Supermajority Voting Rights and Affiliation Issues By Antonio R. Franco Small business owners often look for “angel” investors to help capitalize their businesses. In turn, these angels normally want equity for their investments. They also seek to have some say in how the company is run to protect their interests. Faced with capital needs, small business owners often not only give these minority owners substantial equity but also provide them with supermajority voting rights for certain actions that require the owners’ consent. This poses a dilemma for many small business owners for whom the size of the concern is an eligibility criterion to compete on small business set asides. The Small Business Administration may find an affiliation between such concerns and their minority shareholders (or their affiliated businesses) if supermajority voting rights provide minority shareholders with negative control. Fortunately, in a recent decision, the SBA Office of Hearings and Appeals has established clearer parameters as to how much control a minority owner may have over a small business without triggering an affiliation. The case, EA Engineering, Science and Technology, Inc., SBA No SIZ-4973 (2008), arose after a contract that was set aside for small business was awarded to EA. EA’s size was thereafter protested by a competitor which alleged, among other things, that the Lewis Berger Group, Inc. (“LBG”), a large business with a 49% interest in EA, exercised negative control over the firm. Based in part upon the stockholder’s agreement between EA and LBG, the SBA’s Size Office found EA to be affiliated with LBG. This led to EA’s appeal to OHA. In reversing the adverse size determination, the Office of Hearings and Appeals reviewed, among other things, the stockholder’s agreement which contained supermajority voting rights for: (i) amending, repealing or changing the articles of incorporation or bylaws of EA; (ii) issuing additional shares of stock of EA; and (iii) entering into any business substantially different from that engaged in by EA. OHA also considered the SBA’s affiliation regulations which provide that “[n]egative control includes, but is not limited to, instances, where a minority shareholder has the ability, under the concern’s charter, bylaws, or shareholder’s agreement to prevent a quorum or otherwise block an action by the board of directors or shareholders.” See 13 C.F.R. § 121.103(a)(3). Finding nothing in the shareholder’s agreement that gave LBG the power to prevent a quorum or to block ordinary actions by the board or shareholders, OHA ruled in EA’s favor. OHA also found significant that the supermajority voting rights did not affect how the company was managed and controlled on a day-to-day basis by the majority owner. Thus, according to OHA, LBG could not exercise negative control over EA. Among the most significant holdings in the case was OHA’s refusal to create a de facto prohibition on supermajority voting requirements. According to OHA, such a prohibition would create a chilling effect on a small business concern’s access to capital. With no way to protect their investments, investors would steer away from promising firms in need of venture capital. For small business owners, this ruling not only provides significant guidance on how to structure future transactions with potential investors, it also provides a negotiating tool. If potential investors understand the risk they may be assuming if they insist on substantial control over the company, they may temper their demands when acquiring an interest in a small business. OHA clearly expects the majority small business owners to exercise day-to-day control and management of their firms. Only extraordinary corporate actions, such as the sale of an interest to third parties or changes to governing documents, may be subject to the veto power of the minority owners. OHA’s clarification of the limited rights minority shareholders may exercise over small businesses without triggering affiliation may dissuade some companies from investing in small businesses. For those large businesses still seeking to invest in a small business concern with set aside contracts, OHA’s guidance on supermajority voting rights should mitigate the risks of such transactions. Tony Franco is a partner with PilieroMazza PLLC. Mr. Franco oversees the Government Contracts/Small Business Group. His practice includes all aspects of federal government contracting and administration. He has represented clients before government agencies, and federal and state courts, including the Court of Claims, General Accountability Office, and Board of Contract Appeals.