006 | Articles, Tim Herman

By Tim Herman

Businesses, like marriage, are most often started by idealistic founders, absolutely certain they cannot fail and they have found the co-owner(s) with whom they will share a conflict-free, prosperous and lifelong enterprise. However, the divorce rate among founders in closely-held corporations far exceeds the alarming marital failure rate. For both business owners and lawyers, the courtship and marriage phase of business formation and the separation and divorce phase of business dissolution are fraught with risks and unanticipated consequences, which are now in a state of judicial and legislative evolution. This article will focus on company formation. Please note that for purposes of this article, the term ‘close’ will be used at times to refer to any closely-held entity, as distinguished from a corporation that has elected close corporation status under article 12 of the Texas Business Corporations Act.

Austin has seen the formation of hundreds of the prototypical technology businesses where several engineers or entrepreneurs with a better idea and little capital come together to form an enterprise. In most cases, it is the first real equity investment for the founders — who will likely have had prior personal or family relationships with each other. This lack of business sophistication and their personal connections normally reduce the formality of the founders’ dealings, increasing the risks of unforeseen and irreconcilable disputes. Typically, a close corporation founder will demonstrate an overly-optimistic trust in his co-venturer and will attempt to minimize legal and accounting expenses, which constitute, in a close corporation, a large percentage of organization costs.1

Normally, when the founders consult a lawyer, he will have an attorney-client relationship with each of the individuals who are then of a single mind and without anticipation of conflict now or later. Scarce capital most times dictates using a single lawyer for formation of the business, which is most typically a corporation, to utilize its historical tax and liability advantages.2  The lawyer will prepare articles of incorporation, bylaws and a variety of shareholder agreements dealing with corporate governance, purchase and sale of stock and employment. The founders will all be employees, officers and directors of the new venture.

The fiduciary duties of corporate officers and directors, as a general rule, have run only to the corporation and not the other shareholders.3 Concepts of corporate governance and stock ownership, however, are much different in a closely held corporation than in a publicly held company. For example, in a close corporation, there is no ready market for minority stock; the employee-stockholder interests are intertwined; and dividends are rarely paid, most of the shareholder distributions taking the form of salary and benefits.4

The reasonable expectations of the typical shareholder-employee in a close corporation are most often the following: a) that she have a position as an officer, director and/or employee and participate in the management of company affairs;5 b) that the company will provide continuing employment with most available income being distributed in the form of salaries or benefits;6 and c) that she will not be fired and forced to sell her stock at less than fair value.7 Thus, it is critically important at the outset for owners to articulate, and their lawyer to understand, the reasonable expectations of the owners for the operation of the business; for it is possible that those expectations, regardless of traditional corporate law or the content of the corporate documents and shareholder agreements, may establish legal duties by which the owners conduct will be measured later in the event of a dispute.8

Most companies, particularly those which enjoy some success, eventually experience a parting of the ways between co-owners. In many jurisdictions, including Texas, unanticipated special, if not fiduciary, duties can be imposed on the majority9 and some jurisdictions have even codified them.10 A shareholder oppression cause of action, as defined in Davis v. Sheerin,11 arises when the majority’s conduct substantially defeats the expectations that, objectively viewed, were both reasonable under the circumstances and were central to the minority shareholder’s decision to join the venture. To be actionable, however, the majority must engage in harsh or burdensome conduct, a lack of fair dealing or a visible departure from the standards of fair dealing upon which the minority shareholder should be able to rely.

The most prevalent example of conduct found to constitute a breach of those duties in a close corporation is the termination of a minority stockholder’s employment, thereby effectively frustrating the minority stockholder’s purposes in entering the corporate venture denying him an equal return on his investment.12 The majority almost invariably becomes disenchanted with one or more founders and fires them as at will employees, then attempts to repurchase the minority stock (which usually has no real market value and no dividends) at less than fair value – the classic freeze out. The fact remains that there is a strong Texas presumption in favor of the ability to terminate an at-will employee, even in a shareholder-employee circumstance.13

A frozen-out shareholder-employee might respond in several ways. She might argue that she agreed to make an initial investment of cash (probably her life savings) and take a job with the company (quitting a good job in reliance) only because most of the returns of small businesses are passed through as salary and benefits. So, she would argue, the circumstances and conduct of the parties curtailed the companys right to terminate her without cause and altered the presumption of at-will employment. In addition, she might argue that the original agreements and understandings, taken together with a subsequent pattern of conduct, created an implied contract, which may, or may not, be subject to a statute of frauds defense. Finally, she might argue that an equitable remedy may be judicially fashioned to enable her, as a minority shareholder, to receive fair value for the stock.14

