The Ugly Truth About Giving Others “Skin in the Game” – All About Sharing the Ownership of Your Business

1. The Ugly Truth About Giving Others “Skin in the Game” – All About Sharing the Ownership of Your Business Presented by Teri G. Rasmussen Lane, Alton & Horst, LLC

2. LANE, ALTON & HORST LLCAttorneys and Counselors at LawTwo Miranova Place, Suite 500Columbus, Ohio 43215-5100(614) 228-7052 FAX: (614) 228-0146www.lanealton.com Teri G. Rasmussen Partner and Vice Chair, Business Practice Group Lane, Alton & Horst, LLC trasmussen@lanealton.com (614) 233-4752

3. Teri G. Rasmussen Business Acquisitions and Sales General Corporate and Business Law Joint Ventures and Strategic Alliances Corporate Governance and Shareholder Disputes Contracts and Loan/Lease Documentation Business Formation and Financing Business Planning Creditors’ Rights and Debt Collection Business Bankruptcy and Insolvency UCC and Secured Transactions Commercial Finance Litigation Real Estate

4. Teri G. Rasmussen B.A., with honors, 1981, University of Iowa J.D., cum laude, 1984, University of Michigan Bar Admissions:Supreme Court of Ohio, 1984 U.S. District Court, Southern District of Ohio, 1984 U.S. District Court, Northern District of Ohio, 1993 U. S. Sixth Circuit Court of Appeals, 1997Professional Associations:Columbus Bar Association (Former Chair, Financial Institutions Committee), Ohio State Bar Association (Chair, Banking, Commercial and Bankruptcy Committee) American Bar Association Business Law Section Commercial Law League (CLLA) National Association of Women Business Owners (NAWBO) Executive Women’s Golf Association (EWGA)

5. Teri G. Rasmussen • Special Counsel to the State of Ohio for Wright State University • Special Counsel to Franklin County, Ohio Prosecutor Ron O'Brien • Lead counsel to banks, other secured lenders, and lessors, in structuring, negotiating and documenting scores of commercial loan and lease transactions ranging from hundreds of thousands to tens of millions of dollars, as well as with respect to hundreds of commercial and business collection actions and numerous workout/turnaround situations, ranging from a few thousand dollars to multi-million dollar obligations in asset-based, real estate, line of credit, and all business asset transactions. • Formed numerous limited liability companies and prepared Operating Agreements for businesses ranging from two person family or owner-operated companies to investment vehicles to joint ventures to sophisticated real estate companies.

6. Part I: The Scenario

7. Why Add Shareholders? • Reward Key Employees • Attract Crucial Talent • Compensate for Low Compensation • Raise Equity Capital

8. Understand the Ground Rules • Before bringing anyone into your business, make sure that both parties • Understand the whys for the new ownership opportunity • What it means and what it doesn’t mean • Agree on how you’ll know and what you’ll do if and when it’s over

9. Getting the Right Talent • You are finally ready to commercialize your idea. • Since you don't have a business background, you decide to hire someone else to act as President of the Company. • Because of the start-up nature of the business, your new President demands that she be given stock shares in the new company. • After several years, you find out that the Company's President really isn't very good at finances and decide you'd like to make a change.

10. Rewarding Employees • After your father passed away, the running of the family business has passed to you. • The business has been moderately successful over the years, but now you want to both reward some long-time employees and give greater incentives for performance by giving certain key employees shares of stock in the Company. • While the Company's profits increase substantially initially, eventually you find your employee/shareholders questioning the direction you want to take the Company and why the Company is making your car payments.

11. Easy Money? • Your company needs money, but really isn't bankable at the moment. • Your brother-in-law agrees to put money into the business in exchange for shares of stock. • At first you appreciate his generosity and the business tips he now hands out freely. • However, when you discover he’s cheating on your sister and divorce ensues, you start wondering how you can get rid of the arrogant pain in the neck.

12. Part II: The Danger and the Rule

13. Different Environment, Different Problems • The profitability of a privately owned business is in large part a function of the owners’ and investors’ personal contributions of money, time, and effort. • Ordinary corporate norms such as majority control can lead to serious problems and oppression in the close corporation context.

14. History – Corporate Ownership Power Ironically, the potential for oppression of those with small ownership stakes arose historically out of responses to the problem of oppression by those very people. • At one time, corporate statutes required unanimity for major corporate decisions, thus allowing a small shareholder to extract concessions in exchange for his agreement to a beneficial course of action for the company.

