How to Freeze Out a Minority Shareholder

Company owners who bring in outside investors or business partners may come to rue their decision. Owners and investors may differ strongly on the company’s strategic direction, personnel recruitment or dividend distributions. Primary owners, as the majority shareholder, typically have a couple of options to divorce the company from its minority shareholders, those individuals or entities that own less than 50% of a company’s outstanding shares. Engineering a freeze out is one tactic. A freeze-out is a strategic merger that rids a company of undesired minority shareholders.

Step 1

Form a new company or identify a friendly company to merge with. As the majority owners, you form a brand new company, XYZ, Inc. which you wholly own. Alternatively, you can locate a small company in the same industry that you would like to buy out.

Step 2

Swap your shares in your current company, Old Co., Inc., for 100% of the stock of XYZ, Inc. Hence, you and the other shareholder that comprise your company’s majority shareholders become XYZ, Inc.’s only owners. XYZ., Inc. becomes Old Co., Inc.’s majority owner.

Step 3

Create a merger plan and have your shareholder majority approve it. Structure the merger plan to ensure the minority shareholder of Old Co., Inc. will receive cash for those shares. If XYZ, Inc. owns less than 90% of Old Co., Inc., then the shareholders and board of directors of both companies must approve the merger. This is called a “long-form” merger. Refer to the company’s Shareholders Agreement, Corporate By-Laws or resolutions to determine if a majority or supermajority is required for merger approval. If the Shareholder’s Agreement or other documents do not explicitly state which, most states require that a simple shareholder majority approve a merger.

Finalize the merger by completing all the legal paperwork, then with a handshake.

Step 4

As the majority shareholders of XYZ, Inc., you complete the legal paperwork to merge Old Co., Inc. with XYZ, Inc. to either create a brand new company, LMN, Inc. or fully absorb Old Co., Inc. into XYZ, Inc. The legal paperwork typically includes filing a certificate of merger with the Secretary of State and publishing a legal notice of merger in a legal newspaper.

Step 5

Pay cash to your minority shareholder to purchase all her outstanding shares. Rarely will a minority shareholder contest the offering price. If she does, then the only recourse, assuming no fraud, is for her to request an outside appraisal of the company.

Tips

If you and your other majority shareholders own 90% of the company, the merger is considered a “short-form merger” and does not require shareholder approval. Thus you can skip step 4 and proceed directly step 5.

If you think your minority shareholder would contest the merger, then obtain an outside appraisal by a reputable firm before you proceed with any other step. Base your merger price on that valuation.

Warnings

The minority shareholder will not be able to prevent or stop the merger unless your corporate documentation – Shareholder’s Agreement, Corporate ByLaws, Articles of Incorporation, board resolutions or meeting minutes – state otherwise. Therefore, carefully review your corporate documents at the outset to make sure they contain no such language. If they do, then properly amend them before proceeding.

Since the merger is a stock merger, there will be no tax consequences to the majority shareholders. However, the minority shareholder who receives cash for her stock will have the tax consequences of a stock sale.