Thought Leadership

Employee Owners In Closely Held Businesses: Till Death Do Us Part?

Michael Eisner, once said, “It is rare to find a business partner who is selfless. If you are lucky it happens once in a lifetime.” Eisner himself, at least according to Roy E. Disney, was not necessarily a selfless business partner, as his removal from Disney’s chairmanship evidenced. Eisner’s maxim is a good one, however, and small businesses are no more immune from corporate intrigue than large ones. Learn how to make sure your business does not find itself permanently burdened with a selfish business partner in Joe Beckman’s piece on “Employee Owners in Closely Held Businesses: Till Death Do Us Part?”

Ed. Note: We previously discussed the “accidental partner” in the context of closely held companies. This installment discusses the “permanent employee.

Closely held companies in Minnesota include both limited liability companies and corporations. According to the Minnesota Legislature, as of January 2011, LLCs and corporations are the two most common legal entities formed in Minnesota.

Minnesota statutes permit the owners of closely held companies to enter into contracts with each other that can govern a wide variety of potential ownership transitions. The value of such agreements lies in the minimal up-front investment required to manage, predictably and in a way that minimizes the day-to-day impact on the surviving business, the expectations of the company owners when life’s inevitable changes pop up.

When done correctly, such agreements provide a clear exit strategy for each of the owners. This is smart advance planning for the time when one (or more) of the operators of the business concludes that the continued health and profitability of the business (or the owner’s personal health) requires a restructuring in ownership.

Somebody Has to Go.

As discussed in the accidental partner, small business owners can save hundreds of dollars at the outset of the company’s life by declining to put together articles, bylaws and a member (or shareholder) control agreement tailored to the needs and desires of the owners of the business. Like it or not, however, a business structure often gets reevaluated – usually through much different lenses – when one of life’s “little inconveniences” (a change in the harmony between co-owners, financial distress of an owner, divorce, death, etc.) raises its ugly head.

This modest up-front savings can, and often does, result in the later expenditure of thousands upon thousands of dollars, both by the company and one or more of its owners. Thus, small business owners are wagering this small upfront investment on against the likelihood they will all readily agree on how to restructure the business -and if necessary – agree on the price and the terms of any associated buyout of an Owner (or her heirs) when life changing inevitabilities occur.

Another often overlooked impact of failing to invest in a proper operating agreement or member/shareholder control agreement is the potential for the “unintended lifetime employee.” This “perpetual employee” is a creation of the way Minnesota courts have interpreted

Why is this a Big Deal?

Closely held companies, unlike their publicly traded counterparts, do not have a ready market that an owner may avail herself to when it is time to “cash out.” This lack of liquidity gives rise to potential abuse of minority owners of a business by the majority of a business.

Although the applicable statutes provide a means by which the oppressed owner(s) of a business might seek a court’s assistance both for a corporation, and for a limited liability company. These statutes provide that “any written agreements, including employment agreements and buy-sell agreements, between or among members or between or among one or more [owners] and the [company] are presumed to reflect the parties’ reasonable expectations concerning matters dealt with in the agreements.” As such, the lack of a well drafted shareholder control agreement (for a corporation) or member control agreement (for an LLC) makes this process more time consuming, uncertain and expensive for all involved.

My Partner is Here to Stay.

In the course of unwinding closely held companies in the absence of an appropriate shareholder/member control agreement, Minnesota courts have fashioned a remedy for oppressed minority owners that can create a surprising circumstance for a company. Specifically, an owner/employee of a closely held company has an expectation of “lifetime employment” in and of “an active voice in management of the corporation and input as an employee.”

For example, where a minority owner was terminated by other owners, after the minority owner complained about disproportionate payouts to the majority, the court decided that owner (who is in his late 60s at the time) had had “two separate property rights in the family company: (1) employment with [the company] until voluntary retirement; and (2) a one-third share in the ownership of [the company].” Ultimately, the court upheld a jury verdict that awarded separate damages for the ownership interest and for lost wages.

By contrast, where a member or shareholder control agreement exists, courts will look past potential lifetime employment and voice in management claims, and enforce the terms of the shareholder control agreement. This is true even when the resulting payout to the owner is substantially less than the estimated fair market value of the ownership interest.

How to Plan Ahead.

Fortunately, Minnesota law permits agreements between the shareholders of a corporation or between the owners of a limited liability company (i.e., its members). The purpose of these contracts with among Owners is to help them avoid the expense, distraction and uncertainty of waking up one day with a “permanent employee.” These agreements are known as a “shareholder control agreement” for corporations and a “member control agreement” for LLCs.

These agreements, which are driven off of fairly standard forms then tailored to meet each individual ownership groups perceived needs and concerns. They typically contain clauses that manage expectations at the outset.

When “the founders” are at an early stage, it is much easier to treat each potential “permanent employee” fairly from an economic perspective. The result is that everybody understands the exit plan at the outset. This means a lot less of a chance for surprises – and for substantially less expense and emotional turmoil for all – when life’s changes require a change in the structure of the company.

For information regarding options for safeguarding your closely held business, please contact Hellmuth & Johnson, PLLC business department chair, Joe Beckman.