Forcing Minority Shareholders Out:

Freeze Outs, Squeeze Outs, and Shareholder Dilution

Authored by Bryan Springmeyer Bryan Springmeyer is a California corporate attorney who represents startup companies. The information on this page should not be construed as legal advice.

I’ve noticed that a lot of the search terms that land people on the venture capital anti-dilution page are probably people who are interested in learning about minority shareholder dilution, so I’ve written this article to discuss that issue along with other corporate transactions that can hurt minority shareholders.

I’m often approached by founders of a corporation or other shareholders receiving a minority interest in a company that are concerned about their interest in the corporation diluting. Any shareholder of a venture scale company should hope for dilution in the form of investment transactions that increase the value of the shareholder’s interest, even though they are technically being diluted. However, dilution which does not bring proportional increases in value to the company may be concerning. Additionally, transactions that force or coerce shareholder buyouts are undesirable.

Most startup attorneys will execute stock restriction agreements for co-founders and employees of the startup that give them time vesting stock grants.  These agreements give management a good deal of latitude to terminate a founder/employee’s vesting without receiving too much equity. If, however, there were no restrictions on the stock granted, or a founder departs with more stock than other founders feel they are entitled to, ill intentioned majority stockholders and board members may decide to engage in one of the transactions mentioned below.

Dilutive Financing

A dilutive financing is a sale of equity at a price lower than the previous valuation of the company.  Sometimes this happens because the company lost value and must raise money at a decreased valuation.  Other times, this can be motivated to dilute a shareholder’s interest.

In dilutive financings, courts have looked at:

• Whether there was a need for the financing
• Whether this was an “inside down round” meaning that the directors or majority shareholders stood to gain from the round by the dilutive effect or their own participation in the equity purchase

A financing or stock issue can be unfairly dilutive even without a valuation of the company.

These transactions and others may also be reviewed for the decision of the Board of Directors. Typically, courts afford a good deal of discretion to corporate directors and officers, which is referred to doctrinally as the Business Judgment Rule.  However, if the minority shareholder plaintiff can show satisfactorily to the court that something is amiss and/or that there were conflicts of interest by the directors, the court will scrutinize the transaction and the directors will have to prove "entire fairness," which requires a showing that the minority shareholders received a fair price and were treated fairly procedurally.

Freeze Out Mergers

Freeze-out mergers, also referred to as Squeeze-Outs, (as defined by me in this context) are corporate transactions whereby two entities are merged into a single entity, which may be one of the preexisting entities or a newly formed entity, whereby the minority shareholder is forced to sell their stock for a cash buyout as part of the transaction.

a. Short-form Merger

Delaware statutorily provides a mechanism for mergers where a parent corporation owning 90% or more of each class of stock in a subsidiary may merge with the entity and force the minority shareholders out for a fair value cash buyout. See DEL. CODE ANN. tit. 8, § 253(a). Delaware courts have determined that under this a §253 merger, commonly referred to as a short-form merger, a minority shareholder’s only recourse, absent fraud or illegality, is appraisal (determination of the fair value for the cash buyout). Glassman v. Unocal Exploration Corp., 777 A.2d 242, 243 (Del. 2001).

California also has statutory provisions for short-form mergers, Cal. Corp Code §1110, though the scope of fiduciary duties owed to minority shareholders in California short-form mergers has not been defined.

b. Long-form Merger

For companies incorporated in states that do not have a statute like §253, or in Delaware mergers using other statutory provisions ("long-form mergers") where majority shareholders have the voting power to approve freeze-out mergers which are statutorily recognized, minority shareholders find their protection from the fiduciary duty that majority shareholders (as shareholders, not directors) owe the minority shareholders. See e.g., Jones v. H.F. Ahmanson & Company (1969) 1 Cal.3d 93 (for California corporations); Singer v. Magnavox Co., 380 A.2d 969 (Del. 1977) (for Delaware).

In long-form freeze-out mergers, various state courts have looked at the following factors to determine that majority shareholders breached their fiduciary duty:

• Common majority shareholders pre and post transaction
• Common directors pre and post transaction
• The majority is permitted continued participation in the equity of the surviving corporation while the minority has no choice but to surrender their shares for cash
• Freeze-out of minority stockholders on a cash-out basis is the sole purpose of the merger or, conversely stated, there was no independent purpose of the merger.
• Price paid for the minority shareholder’s shares
• Procedural fairness of the transaction, such as its timing, initiation, structure, financing, development, disclosure to the independent directors and shareholders, and how the necessary approvals were obtained

As a rule of thumb, long-form mergers which have an independent, legitimate business reason that have a consequential, but fair impact on minority shareholders will likely survive scrutiny, whereas transactions engaged in for the purposes of forcing a minority shareholder out or otherwise adversely impacting their ownership rights will likely subject the majority shareholder to liability and/or invalidate the transaction.

From a financial and practical standpoint, a freeze out merger may be an unappealing transaction for most funded startups. First, the transaction invites litigation (appraisal litigation if short-form), which increases the transaction costs and complicates impending investment deals. Second, the company must come up with the cash to buy the minority stockholder out. Appraisal litigation considers previous valuations as well as potential fundraisings or other circumstances which would increase the value of the company. Having to liquidate a stockholder before an exit will be burdensome if not impossible, and likely to trigger the rights of investors who do not want their funds used to liquidate a stockholder.

For startups that have no funding and/or have defensibly small valuations, the threat of litigation (at present) and cost to buy out the stockholder are both lower.

Co-sale rights and a founder class of stock make a freezeout more difficult to accomplish.

Related Pages:

Founder Dilution
Dissenter's Rights in California LLCs
Anti-Dilution in Venture Capital Transactions
The Dilution Monster