Jointly held businesses: Four key exit provisions

Recently a group including former baseball star Alex Rodriguez tried to buy a controlling interest in the Minnesota Timberwolves and the Minnesota Lynx for $1.5 billion. But the deal ran into legal hot water. The Timberwolves’ second largest shareholder, Meyer Orbach, is not a fan of the deal, so he filed a lawsuit in federal court seeking to put the transfer on hold.

What’s the fuss about? Orbach alleges that the sale violates the franchise’s partnership agreement. Specifically, he claims that the teams’ majority owner failed to honor tag-along rights that would have allowed minority investors like Orbach to sell their ownership interest before the majority owner sold his.

While it’s not clear how the dispute will unfold, the drama introduces an important consideration for anyone who jointly owns a business—how you or your partners can exit the venture, whether voluntarily or because of a falling out. Below are some typical issues that you may want to address in your company’s governing documents.

To begin, what happens if one owner wants to sell some or all of their ownership in the business? Normally, the company documents will have a pre-emptive rights clause that prohibits such a sale until the selling owner has given the non-selling owners a reasonable chance to buy them. If the non-selling owners decline, then the selling owner can market their ownership interest to outsiders on terms no better than the non-selling owners received. For instance, if a selling owner offered to sell his ownership for $100,000 to his fellow owners, he could not turn around and offer the same ownership to outsiders for $50,000 because the outsiders would have received a better offer than the other owners. But if the selling owner offered to sell his ownership for $100,000 to his fellow owners, he could sell those same rights to outsiders for $120,000 because the outsiders received a worse offer.

Next, what happens if a majority owner wants to sell? Because they own a majority of the business, whoever buys their stake will take control. So, a majority owner can often sell its ownership at a premium. But minority owners are not so lucky. Not only does their minority ownership trade at a discount but they may have little say in who the new majority owners might be. To protect minority owners, company documents frequently include a tag-along clause that allows minority owners to sell their ownership on the same terms as the majority owner. This clause, in turn, enables minority owners to extract the same price as a majority owner while also potentially giving them some influence over ownership sales.

Third, what if the controlling owner wants to sell the entire business but the minority owners don’t? In these cases, minority owners can hold the deal hostage until they get paid a king’s ransom. Not good for the majority owner. To prevent this scenario, company documents regularly contain a drag-along clause. This clause allows a controlling owner to force the minority owners to sell too if the controlling owner finds a buyer willing to acquire the entire business.

Sometimes drag-along clauses are combined with a pre-emptive rights clause. In other words, the controlling owner will offer to sell the company to the minority owners. But if the minority owners don’t want to buy, then they can be forced to sell to the outsider buyer.

Finally, what happens if owners have fallen out? Maybe they don’t think their fellow owners are holding their own weight. Or perhaps personality clashes have escalated beyond repair. Whatever the reason, the owners may not be able to work together any more. In that case, company documents commonly have forced-sale clauses. These clauses give each owner a way to push out an unwanted owner.

Forced-sale provisions come in many shapes and sizes. But the most common version is similar to the I-cut-you-pick approach to deciding how to split the last piece of cake. Under it, one owner offers to buy the other owner’s stake for a pre-determined price (such as the company’s market price as determined by an independent evaluation). The second owner then has two choices: They can sell their interest at that price or they can buy the first owner’s stake for the same price.

When drafting forced-sale provisions, it’s important to be careful. While they can be helpful, they also can trigger unequal results. For instance, let’s say one owner is going through financial difficulties. That’s a perfect time for a fellow owner to activate the forced-sale provision knowing full well that the struggling owner will have no choice but to sell.

As the four scenarios suggest, jointly held businesses have some complications that a single owner does not need to worry about. If you are considering becoming a part-owner of a business, you will want to think through these scenarios and tailor a solution specific to your needs. Don’t just find a contract template somewhere and assume it will adequately address your situation.

This column is for informational purposes only and is not intended to be taken as legal advice. For your specific case, consult a lawyer.