Oct. 1, 2020 • by Jeffrey Pote

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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.”

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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.

Triggering Events

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:

  1. Rights of First Refusal, Cross-Purchase Rights, or Redemption Rights;FN3

  2. Buy-Out Rights;FN4

  3. Pre-Emptive Rights;FN5

  4. Drag-Along Rights;FN6

  5. Tag-Along Rights;FN7

  6. Put Rights;FN8

  7. Call Rights;FN9

  8. Management or Employment Rights;FN10

  9. Dividend, Distribution, or other Compensation Rights;FN11 and

  10. Dispute Resolution Provisions;FN12

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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.

Click Here to Toggle End Notes:

FN1: Of course, what it means to “preserve” or “maintain” control will be different if you are in a majority as opposed to minority ownership position. For a majority owner, keeping control will have to do with the ability to direct the business and determine courses of conduct. But for a minority owner, it may have to do more with holding onto an agreed upon position in management (e.g. being an officer or electing a director) or maintaining a certain share of company profits.

FN2: How to handle the valuation of shares or interests is not a matter to be neglected. Owners would be wise to consider whether to use a set value, formula, or an outside appraiser to determine the value of the company and its ownership interests. Each of these options involves various tradeoffs and, generally, the easier the option (e.g. set value) the more likely that the outcome will involve regrettable tax consequences or disappointed owners. Along these lines, owners may want to consider not simply how to handle valuation, but how to finance any payouts (and whether insurance is an appropriate financing solution). Discounts to the valuation may also be appropriate to reflect the fact that (1) ownership interests in non-publicly traded companies lack marketability or (2) a particular owner’s interest or share in the company is a noncontrolling or minority interest.

FN3: Rights of First Refusal, Cross-Purchase Rights, and Redemption Rights permit the company, the other owners, or both to purchase an offering owner’s interests or shares before permitting their sale to a third-party.

FN4: Buy-Out Rights permit an owner to make an offer to usually only a single other co-owner, but sometimes more, to purchase all of their interests or shares in the company and then requires the co-owner(s) to decide whether to buy or sell at the offered price.

FN5: Pre-Emptive Rights permit owners, when new units or shares in the company are first issued, to purchase enough of those new units or shares so as to maintain their relative share or proportion of ownership in the company – in other words, to prevent their share of ownership in the company from being diluted by the issuance of new units or shares.

FN6: Drag-Along Rights permit a majority owner to force minority owners to sell their interests or shares in the company to a third party upon a permitted sale by the majority owner.

FN7: Tag-Along Rights permit minority owners to have their interests or shares in the company purchased by any third party who purchases the interests or shares of a majority owner.

FN8: Put Rights permit owners to require the company to purchase their interests or shares at a guaranteed minimum price, which may reflect a discount from their fair market value.

FN9: Call Rights permit the company to require owners to sell their interests or shares back to the company at a guaranteed price, which generally reflects a premium on their fair market value.

FN10: Management or Employment Rights grant the right owners to hold or maintain various agreed upon directorship, management, or employment positions in the company, such has having a seat on the board of a corporation or cooperative, or being an officer of the company. In any such agreement, the terms of the compensation are as important as the term of the agreement.

FN11: Dividend, Distribution, or other Compensation Rights requires the company to issue dividends, make distributions, or provide other compensation at such times and in such amounts as determined by the agreement of the owners. In general, salaries or other compensation related to employment of owners in the company can be advantageous from a tax perspective as well as owners who are employees in the business, while non-employee owners usually benefit from dividends and distributions instead of employment-related compensation.

FN12: Dispute Resolution Provisions permit or require owners and the company to utilize various agreed upon methods of resolving or adjudicating deadlocks or disputes among the owners or between the company and any owner. Owners may wish to consider whether to permit or require arbitration or to require owners to comply with the terms of the agreement or to simply allow monetary compensation for any breach.

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