Founders Beware: Be Fair to Your Minority Shareholder

Author: Chris Young, PhD

Throughout my career in strategy, mergers, acquisitions, and ventures, I had the blessings to work on various transactions, of which many included the selling of companies with minority shareholder interests. But for a very few transactions, almost none of them seriously considered the rights and perspectives of the minority shareholders. The minority shareholders were from various places, some employees, others vendors, some friends and family investors, and few professional investors. These shareholders usually looked toward the advice of the majority shareholder, who often had similarly aligned incentives. However, this is not always the case, and much more often than you can think – the majority and minority shareholders' motivations and incentives are not aligned. Should these misalignments be discovered, and should a minority shareholder identify that they are not adequately considered in a transaction – watchout – beware – a lawsuit may be in the midst.

 How can you reduce this risk as a majority shareholder? What can you request of your advisor or banker?  You should ask for a fairness opinion.  A fairness opinion is not a valuation but is a document prepared by an objective 3rd party that analyzes the deal from the position of fairness. Particularly, this 3rd party is asking the question: “Are the all classes and types of shareholders receiving fair proceeds from the transaction?” This is a more complicated analysis if there are different types of stock, such as common, or preferreds, and if there are majority and minority shareholders. It can be even further complicated based on the future role of the majority shareholder. For example, some transactions are structured where the majority shareholder of the seller, say the CEO, may take a position with the buyer, and some of her compensation could be included in her new compensation package. Additionally, some transactions pop-up out from nowhere, and are done hastily, rushed and do not consider all of the facts, which can hurt a minority shareholder in the process. These are just a few examples, among an endless array of problems that can come up, if a majority shareholder does not consider the position of the minorities.

However, I suggest you do not take my word for it. Below is some case law which may help influence your decision.

In the case of Smith v. Van Gorkom, the court ruled against the board of Trans Union, who voted for a buyout without obtaining a fairness opinion from an independent financial advisor. In the Van Gorkom case, the court held that Trans Union did not support the price or the particulars of the transaction, and did not share and or obtain all of the necessary information required to make an informed shareholder or board decision. In Sealy Mattress Co. of NJ v. Sealy, Inc., the court provided a view into three required components to establish a fair deal and a fair price. First, the shareholders and board of directors must: (1) have enough time to properly review the transaction, and (2) obtain a valuation of the company for sale. There must also be (3) evidence that the majority shareholders dealt fairly with the minority group, as evidenced by the hiring of an independent party who analyzes the fairness of the transaction to the minority and majority shareholders.

 Second - "Before making a business decision, the directors of a corporation, in discharging their duty of care (4) must inform themselves of all available material information.” A third factor evidencing the presence or absence of fair dealing is whether the defendant fiduciaries (5) disclosed to the minority stockholders all material facts about the merger. That the defendants [shareholders] had a fiduciary obligation to disclose all material facts in an atmosphere of complete candor is unquestioned."[1]

Concerning the Sealy case, the trial court held that the majority shareholders did not avail themselves of all the pertinent information, did not look after the best interest of the minority shareholders, did not provide all of the known data to the shareholders, and did not provide meaningful insight into the value of the company.

To make things scarier for a majority shareholder, consider the remedies if you are found at fault:

1. The transaction can be unwound. This will cause enormous disruption to the operations of any business.

2. Normally a competitor is a buyer, and if so, they now have a detailed look into your operations.

3. This is VERY COSTLY, probably in the millions, if not tens of millions of dollars for lawyers, experts, accountants, and other professionals.

4. The amount of time required, and stress created is enormous and will take the eye off the ball – creating incredible harm to your company.

5. The minority shareholders, should they prevail, may also seek historical damages for the loss of profits that they would have had, but for the transaction.

6. The minority shareholders may also seek that the company pay for legal fees, which further adds to the enormity of a bill.

The risk associated with doing a deal, while not spending the time or money to obtain a fairness opinion is just silly!  There it is, I said, it is silly and will hurt you.  The risk far exceeds the cost to get a fairness opinion. One other last remark – DO NOT ASK YOUR BANKER OR ADVISOR TO PERFORM IT.  They are not an independent 3rd party.   

I hope the summarized tips above are helpful for the majority business owner who is contemplating a sale. Most of you have spent your entire lives building incredible companies and one silly mistake can bring it all down.  Pay attention, get a fairness opinion completed.

 If you have any questions about your business, valuation, fairness opinion, or want to chat about these sorts of things – give me a call at 347-522-0480. 

                                                                        Your friend in business,                                                                         Christopher Young, Ph.D.