One topic of conversation that always sparks a lot of interest is how to organize the ownership structure of the company when co-owners or investors are involved. This post begins a four part series looking at key topics to consider when organizing a company with multiple owners. In this post, we look at voting power and how it can be distributed. This topic alone could fill an entire semester in business or law school, so this brief discussion is meant as a beginning point for a review of your own business plans.
For a one person shop, it is not uncommon for there to be no written shareholders agreement at all. This is not advisable. Banks like to see these documents. Eventually you may bring on partners and that process is cumbersome enough without also having to draft the shareholders’ agreement from scratch simultaneously. This task is best done at the beginning of your business and revisited periodically every year or every couple of years.
First, we have to get some housekeeping done. It should be noted that corporations and limited liability companies have different terminology. Corporations have shareholders; LLCs have members. Corporations have shareholder agreements; LLCs have operating agreements. The equity interests of a corporation are called shares; and the equity interests of a LLC are called membership interests. For the purposes of this post, we will refer to shareholders, shareholders agreements, and shares. To the extent limited liability companies follow different rules, such will be noted.
Now that lengthy instruction has been provided, let’s talk about the most important topic in any such negotiation: the issue of control and voting power. This is best illustrated by example.
Majority vs. Supermajority Voting
Power is exercised within a corporation by the voting power of the shareholders. The more voting shares you have, the more influence you will wield in company decision making. You should never assume that owning a simple majority of the voting shares (more than 50% of the voting shares) gives you the right to call all the shots.
Shareholders Agreements, if properly drafted, will clearly define what amount of the vote is necessary to control certain issues. For example, the day to day management of the business will be delegated to the company’s president or CEO, and that will be expressly written into the document. But there are larger issues to consider with arguably a larger impact on the business. What follows are some examples:
The hiring and firing of employees;
Bringing on additional investors;
Declaring bankruptcy;
Dissolving the company;
Pledging the assets of the business as collateral for a loan.
These larger issues will typically require a supermajority vote to be approved. A supermajority is some number (which you will determine in your Shareholders Agreement) of votes. It might be 65%, 70% or 80% of the voting shares. Why this technique is used for critical decision making is to ensure some consensus on these larger items among the key shareholders.
One thing I strongly urge my clients to always avoid is requiring unanimous votes for any issue whatsoever. In other words, avoid requiring a 100% vote in your Shareholders Agreement. Why would you want to avoid this? The answer is pretty simple but surprising.
The shareholder who becomes the most powerful person in a unanimous vote scenario is the shareholder who owns the smallest amount of shares. It completely turns the tables of how decision making and voting typically unfolds within the company. This is best illustrated by an example:
The Company needs a $100,000 loan to fund new production capability which could net the company $500,000 in profits. The Company’s Shareholders Agreement requires a unanimous vote to authorize the loan transaction. The Company has three owners, A, B and C.
A and B together own 95% of the company’s voting shares. C owns 5% of the voting shares and rarely attends any meetings or has any connection to the business. The Bank has reviewed the company’s Shareholders Agreement and sees that a vote of 100% of the shares is required to authorize the loan transaction. The Bank then requires a corporate resolution signed by all of A, B and C which states that the loan transaction is authorized but he company. C refuses to sign the resolution, leaving A and B at C’s mercy.
Things like this actually do happen. For that reason, avoid unanimous voting requirements.
Voting vs. Nonvoting Shares
Another effective technique to concentrate power and control is through the use of multiple classes of shares. Companies often have more than one class of shares, each with different voting and economic rights attached to them. For the purposes of this post, we will focus on voting shares and nonvoting shares. The Company can achieve several different goals through the use of nonvoting shares:
To incentivize younger workers to take on a larger management role within the ranks of the organization;
To reward outstanding producers while not giving up any voting power;
To retain workers with seniority from leaving the business for more lucrative opportunities.
From the standpoint of corporate decision making, nonvoting shares are exactly what they sound like: an equity interest in the business with no voting rights. For the reasons listed above, nonvoting shares are something to consider for businesses that have a diverse multigenerational leadership group in particular. Having a class of nonvoting shares can create a career path for younger workers within an organization, and thus provide some continuity for the business long term.
This post is not intended to be an exhaustive discussion of all facets of voting power within a company; it can however be a launching point for your own review of your business. If you want to discuss your specific situation, please contact me.