15. Meinhard v. Salmon, 164 N.E. 545 (1928) • Judge Cardozo determined that defendant breached is duty to his business partner by arranging a number of favorable business deals with the landlord concerning adjacent property to the exclusion of the business partner • “The trouble about his conduct is that he excluded his coadventurer from any chance to compete, from any chance to enjoy the opportunity for benefit that had come to him alone by virtue of his agency.” • No answer is it to say that the chance would have been of little value even if seasonably offered.”

16. Meinhard v. Salmon, 164 N.E. 545 (1928) • "joint adventurers, like co partners, owe to one another …. the duty of finest loyalty." • "many forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties." • "Not honesty alone, but the punctillo of an honor the most sensitive, is then the standard of behavior."

17. Equal Opportunity Principle Donahue v. Rodd Electrotype Company, 328 N.E.2d 505 (Mass. 1975) Facts: Majority shareholders/directors of family-controlled decided to cause the Company to redeem the shares held by Harry Rodd, the Company's retiring patriarch. When the Company refused to extend the offer to the survivors of employee-shareholder Joseph Donahue, Donahue's widow sued, seeking either to stop the Company's redemption of Rodd's shares or to compel the purchase of Donahue's share on the same terms.

18. Donahue v. Rodd Electrotype CompanyTale of Two Lives • Harry Rodd and Joseph Donahue both started working for Royal Electrotype Company of New England, Inc. during the Depression in the mid 1930’s, but their work paths within the company were quite different. • Rodd quickly became part of management and ultimately became President to the Company. • Donahue achieved only the position of plant supervisor and never participated in the “management aspect” of the business

19. Donahue v. Rodd Electrotype CompanyThe Road to Majority Ownership • Although both Rodd and Donahue were given the opportunity to buy stock in the Company, Rodd took fuller advantage of the opportunity, buying 200 shares to Donahue’s 50 shares. • In 1955, Rodd loaned the Company money to redeem the 725 shares held by the Company’s parent company and 25 shares held by another minority shareholder. • Rodd mortgaged his house to obtain some of the necessary funds. • This left Rodd with an 80% ownership interest in the Company which was subsequently renamed Rodd Electrotype

20. Donahue v. Rodd Electrotype CompanyThe Fruits of Majority Ownership • During the 1960’s, Rodd’s sons began working for the Company and Rodd gradually began gifting some of his shares to his daughter and two sons. • In 1970 when Rodd was 77, his sons wanted him to retire. • Rodd was not averse to the suggestion, but wanted some financial arrangement to be made with respect to his remaining ownership interest.

21. Donahue v. Rodd Electrotype CompanyCashing Out • The Company agreed to redeem 45 shares, slightly less than half of Rodd’s remaining shares • At a special Board of Directors meeting, Rodd resigned as a director and his son Frederick was elected to replace him. Rodd’s other son Charles and the Company’s attorney were the other two directors. • Rodd then continued with his gifting program with respect to his remaining shares and completed his divestiture of Company stock the following year.

22. Donahue v. Rodd Electrotype CompanyMinority Shareholder Perspective • Approximately nine months after Rodd’s shares had been redeemed and after Rodd had completed his divestiture of his ownership interest in the Company, Donahue’s widow (to whom Donahue’s shares had passed) learned about the transaction for the first time and was unhappy about it. • Donahue’s shares were then offered to the Company which refused to purchase them on the grounds that the Company was not in a financial position to do so.

23. Donahue v. Rodd Electrotype CompanyA rose by any other name….. • Although the Trial Court and the Court of Appeals found nothing wrong with what had transpired, the Massachusetts Supreme Court REVERSED • Because of small number of shareholders and absence of liquid market, close corporation are more like partnerships than publicly traded companies and therefore shareholders owe fiduciary duty to on another

24. Close Corporation = Partnership “Just as in a partnership, the relationship among the stockholders must be one of trust, confidence and absolute loyalty if the enterprise is to succeed…. All participants rely on the fidelity and abilities of those stockholders who hold office. Disloyalty and self-seeking conduct on the part of any stockholder will engender bickering, corporate stalemates, and, perhaps, efforts to achieve dissolution.”

25. Plight of Minority Shareholder “Many minority stockholders will be unwilling or unable to wait for an alteration in majority policy. Typically, the minority stockholder in a close corporation has a substantial percentage of his personal assets invested in the corporation. The stockholder may have anticipated that his salary from his position with the corporation would be his livelihood…. At this point, the true plight of the minority stockholder in a close corporation becomes manifest. He cannot easily reclaim his capital.”

