A PRIVATE COMPANY PROXY CONTEST??
Public Company Changes in Control
An outsider (or insider) who wants to take control of a public company may buy up its ownership interests, which are purchasable in the open market, by private acquisitions, or through tender offers. Or the acquirer may instead try to take control of the public company by winning a proxy fight. One method focuses on first acquiring economic control, which then results in managerial control; the other method reverses the procedure.
Private Company Changes in Control Effected by Outside Events and Conditions
On the other hand, managers/owners of a private company often consider themselves relatively invulnerable to uninvited changes in control. Only "relatively," because they recognize that the impersonal marketplace/economy may trigger involuntary changes in control. For example, impersonal and general economic conditions, such as more competitive market conditions or economic downturns, may eventually force a private company to close its doors, to seek or to be forced into bankruptcy, or to sell out to a more successful competitor. Personal injuries on the company's premises, a thieving cashier, or a casualty loss — that is, not impersonal or general economic conditions, but adverse events or circumstances affecting that company specifically but not others in the same line of business or in the same geographic region -- may lead to the same or similar results.
Some of those and many other risks can be guarded against or at least ameliorated, either by careful management practices or third party insurance.
What both categories of risk have in common is that, by and large, they originate from outside of the company's governance and ownership structure (assuming minimum competency and integrity of the management team).
Private Company Protections Against Changes in Control Triggered by Shifts in Ownership or Changes in Management Composition
But what if control of the company were at risk from within?
Many founders of private companies engage good legal and accounting advisors, and follow their counsel, to build a stable, compliant structure for the business. Among other things, they select a suitable legal structure (corporation, limited partnership or limited liability company, for example) and require the managers/directors and owners to enter into appropriate internal governance agreements (shareholders agreement, limited partnership agreement, or company agreement, for example).
The founders are absolutely right to follow the advice of their attorneys when it comes to insisting that all owners and managers/directors execute appropriate internal governance instruments. In another blog, I may discuss some of the consequences that ensue if a privately held company's owners and managers fail to enter into such contracts. For now, I will just observe that if the owners and managers omit to agree upon how the company is to be funded, how profits and losses are to be allocated, how cash is to be distributed, how the entity is to be managed, whether and how an owner may transfer his ownership interest, and when the company is to be dissolved and terminated, then the law will supply the answers to fill that vacuum. Few founders, managers/directors and owners will be likely to find the law's default provisions on those topics satisfactory in all circumstances.
Any well drafted shareholders agreement, partnership (and limited partnership) agreement, or company agreement will address the two matters that open this blog: change of ownership and change of management control.
For a private company, changes in ownership can have fatal consequences. After all, the owners of a private company usually want exactly that — "privacy" in their affairs. The precondition for privacy is to exclude everyone from the ownership group except the small circle of original owners, which means their mutual agreement not to transfer their ownership interests to outsiders. Narrowly drafted exceptions to the transferability prohibition are usually admitted in order to permit intrafamily transfers and transfers for estate planning purposes. And because an absolute prohibition against alienation of personal property is not permitted by law, the agreement's transfer restriction provisions should make the restrictions conditional instead of absolute. An example of a conditional restriction is one that bars an owner (shareholder/partner/member) from selling his interest (shares/partnership interest/membership interest) to any person that is not already an owner of the entity, without first offering to sell the same interest on the same financial terms to the entity or to all of the other owners; a requirement like that means the company's ownership will remain in the hands of the original owners (minus one).
Similarly, a change in managerial control can have devastating effects on a private company. That is why the shareholders agreement/partnership agreement/company agreement usually designates the specific individuals to serve as (or to be elected or appointed) the initial directors/managers. (In the case of a limited partnership agreement, the general partner must be the manager, while the limited partners in general must not have managerial authority over the entity; even in this situation, where the general partner is itself an entity and not an individual, the limited partnership agreement often includes covenants or conditions that specific individuals must at all times be the managers of the general partner.) Those agreements usually address the possibility of future changes in the composition of management, whether due to resignation, removal from office or other reason, by establishing a methodology by which the circle of original owners will control the selection of managerial successors.
Comparing the observation made at the beginning of this blog about how changes in control may be effected in public companies by means of purchasing ownership control (by purchasing existing ownership interests) or by exercising voting control over the selection of management, it would at first appear that private companies governed by properly prepared governing agreements would simply not be vulnerable to similar uninvited changes in control.
But in the next part of this blog, I will point out a potential gap in the private company's fence.