Preparation and planning is an essential part of sustaining any good business. As Benjamin Franklin famously advised, an ounce of prevention is worth a pound of cure. But in many instances owners may not think about what might happen when a co-owner wants to sell their interests or shares in the business to another person or company. Or maybe an owner unexpectedly passes away, files for bankruptcy, or goes through a divorce. Do you know what would happen to your business and its ownership in one of these situations?
The good news is that these situations do NOT need to disrupt your business or unexpectedly jeopardize its assets, even in closely held businesses where the owners are active participants in the management of the company. With a bit of planning and preparation when things are good, an agreement can be reached among the owners that provides a course of action or roadmap to follow to help your business transition smoothly in these challenging situations while at the same time avoiding costly and time-consuming litigation. By having formal agreement, owners can protect their business and assets, preserve their involvement in the business and affairs of the company, and have a say in who gets to be a fellow co-owner.FN1
Overview of Buy-Sell and Related Agreements
These agreements come in various forms depending on the type of business entity. In a corporation, they are generally called “shareholders’ agreements.” In a partnership, “partnership agreement.” While an LLC has “operating agreements,” and cooperatives have “membership agreements.”
There are also more generic agreements that may be used by owners of various types of businesses, like “buy-sell agreements” and “buy-out agreements.” I’ll refer to these agreements as buy-sell agreements, but any of the just mentioned agreements could be used for the same effect and purposes.
"These agreements... are formal agreements among the owners designed to govern certain situations, like the death, retirement, withdrawals, or other circumstances involving the owners, or the ability of any owner to transfer their ownership in another person.
None of these agreements is strictly required to form or operate any particular type of business entity, which is why too often business owners do not have a written buy-sell or other such agreement in place. But that does not mean that these agreements are unimportant.
What these agreements all have in common is that they are formal agreements among the owners designed to govern certain situations, like the death, retirement, withdrawals, or other circumstances involving the owners, or the ability of any owner to transfer their ownership in another person. It is often also a good idea to have the company itself as a party to these agreements and maybe any spouses of the owners as well (since both the company and any spouse may have their rights and obligations affected by the terms of the agreement).
For example, a buy-sell agreement may require the company to purchase the ownership interest of any owner upon their death to avoid a situation where the other owners end up sharing their business with the deceased owner’s spouse, heirs, or devisees. Or, in situations of deadlock or prolonged disagreement, an owner may be permitted to make a buy-out offer to another owner, who may be forced to choose either to accept the offer or buy the offering owner’s interests or shares. Or, more generally, an owner may be required to permit the company or other owners to buy their interests or shares before selling or transferring them to any third party.
These agreements can be tailored to address a variety of situations, including (1) the transfer (whether voluntary or involuntary) of ownership interests or shares in the company, (2) exits or withdrawals of owners and what rights they have related to repayment of capital, (3) the retirement of any owner and their rights and obligations in those circumstances, (4) the insolvency or bankruptcy of any owner and what will happen to their interests or shares in the company upon such event, (5) the termination of the employment of someone who is also an owner, and (6) any deadlock or dispute among the owners and how it should be resolved.
These situations are commonly referred to as “triggering events” and the situations that constitute triggering events in any buy-sell agreement need to be carefully considered and defined. But it is just as important to thoughtfully describe and prescribe the procedure, process, and timelines that are kicked off by any triggering event. Furthermore, owners should think through, perhaps with the guidance and advice of a professional, how their ownership interests or shares in the company should be and will be valued and whether any discounts to this valuation should be made due to the lack of marketability of any interest or share, or the lack of control in the company that a minority owner possesses.FN2
Ownership Rights and Agreement Provisions
Buy-sell and related agreements help owners keep control by prescribing the rights and obligations of the owners. An experienced attorney has various potential tools in the toolbox here to help, the most common options include:
Rights of First Refusal, Cross-Purchase Rights, or Redemption Rights;FN3
Management or Employment Rights;FN10
Dividend, Distribution, or other Compensation Rights;FN11 and
Dispute Resolution Provisions;FN12
These are just some options and even these will need to be drafted carefully to ensure that owners have a clear roadmap so as to avoid needless disputes. For example, if the company or owners are exercising their refusal rights, will they have to purchase all of the offering owner’s interests or shares, or can they exercise their rights to purchase only a portion of those interests or shares? Or, if an owner’s interest or share in the company is to be purchased or liquidated upon their death or bankruptcy, should repayment be permitted over a certain period of time and should insurance be required cover the cost of repayment?
Of course, there are different kinds of closely held businesses, and the sort of entity that the business was organized as will dictate the options available to its owners. And some entities have more flexibility than others. For example, in a corporation, the economic and inspection rights of shareholders are necessarily tied together through ownership of shares or stock. And for voting stock or shares, those voting rights are necessarily connected as well. But in an LLC, economic rights are by default separated from voting and inspection rights, giving LLC owners (members) considerably more flexibility. If a third party ends up with only economic rights, the need for the company to purchase or liquidate the interests or shares may be considerably reduced.
Moreover, in an LLC, at least in Colorado, a certain supermajority percentage of owners may, according to the reasonable terms of a formal agreement, expel another owner and this expulsion may be with or without cause, depending on the terms of the agreement. Of course, no member wishes to be subject to the possibility of expulsion, but when properly drafted, such provisions give members significant control over ownership by giving them, by some agreed upon majority or supermajority, the right or authority to terminate the membership of persons who only have become members by operation of law, who have become disruptive to the business, or who intentionally violate the terms of governing agreements.
Finally, it is important to consider how a buy-sell or related agreement can be amended. In general, amendment of the agreement should not be easier to achieve than compliance with the stricter provisions of the agreement. Otherwise amendment could become an easy way of avoiding such provisions at precisely the time they are most needed.
Thinking through possible scenarios and thoughtfully determining fair procedures and processes are not trivial tasks and having formal agreement is not a magic bullet. Each business and its owners will have different needs, desires, and expectations. But when buy-sell and related agreements are prepared correctly, they can provide a smooth transition in ownership, properly compensate any departing owner, and limit potential new owners to those whom the current owners want to work with as future co-owners.
Drafting a buy-sell or related agreement can raise some thorny issues, but an experienced attorney may be able to help. If you need assistance with drafting, reviewing, or revising a buy-sell or similar agreement, please Reach out, Today!
This article provides only general information and is not intended to be a substitute for legal advice.