26. Equal Opportunity Principle “The controlling group may not, consistent with its strict duty to the minority, utilize its control of the corporation to obtain special advantages and disproportionate benefit from its share ownership…. We hold that in any case in which the controlling stockholders have exercised their power over the corporation to deny the minority such equal opportunity, the minority shall be entitled to appropriate relief.”

27. Ohio Adoption of Equal Opportunity Principle • Estate of Schroer v. Stamco Supply Inc., 482 N.E.2d 975 ( App. Dist 1984) • Company purchased shares of controlling shareholder matriarch (CEO's Mom) and later those held by CEO’s brother without informing other shareholders. • Minority shareholder found out and her request of the Company to buy her shares in a similar manner • Company refuses to purchase shares from minority shareholder

28. Estate of Schroer v. Stamco Supply Inc. • “Stockholders in a close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise owed by one partner to another, to deal inter sese in the utmost good faith.” Syllabus ¶1 • Fiduciary duty breached by Company refusal to redeem shares of minority shareholder on same terms. Syllabus ¶2

29. “Heightened Fiduciary Duty” Crosby v. Beam, 47 Ohio St. 3d 105, 548 N.E.2d 217 (1989) • Facts: Minority shareholder alleged that majority shareholders improperly expended Company funds to pay unreasonable salaries to themselves and personal expenses • Holding: A "heightened fiduciary duty" exists between shareholders of close corporations. Majority or controlling shareholders breach such fiduciary duty to minority shareholders when control of the close corporation is utilized to prevent the minority from having an equal opportunity in the corporation.

30. “Heightened Fiduciary Duty” = Equal Opportunity Principle “Where majority or controlling shareholders in a close corporation breach their heightened fiduciary duty to minority shareholders by utilizing their majority control of the corporation to their own advantage, without providing minority shareholders with an equal opportunity to benefit, such breach, absent a legitimate business purpose, is actionable." ” - Crosby v. Beam, 1989

31. “Legitimate Business Reasons” • Gigax v. Repka, 83 Ohio App.3d 615, 615 N.E.2d 644 (2d App. Dist Montgomery Cty. 1992) • Facts: Gigax, Repka and Lensch (together with their wives) were shareholders in a close corporation engaged in contracting. Eventually Repka and Lensch became unhappy with Gigax’s job performance and decided that his employment should be terminated. • Repka and Lensch changed the locks, revoked Gigax's check writing privileges and terminated his employment. • It was alleged that Gigax’s “profitability margin had substantially declined, and legal and public relations problems frequently arose out of his jobs.”

32. Gigax v. Repka: Odd Man Out • Gigax denied the allegations and sought injunction preventing termination of his employment. Gigax had been president and vice president of the company at various times and, at the time of his employment termination, was corporate secretary • All three men worked at the Company, but none had an employment contract. • Other two shareholders contended that Gigax was an “at-will employee” terminable at any time by vote of the other two.

33. Gigax v. Repka: “Legitimate Business Reasons” • To determine whether employment termination is acceptable, a court must "balance the need to protect the minority shareholder-employee with the needs of the close corporation in ridding itself of the unproductive or troublesome employee“ • Removal of shareholder in close corporation must be based on "legitimate business reasons".

34. Gigax v. Repka: Firing a Fellow Shareholder Can’t Be Done Without a Reason Removal of shareholder in close corporation must be based on "legitimate business reasons". In this case was not done for legitimate business reasons because • Each shareholder had experienced a decline in profitability at some point since formation of company • Decline in terminated shareholder profitability not necessarily directly attributable to him • Failure to inform terminated shareholder of dissatisfaction

35. Ohio Close Corporation Shareholder Heightened Fiduciary Duty Rule Under Ohio law, owners of small businesses with only a few shareholders, members, or partners have a “heightened fiduciary duty” toward one another. • Applies no matter how small the ownership interest of the minority shareholder is • Means that controlling shareholders DO NOT have ability to run the company in ANY way they see fit • Must have “legitimate business purpose” when taking adverse action toward fellow shareholder

36. Obligation of Controlling Owners “Majority shareholders owe minority shareholders a fiduciary duty, whereby the majority shareholders owe minority shareholders good faith, loyalty, disclosure, and an obligation to refrain from self-dealing. Absent a legitimate business purpose, majority shareholders in a close corporation owe a duty to all minority shareholders not to utilize their majority control to their own advantage without providing minority shareholders with an equal opportunity to benefit” - Mulchin v. ZZZ Anesthesia, Inc., 2006 Ohio 5773, 2006 Ohio App. LEXIS 5757 (6th App. Dist. – Erie Cty)

37. Heightened Fiduciary Duty Rule • Fiduciary duty is greater than obligation of fairness implied in arms-length transactions • Requires one to promote the collective, long term interest of the Company • Forbids promotion of limited personal short term interests

38. What About LLC Members? • Although it is not completely clear in all cases, courts generally apply the “heightened fiduciary duty” to LLCs as well • Some authority exists that fiduciary duty can be reduced or possibly eliminated through an express provision in the LLC Operating Agreement. McConnell v. Hunt Sports Enters,, 724 N.E. 2d 1193, 1215 (App. Dist. 1999) ("a contract may define the scope of fiduciary duties between parties to the contract.")

