A Shareholder Agreement Trap for Shareholder Employees

In Corporate Law, Shareholder Agreements, Shareholder Strategiesby Joseph PullLeave a Comment

Shareholder agreements are common among owners of closely held corporations or LLCs. These agreements are generally enforceable under Minnesota law.[1] Frequently, such agreements include provisions governing the transfer of ownership interests. The interaction of certain combinations of common provisions governing the transfer of ownership interests can create unfortunate incentives that minority shareholder employees should be aware of.

Specifically, many shareholder agreements require that an individual must remain employed by the company to remain a shareholder. Such a provision may appear to be an innocuous safeguard against absentee ownership. But these provisions can create perverse incentives when coupled with another provision that requires a departing shareholder to sell his interest at a buyout price determined by a fixed formula – book value or perhaps even a fixed, nominal price.

Why? If the company experiences success, a situation can arise where the majority owner (or an alliance of owners who together control a majority of the shares) discovers that the true per-share value of the company far exceeds the price set by the shareholder agreement to buy out a terminated employee’s ownership interest. That situation sets the stage for an aggressive majority owner to exert management power and terminate the employment of the minority owner, thereby forcing the minority owner to sell her shares at the shareholder agreement price far below their true value, to the great financial benefit of the majority owner. In essence, the controlling shareholder can use his power to control employment decisions as a tool to appropriate for himself the value of the minority owner-employee’s shares through a forced buyout.

In such a scenario, the minority owner might sue, asserting that the majority owner’s conduct is oppressive, unfairly prejudicial, and contrary to her reasonable expectations as an owner. But the majority owner, anticipating litigation, may create in advance a record of plausible reasons to terminate the minority owner’s employment. If the agreement requires a buyout at a given price, and if the majority owner has documented a plausible business reason to terminate the minority owner’s employment, the minority owner may be trapped without hope of escape. In a legal fight over share ownership, the party that can point to the plain language of the shareholder agreement as supporting its side has an enormous advantage.

Perverse incentives for the majority shareholder may arise from the combination of (1) forced sale of shares upon termination of employment, and (2) a formula establishing the price to be paid in a forced sale. Majority share ownership typically means power to control management, and management can terminate employees. The majority owner may find itself in a place where it can force the minority owner to sell shares at a steep discount from their true value simply by terminating the minority owner’s employment.

Two cases with facts roughly along the lines of this pattern, resulting in appellate opinions in Minnesota, are Hansen v. N’compass Sols. Inc.,[2] and Drewitz v. Motorwerks, Inc.[3]  In Hansen, one of four co-founders of a company served as the CEO until his employment was terminated by the other owners. The shareholder agreement expressly provided that Hansen’s employment could be terminated, and termination of his employment gave the company the right to buy his shares. The shareholder agreement also established a process for valuing the shares. After disputing with the other owners about the appraisal process, Hansen eventually agreed to a buyout price for his shares. He also filed a lawsuit challenging his termination and alleging breach of fiduciary duty by the other shareholders, but the court ruled in favor of the other shareholders on these claims.

In Drewitz, the shareholder agreement provided that termination of Drewitz’s employment would trigger a ninety-day period in which the company or another shareholder was obligated to purchase Drewitz’s shares at their book value. The company terminated Drewitz and he sued, claiming the termination violated his reasonable expectations of continued employment and breached the company’s fiduciary duty.  Drewitz sought an order that the company purchase his shares at fair value rather than the lower book value. After eight years of litigation, this claim failed, and the Court of Appeals ruled that book value was the proper price for buyout of his shares.[4]

Every case has its own facts, and Hansen and Drewitz do not mean that all minority shareholders will lose in court if they sue after being forced to sell their stock as a result of being terminated from employment.  These cases do give warning, though, that investor-employees may want to demand in their shareholder agreement some limitations or rules governing the power of the other investors to terminate employment, if the agreement requires the sale of shares upon the termination of employment. Alternately, eliminating the requirement to sell all ownership interest upon the termination of employment would defuse this trap. It is the combination of the two factors – the ability to terminate employment, and the requirement to sell shares at a given price upon the termination of employment – that creates the danger.[5]

[1] Minn. Stat. § 302A.457 (corporation); Minn. Stat. § 322C.0110 (LLC).

[2] No. A14-0869 (Minn. Ct. App. Apr. 6, 2015).

[3] No. A04-2338, 728 N.W.2d 231, 233–34 (Minn. 2007).

[4] Drewitz v. Motorwerks, Inc., no. A12-0604 (Minn. Ct. App. Nov. 13, 2012). Drewitz was terminated in 1999. He first filed a lawsuit related to the termination that same year. For the next eighteen years, he litigated two separate actions against Motorwerks and its owners, resulting in six separate opinions from the Minnesota Court of Appeals and one Minnesota Supreme Court opinion.

[5] Setting “fair value” as the price to be paid for the shares can also reduce risk to the employee-shareholder, though not eliminate it. Situations can arise where the “fair value” of stock today is far lower than the subjective value placed upon the stock by those familiar with the company — such as where the company anticipates a substantial positive development in the future which is formally uncertain but in practice highly likely.

About the Author
Joseph Pull

Joseph Pull

Mr. Pull has represented clients concerning a wide variety of commercial and financial disputes, in state and federal courts inside and outside Minnesota. He provides counsel to owners of closely held businesses or partnerships, individuals involved in estate and trust disputes, businesses facing breach of contract or tort liability concerns, securities owners, and others. View Mr Pull's profile here.

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