To avoid problems from the start for both lawyers and equity participants, the following suggestions should be considered at formation:

  1. The most effective method of avoiding the shareholder oppression or breach of fiduciary duty claim is by prudent drafting of shareholder agreements at the time of formation.15 These agreements, however, must be explicit; shareholders commonly fail to anticipate their exposure because of personal relationships, as well as naivetë, bad legal advice, optimism for new business or concern over the cost of planning. The careful practitioner will explain to each shareholder the possibilities and, to protect their respective reasonable expectations, make termination of employment possible only for cause, defining in detail the potential justifications. The stock buy-sell provisions should be drafted to provide fair value to the departing or frozen out investor. Any increase in potential cost to the company can, at least partially be addressed through liberal payment terms.
  2. The lawyer who handles the formation and continues to represent the company should make clear that he will not provide assistance to the majority or any other stockholder in freezing out or terminating the employment of the minority shareholder, his former client.16 Juries can become quite exercised at a lawyer who prepares documents or orchestrates the involuntary termination, even though the lawyer may at that time represent only the company and not the individuals. While commonplace, a lawyer should avoid taking an equity position in lieu of a fee, for if the company is unsuccessful or a shareholder is aggrieved, the independence of the lawyers judgment (and his EO policy) will be in play.
  3. Consider another state for incorporation, as Texas courts will apply the substantive law of the state of incorporation. Delaware, for example, has traditionally refused to provide any special protection for minority shareholders, even those in a close corporation.17  The Delaware Supreme Court, however, has considered the imposition of special duties on a majority shareholder under Delaware’s total fairness test when faced with a true freeze out of a minority shareholder.18

While every new small business venture will have its own special twists, if you follow my advice it should help to keep you, and your clients, out of trouble down the line. In the next article of this two-part series, we will take a look at what to do when things go awry between small business entrepreneurs.

Footnotes

  1. ONEAL THOMPSON, CLOSE CORPORATIONS �1.21 (3rd ed. 1998).
  2. LLCs and LLPs now provide similar tax and liability protections, but generally imposed more rigorous duties between co-owners.
  3. Hoggett v. Brown, 971 S.W.2d 472, 488 (Tex.App.-Houston [14th Dist.] 1997, writ denied).
  4. ONEAL THOMPSON, supra note 1, at �6.02.
  5. Wilkes v. Springside Nursing Home, Inc., 353 N.E. 2d 657 (Mass. 1976); Willis v. Bydalek, 997 S.W.2d 798, 802 (Tex.App.-Houston [1st Dist.] 1999, pet. denied) (finding that employment and management part of reasonable expectations but under facts, lock out was not oppression).
  6. Duncan v. Lichtenberger, 671 S.W.2d 948 (Tex.App.-Fort Worth, 1984, writ refd n.r.e.).
  7. Patton v. Nicholas, 279 S.W.2d 848, 852 (Tex. 1955); McCallum v. Rosens Diversified, 153 F.3d 701, 703 (8th Cir. 1998).
  8. Davis v. Sheerin, 754 S.W.2d 375, 381 (Tex.App.-Houston [1st Dist.] 1988, writ denied); TEX. BUS. CORP. ACT ANN. art. 7.05.
  9. Id. at 383.
  10. TEX. BUS. CORP. ACT ANN. art. 7.05A(1)(c) (receiver may be appointed when acts of directors or those in control of corporation are illegal, oppressive or fraudulent.). See also, MINN. STAT. ANN. �302A.751(1)(a)(2) (providing equitable relief when majority acted in a manner unfairly prejudicial..).
  11. Davis, 754 S.W. 2d at 381.
  12. Wilkes v. Springside Nursing Home, Inc., 353 N.E. 2d 657 (Mass. 1976).
  13. Willis v. Bydalek, 997 S.W.2d 798 (Tex.App.-Houston [1st Dist.] 1999, pet. denied).
  14. Douglas Mole, Reasonable Expectations v. Implied-In-Fact Contracts: Is the Shareholder Oppression Doctrine Needed?, 42 B. C. L. REV. 989, 1038-42 (2001).
  15. E.g.,TEX. BUS. CORP. ACT ANN. art. 12.32.
  16. TEX. DISCIPLINARY R. PROFL CONDUCT 106(d).
  17. Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993).
  18. Little v. Waters, No. __________, 1992 WL 25758 (Del. Ch.[Ch.?] [Month and date,]1992).

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