39. Why Are the Rules Different? • Shareholders in privately held close corporations have a different set of expectations and vulnerabilities than do shareholders of publicly traded companies • All owners are likely to be very involved with the business on a daily basis. Minority owners often expect to draw a salary which is often a defacto dividend. • If the corporation is structured as a Subchapter-S corporation, as many close corporations are, shareholders are obligated to pay taxes on their pro rata share of the Company’s income, even if no dividends are paid out or the shareholder is fired from his job, thereby losing his source of income.

40. Why Are the Rules Different? • Exiting a bad investment in a close corporation isn’t as easy as calling a broker. It may be extremely difficult, if not impossible, for the unhappy shareholder to recoup what in many cases is a personally huge investment. • No readily available market exists for the ownership interests. • There may rights of first refusal or other restrictions on transferability. • Valuation of the ownership interest can sometimes be difficult, especially in “knowledge work” based business with few tangible assets or inventory.

41. Why Are the Rules Different? Voting control gives the controlling shareholders the keys to corporate machinery and a degree of control and influence greater than generally wielded by any one shareholder in publicly traded companies

42. Part III: The Application of the Rule

43. Miller v. McCann,1997 Ohio App. LEXIS 5778 (1st App. Dist.-Hamilton Cty) • Ronald McCann owns 75% of AOS and is Company’s President; Ken Miller owns 25% • McCann’s wife Delores works for AOS at a 1991 salary of $30,000 • From 1992-1995, compensation increases Year Base Bonus 1992 $30,000 $8,000 1993 $30,000 $14,000 1994 $40,000 $25,000 1995 $54,000 $75,000

44. Miller v. McCann • McCann’s daughter Karen worked part-time for AOS during the Summer, but needs additional money for school • AOS pays Karen unearned bonuses of $500-$700 a month totaling $25,000 • McCann doesn’t tell Miller about bonuses and doesn’t offer to provide a similar benefit for Miller’s kids, saying “The payroll records were open to Ken. He could have seen it himself.”

45. Miller v. McCann • “The unearned bonuses to the McCann children are clearly benefits given to the majority shareholder,  McCann, and not shared by the minority. These bonuses present clear evidence of a breach of a fiduciary duty and a preferred dividend. “ • “As for the salary of Delores, there is some evidence that her 1995 compensation consisted of bonuses that she did not earn and that may have been awarded to her by Ronald McCann to reduce the company's profit margin for tax purposes. While there is also evidence that this use of bonuses was a company practice that Kenneth might have benefited from himself, we hold that there was sufficient evidence of record for a jury to consider whether a component of Delores McCann's 1995 salary constituted a preferred dividend.” • “Similarly, we hold that there was sufficient evidence to go to the jury on whether McCann converted the gas grill, the massage chair, and the fencing, although these claims seem trivial in the context of this case.”

46. Obvious Cant’s • Employing family members at unjustified high salaries • Giving family members special perks such as company car, golf membership if they wouldn’t receive in similar position elsewhere • Siphoning off earnings through exorbitant salaries and bonuses • Using Company funds to buy personal items

47. Obvious Cant’s • Cannot compete with company • Cannot usurp its commercial opportunities • Refusal to declare dividends • Refusal to distribute earnings as bonuses or retirement benefits • Removal as director or officer

48. Obvious Cant’s • Similar businesses pay President $300,000 • Company has high profits and can afford to pay as much as $700,000 • OK? • NO, excess profits must be distributed to all shareholders as dividends

49. Problematic Situations • Employment Termination • Involuntary dissolution of corporation • Chilling effect on operational freedom • Restrictions on sale of company

50. Effect on Exit Strategies – “Fair Cash Value” • By statute, minority shareholders in a Ohio corporation have the right to demand the “fair cash value” of their shares upon the sale of the corporation or substantially all of its assets. Ohio Revised Code 1701.85 • This becomes important if the corporation is struggling and the minority shareholder believes the majority stakeholder is selling out for too little.