Oh, the ties that bind Featured

9:52am EDT July 22, 2002

Disputes between shareholders are an unfortunately common problem for closely held corporations. At the least, a shareholder dispute distracts shareholders from the corporation’s business. At worst, it can prove the undoing of a once-successful business.

Fortunately, many shareholder disputes can be avoided. Here’s how:

Pay attention to the personal relationships between shareholders. Closely held corporations are often formed to impose formal structures on informal business relationships between family members or friends. Unfortunately, although such family relationships and friendships are almost always happy when corporations are formed, they don’t always stay that way.

Law books are filled with cases involving business disputes that erupted after friendships or family relationships went sour, with shareholders having found themselves unable or unwilling to keep their personal troubles separate from the conduct of their business.

Thus, the first, and perhaps simplest and best, way for the owners of a closely held corporation to avoid shareholder disputes is to maintain good personal relationships with one another. Healthy shareholder relationships are simply not fertile ground for shareholder disputes.

Air everyone’s expectations. People who start their own businesses may do so to attain any one of a number of goals. Some want to make fortunes; others are satisfied if they make a comfortable living. Some dream of building business empires that will make them famous; others are happy to work in anonymity.

Although none of those goals are intrinsically right or wrong, it might prove impossible for any one corporation to satisfy the individual goals of each of its shareholders. Disputes are likely to follow when shareholders take inconsistent views on what they hope to put into and take out of a corporation.

Accordingly, before forming a closely held corporation, make sure the prospective owners’ business goals and plans are similar enough so that disagreements are not inevitable. A prospective shareholder should reconsider carefully plans to go into business with people who have inconsistent goals for the business.

Take care of succession. Even if the owners of a closely held corporation maintain good personal relationships, and even if they are on board with the direction the business is headed, the unexpected death of an owner can still spell trouble. This is especially the case when the former owner’s shares are inherited by a relative who has no past involvement and no interest in the business.

Unless the new shareholder resolves to become an active participant in the business, it is natural for him or her to view the business primarily as a source of passive income. Just as naturally, the surviving original shareholders will view the newcomer as dead weight.

Such attitudes form the seeds of many shareholder disputes. This subset of shareholder dispute can, however, be avoided. Shareholders should agree on what happens to their respective interests in the corporation if one of them dies, and they may also consider providing a mechanism for the surviving shareholders to buy out the interest of a deceased shareholder.

Agree on a means to determine a fair buyout price. Even a dispute that has been “resolved” can cause significant problems if a shareholder is unhappy enough with the solution to want out of the corporation. An unhappy dissident shareholder can spell doom for a closely held corporation. The case books are filled with examples of majority shareholders who succumbed to the temptation to try to squeeze the dissident shareholder out of the corporation, and dissident shareholders who, feeling they had no stake in the corporation’s success, failed to bring corporate opportunities to management’s attention or began to compete against the corporation for business.

Unfortunately, because there is rarely a market for minority ownership shares in a closely held corporation embroiled in an ownership dispute, the dissident shareholder may either be tied to an unhappy business relationship or forced to accept whatever price the majority decides to offer for shares to get out.

The litigation that inevitably follows is often heated, protracted and expensive. Such litigation can be avoided if shareholders plan ahead and develop a method for determining the price that a dissenting shareholder will be paid for his or her interest in the corporation.

John K. Baillie is an associate in the litigation group at Houston Harbaugh, a Pittsburgh-based law firm that concentrates on the legal problems faced by closely held businesses. Reach him by e-mail at jbaillie@hh-law.com.