In many contexts, a 50/50 split is a sign of equity and fairness. But when members of a closely held corporation or limited liability company (LLC) find themselves divided right down the middle on significant matters, it can paralyze a business and create tension and acrimony among those running the company.
Deadlocks are a distinct possibility for any company where equity interests and voting rights are evenly split among shareholders and members. Unless the business has a mechanism in place as to how to resolve deadlocks, the parties may turn to a court seeking judicial dissolution to resolve the deadlock. This is often in nobody’s best interest, and embroils the parties in costly and disruptive litigation. To avoid such conflicts, corporate shareholders and LLC owners should include deadlock provisions in their shareholder and operating agreements.
Rarely does an hour go by without a business owner making some kind of decision involving the company. But most day-to-day business decisions don’t require the assent of a majority or all of the shareholders or members, nor do they implicate the direction or viability of the company. Two owners with equal voting rights may disagree as to whether to order pizza or sandwiches for lunch, but that stalemate is hardly the type of deadlock that a clause in a shareholder operating agreement is designed to address.
The kinds of matters that can lead to consequential deadlocks usually involve actions taken outside the ordinary course of business or that impact the fundamental direction of the company, such as a merger or sale of substantially all of the business’ assets. That is why a deadlock provision should clearly define the types of issues and disagreements that could trigger its application.
Deadlock Resolution Mechanisms
Just like the world of sports has many different ways of resolving ties – sudden death, shootouts, extra innings – business owners can incorporate several different kinds of deadlock resolution provisions in their governing document. Three of the most common mechanisms include:
Colorful as all of the foregoing names are, they really just refer to a “buy-sell” agreement or arrangement that can be triggered in the event of a deadlock.
Such provisions essentially allow one owner to offer to purchase the interest of the other deadlocked owner at a set price and terms. The offeree must then either accept the given price and terms or purchase the offeror’s interest for the same price and terms (assuming equivalent percentage interests).
A shotgun provision is a pretty blunt instrument. Often, the mere possibility that either of the deadlocked owners may find themselves on the outside looking in after the clause is triggered is enough to get them to the bargaining table to resolve their differences.
When two or more owners compete for control of a business amid a deadlock, an auction is often a very workable solution. It is similar to a shotgun approach in that the offering party may have the chance to pay a price of their own choosing, even to pay a premium. However, it is very different from a shotgun in the sense that the auction process does not penalize the owner making a low offer since the other member only has to make a higher offer to avoid an unfair transaction.
Sealed Bid/“Texas Shoot-Out”
In this cousin of a shotgun deadlock provision, each owner submits a sealed offer for the others’ shares to an independent third party. That third party opens the bids simultaneously and the highest sealed bid “wins,” meaning the owner who had a higher bid will be required to purchase the others’ shares at the stated bid price.
When business owners take their disputes to court, they are essentially putting their fate in the hands of a third party who may know the law but may or may not have adequate knowledge of the company or its industry. Similarly, a tie-breaking deadlock mechanism gives a third party the authority to make the call as to how to resolve the deadlock or value the parties’ interests. That party can be the board of an affiliated entity, external or internal or external professional advisors, one or more mediators/arbitrators, or an industry expert. Whoever the tie-breaker is, they should have a baseline of familiarity with the company, its industry, and its position in the marketplace.
Given the very real likelihood of deadlock among business owners, and the existential threat that a stalemate can pose to a company’s ongoing viability, small business owners should ensure that their shareholder or operating agreement contains robust and clear deadlock provisions. If you have questions or concerns about deadlock provisions or need assistance preparing governing documents for your company, please contact me at 312-840-7004 or firstname.lastname@example.org.