Closely held corporations present unique legal issues on a number of fronts. The limited ownership group makes personal relationships more important and increases volatility amongst the group. Owners of closely held companies tend to be more involved in the operations of the company.
What Is a Closely Held Corporation?
The most general definition of a closely held corporation is a company with a small number of shareholders. In Texas, there is a statutory process by which a typical for profit corporation may form a close corporation but this is not the only version of a closely held corporation. A closely held corporation may exist even without a close corporation designation under state law. S Corporations (a tax designation) are often closely held corporations because of their inherent shareholder limitation.
Regardless of how you define or create a closely held corporation, they have three distinct characteristics: (1) there are a limited number of shareholders; (2) there is a limited market for the companies stock (if any); and (3) the owners are often directly involved in the operations of the company.
What Characteristics Make Closely Held Companies Unique?
Limited Number of Shareholders. The limited numbers of shareholders is the single biggest difference between a closely held company and a public company. The shareholders almost always know each other prior to forming the company and usually form the company with a specific purpose and understanding about their roles and goals. These goals may be delineated in the bylaws or a shareholder’s agreement. The limited number of shareholders exponentially increases the importance of understanding their personalities and personal relationships. The personality of the shareholder or shareholders owning a majority in interest can come to dominate the management and direction of the company.
Limited Stock Market. By its nature, a closely held company offers a limited market for a shareholder to sell his stock. Often times the company is formed with unique roles for each shareholder. A third party will not be interested or able to fill that role if it acquires an ownership interest. In addition, closely held companies often place limitations on the transferability of stock. Given these limitations, a shareholder who wishes to sell his interest in the company is often limited to selling his shares back to the company or to the other shareholders.
Shareholders As Directors, Officers, or Employees. Many times shareholders of closely held companies take on significant roles within the corporation as directors, officers, or employees. This can create issues down the road, especially in situations where a minority shareholder feels disenfranchised. For instance, should employee shareholders be given an employment contract or remain an at-will employee? What happens if one shareholder leaves employment with the company while the remaining shareholders continue to draw a salary? Either scenario could have a significant impact on a shareholder’s economic return.
What Are Some of the Unique Legal Issues Affecting Closely Held Corporations?
Minority Shareholder Rights. Most legal issues for closely held companies arise when there is an inequality in ownership between two shareholders or the existence of more than two shareholders. In either situation, there is a minority shareholder. With two shareholders holding unequal interests, the shareholder with the lesser interest is obviously a minority shareholder. However, anyone who owns less than 50% of the company can be a minority shareholder even if that shareholder in fact owns a greater stake in the company than any other individual shareholder.
For instance, take a company where A owns 48% of stock, B owns 26%, and C owns 26%. No one shareholder holds a majority interest. But if B and C jointly decide on a course of action that negatively affects A, then A can be considered a minority shareholder.
This is important because the law affords minority shareholders special protections one of which is protection from oppressive conduct by the majority. In Texas, oppressive conduct exists in two circumstances:
- when the majority shareholders’ conduct substantially defeats the minority’s expectations that, objectively viewed, are both reasonable under the circumstances and central to the minority shareholder’s decision to join the venture; or
- burdensome, harsh, or wrongful conduct, a lack of probity and fair dealing in the company’s affairs to the prejudice of some members; or a visible departure from the standards of fair dealing and a violation of fair play on which each shareholder is entitled to rely.
Control Rights. Given the limited number of shareholders, it is relatively easy for one shareholder or a small group of shareholders to form a majority that can control the company and direct its actions with limited input from the minority. This is separate from an issue of oppression as corporations are designed to work this way by default. There are various scenarios where control can be an issue.
The first example is the instance in which the majority and minority interest holders share a common vision when starting a new venture. However, over time the shared vision distorts and the minority interest holder becomes less effective in the decision-making process to the point of having no real control over the direction of the company. As long as the legal formalities are followed (notice, meetings, elections, etc.), there is no recourse for the minority shareholder because most corporations default to a majority in interest rules.
A second example comes with the “big fish” investor. Let’s take a group of engineers A, B, and C, who have a great idea but no capital. Along comes investor D with all the money in the world and they form a corporations with an equity structure as follows: A, B, and C each have 20%; D has 40%. D has the largest stake in the company because he fronts all of the capital and he expects to be able to direct the company’s actions in order to protect that capital investment. But is that actually the case? A, B, and C can still control the company as a group.