INFOTECH AND THE LAW: Don't let a bad shareholder undermine the company

A major challenge to business success can be the business owners. Do each of them believe that the other owners deserve their equity stake? What can shareholders do when they conclude that one of them is not pulling his weight?

Common causes of dissatisfaction with shareholders who are employees of the business are:
  • The shareholder does not devote adequate time or energy to the business

  • The shareholder fails to fulfill the promises that induced the company to award him ownership

  • The shareholder's behavior harms company morale or the company's reputation.

Companies should plan to be disappointed. Every business should have agreements describing when and how shareholders can be bought out ? sometimes without their consent. Usually, shareholders' agreements include buyout provisions along with a number of other clauses related to corporate control. Some companies establish employee stock ownership plans, which dictate the terms of stock ownership for all employee stockholders.

Businesses also should consider whether each shareholder's shares should "vest," or be earned only while the shareholder works for the company. Vesting is especially justifiable at the inception of a business, when no shareholder knows which, if any, of them will fall short of expectations. If the shareholders agree that vesting is appropriate, they must agree when and how a shareholder's employment can be terminated and vesting stopped. This raises the question: Who works for whom?

Harder cases appear at companies without shareholder buyout plans. Shareholders seeking to buy out a potentially unwilling shareholder must comply with the law. If one shareholder can show that others broke rules, violated duties or acted unethically, the results usually damage the company and disrupt the buyout process. Before starting a buyout, shareholders should consider what legal duties they must fulfill.

In the absence of agreements, how can shareholders complete a shareholder buyout? Employment laws are little help, as terminating the shareholders' employment does not (without an agreement) require them to sell their shares back to the company. Nor are corporate laws especially useful. Some state laws may provide remedies for corporate waste, deadlock or similar problems, but typical dissatisfaction with a single shareholder's conduct is not relieved by these claims.

Most unwanted shareholder problems involve long, emotional and expensive negotiation. Purchasing shareholders evaluate their leverage over the unwilling seller. They usually explore whether the unwanted shareholder has violated any legal duties to the company or his fellow shareholders and whether a buyout outweighs the burden of letting the shareholder keep his shares.

A key question involves valuation of company shares. Some common issues in negotiating valuation are control premiums, liquidity and minority discounts, and whether to use an earn-out. An objective, professional appraiser may help, but shareholders should take care in selecting one, as outside appraisals can become authoritative.

Sometimes shareholders turn to more provocative solutions such as issuing shares or options to dilute the unwanted shareholder, executing a "squeeze out" merger, paying cash bonuses to other shareholders, or terminating the unwanted shareholder's employment. These tactics often invite litigation and should be evaluated by an experienced lawyer.

A critical component of a buyout is the receipt of mutually satisfactory release of claims. Generally, these releases prevent the parties from suing each other. Such a release lets each of the parties put the shareholder dispute behind them and focus on productive pursuits.

Matt Swartz is a partner in the corporate and securities practice at the McLean, Virginia office of Pillsbury Winthrop Shaw Pittman LLP. He can be reached at matthew.swartz@pillsburylaw.com.

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