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Buying Out a Minority Owner; Is Now the Time to Consider?




by:
Kevin S. Woltjen
Strasburger & Price, LLP - Dallas Office

 
July 22, 2010

Previously published on July 07, 2010

Are we still in a recession?  When did we emerge from it; how bad was it?  While economists will argue about such questions, most people will agree that a great number of Americans currently face financial stress.  When people experience financial stress, they often curtail spending and more closely evaluate their various investments, especially when it is a minority ownership position in a private business.  This newsletter discusses why current financial conditions might make now an ideal time for a business to consider buying out minority owners and addresses some legal concerns that might arise in such a buyout.

The last 18 months have seen an increase in the number of minority owners exercising their legitimate right to inspect books and records, as well as questioning and criticizing managerial decisions, results of operations and dividend payments.  While inspecting books and records and engaging management on operational and financial issues is an admirable and often productive pursuit, and many businesses enjoy having engaged minority owners, occasionally minority owners pursue these activities to motivate the business to buy them out.  Rather than endure these potentially hostile situations, a business might consider buying out minority owners.

In addition to the facts that minority owners may be receptive to the idea of cashing out their investment now and majority owners may welcome the elimination of the distraction of minority owners, current valuations and financing terms present favorable circumstances for the business and the continuing owners. 

Valuation
If a minority owner is not required to sell, the buyout is a negotiated transaction.  When deciding on a buyout price, parties often obtain a valuation of the business, and agree beforehand either on the valuation firm or valuation methodology.  A common valuation methodology for the purchase of a minority interest is premised on a multiple of a business’s trailing 12-18 month performance.  Although a valuation will typically also consider growth prospects, a business that has experienced a drop in results of operations over the past 12 -18 months may be in a position to buy out a minority interest at an historically low valuation. 

Financing
Once a business decides to buy out a minority owner, external financing will typically be required.  A number of banks are actively pursuing lending relationships that can lead to the recapitalization of a business to take out minority shareholders.  Additionally, interest rates are at historically low levels, making borrowing funds for a buyout less expensive than in some time.  Therefore, if a business has a solid balance sheet and a history of earnings, with interest rates at such attractive levels, now, indeed, may be an attractive time for management/majority ownership to consider having the business offer to buy out disgruntled minority owners.

A company considering a minority owner buyout must also ensure that the buyout complies with state law.  Texas law specifically allows for a Texas entity to acquire its own ownership interests, provided the acquisition meets certain requirements.2  To ensure a business does not strip out all of its funds to the detriment of its creditors, Texas law imposes limits on buyout payments to owners, which qualify as “distributions” to owners.  For example, a Texas corporation may make a distribution to a shareholder provided, among other things, (i) the corporation would not be insolvent after the distribution,3 and (ii) the distribution does not exceed the “distribution limit.”4  Although the applicable distribution limit for Texas corporations will be either the corporation’s “net assets” or its “surplus,” most Texas corporations seeking to buyout a minority shareholder will be required to satisfy the surplus test, which prohibits a corporation from making a distribution if it exceeds the amount by which the corporation’s net assets exceed its stated capital.5  Texas corporations are allowed to use a wide variety of reasonable accounting practices and principles when calculating net assets, stated capital, surplus and each of their respective components.6  If your business has sufficient surplus or net assets, it is in a position to buy out minority owners.

Limited liability companies organized under Texas law face a similar restriction on distributions.  The company may only buy out, or make a distribution to, a company member if, immediately after the distribution, the fair value of the company’s total assets exceed the company’s total liabilities, excluding certain liabilities.7  Texas limited partnerships seeking to buy out a partner face requirements substantially similar to those imposed on Texas limited liability companies.8

Compliance with state law provisions limiting distributions to owners is critical because the governing body of an entity that does not satisfy these requirements can be held personally liable.  For example, the directors of a corporation who approve a prohibited distribution, which could be considered a fraudulent conveyance or result in the corporation becoming insolvent, are personally liable to the corporation for the amount by which the distribution exceeds the amount permitted.9  However, a director will avoid such liability if, in approving the distribution, the director relies in good faith and with ordinary care on financial information prepared or presented by one or more officers or employees of the corporation or by another person if the director reasonably believes such information is within that person’s professional or expert competence.10 

Another state law concern when considering a buyout of a minority owner is whether the company and the majority owners have breached any fiduciary duties owed to the minority owners in connection with the buyout.  Aside from the obvious problem of withholding material information from the valuation process, courts have upheld shareholder oppression claims against directors who engage in techniques designed to force minority shareholders to accept a low price for their shares (i.e., maliciously withholding dividends).  Damages in shareholder oppression actions can range from injunctive relief, such as a mandatory dividend payment, to a buy out at what the court perceives to be “fair value” of the shares in more egregious cases.11  Prudence dictates that directors maintain records of materials utilized when considering a buyout, as well as details of negotiations of the buyout.

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1The discussion that follows presumes that a buy out is not effected in connection with a winding up and termination of the business.  A winding up and termination raises additional issues that are beyond the scope of this newsletter.
2 Tex. Bus. Orgs. Code Ann. § 2.101(9) (Vernon 2010).
3  Id. at§ 1.002(40).  An entity is insolvent if it is “unable to pay its debts as they become due in the usual course of business or affairs.” Id.
4 Id. at § 21.303.
5 Id. at § 21.301.
6 Id. at § 21.314.
7 Id. at § 101.206.
8 Id.
9 Id. at § 21.316.
10 Id. at § 21.316(c).
11 Davis v. Sheerin, 754 S.W.2d 375 (Tex. App.— Houston [1st Dist.] 1988, writ denied).



 

The views expressed in this document are solely the views of the author and not Martindale-Hubbell. This document is intended for informational purposes only and is not legal advice or a substitute for consultation with a licensed legal professional in a particular case or circumstance.
 

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