When I was a very young lawyer, I handled two divorce actions for a aunt and niece. I decided after that I was not cut out for domestic disputes. However, I have spent time over my career dealing with another and almost as messy type of divorce, the business divorce. When two or three people get together to form a Start-Up of any sort there is nothing but good will between the parties. Unfortunately, even if the business is successful, and particularly if it is not, those same “friends” can turn into very ugly “enemies” very quickly leading to disputes and even litigation as to who owns what and the future of the business. This post will deal with a typical situation of a closely-held business and give some general thoughts on how to avoid certain of these dispute by doing some careful planning at the beginning of the life of the business. As always these posts are not meant to be legal advice, but just an overview of some common problems.Always consult your own lawyer or accountant before taking any action effecting your business.
PREPARE A PLAN BEFORE FORMING THE ENTITY
Before you form the partnership or corporation or limited liability company, the most important first step is to prepare a plan of action that is approved by all of the potential owners. If the idea is to run a certain type of business, the potential owners should agree on the general parameters of the business plan, Also the plan should provide for the percentage of ownership that each participant will get, the general responsibilities of each owner, the investment in terms of dollars or other assets whether tangible or intangible (such a patents) that each potential owner is agreeing to contribute to the new business, and if there are passive “investors” what will be the rights of the passive “investor” to the business . Having such an outline and sticking to it will avoid a lot of issues later when things get unsettled and people “forget” what they had agreed to originally.
CLARIFY THE RIGHTS AND RESPONSIBILITIES FINANCIALLY OF EACH OWNER INVOLVED IN THE BUSINESS
In addition to the original investment, an agreement in writing as to any future required investment in the company by each the owners should be clearly set out in the original outline prepared before forming the business. Also it is common in Start-Up businesses to provide that ownership in the business will “vest” over time. That is that percentage of ownership may increase over a period of time to make sure that an owner does not withdraw from active participation in the business before the business reaches a certain stage of development. This can be crucial if the business is in a development phase for a period of time.
MAKE SURE YOU AGREE AS TO THE CHAIN OF COMMAND
If possible the outline of the plan for the new business should try and clarify the responsibility of each of the owners or elected officers. It should be clear which management decisions can be undertake with or without consent from the owners. Make sure that if the business is a corporation or other registered entity that the business’ attorney reviews the laws of the state of formation to determine what decisions are required by law by owners as opposed to management.
CHOOSING THE FORM OF ENTITY
This is the subject of an entire post, but the State that a business chooses and the form of entity the business chooses will be governed by cost, tax consequences, future plans for investors and a host of other considerations. These consideration are important and should involve the potential owners consulting with their accountant and attorney to make sure each of the potential owners understand the implications of each form of business entity. This post will not deal with these considerations, but it will be the subject of a future post.
WHAT EVER FORM THE BUSINESS CHOOSES MAKE SURE THE ORIGINAL PLAN IS REFLECTED IN THE FORMATION DOCUMENTS
Coming up with a great plan setting out all of the elements discussed in this post is great, but make sure that each of these agreements is reflected in the documents forming the new business entity. Before the formation documents are filed with the Secretary of State of the state the business has chosen, make sure that the business’ attorney has reflected, to extent permitted under the applicable law, the agreement among the owners forming the business. The business’ attorney can clarify which agreements can be reflected or should be reflected in documents filed with the State and which should be reflected in other documents forming the business.
THE IMPORTANCE OF A BUY-SELL AGREEMENT OR SIMILAR METHOD OF CASHING OUT OWNERS
Where ever it is contained, either in an operating agreement for an LLC, a buy-sell agreement among shareholders or a partnership agreement, it is crucial that the rules by which an owner can be bought out or is required to sell the owner’s ownership interest either to the business or the other owners is set out in writing at the time the business if formed. Particularly, where ownership vests in each owner over time, if one of the owners decides to abandon the business, it is extremely important that the other owners understand what it will cost to repurchase that owners ownership interest and whether the departing owner can be required to sell such owner’s ownership interest. Also don’t forget about other instances that might make purchase of a ownership interest important–the divorce of an owner–the bankruptcy of an owner–the death of an owner. Some of these eventualities, such as death, should be covered by insurance policies, but many cannot.
The crucial elements of any agreement concerning the required sale or repurchase of an owner’s ownership interest are: (i) what event or events trigger the right to repurchase the ownership interest, (ii) how the ownership interest is determined if there is vesting over time, (iii) how the price of the ownership interest is determined, (iv) can the business or any of the owners purchase the ownership interest of the departing owners, and (v) what is the requirement to make payment for the ownership interest purchased, and can that payment be made over time rather than in cash.
Traditionally, the major triggering event in any agreement by owners to purchase the interest of another owner is the death of that owner. This usually involved an agreement with a set price for the interest to be purchased on death or a valuation method that could involve a variety of professionals. The departed owner’s interest would be purchased using life insurance proceeds on the life of the departed owner and the purchase would be by the business. This could be varied to provide for a right of the other owners to purchase or even a right to allow the estate of the deceased owner to distribute the owners interest in the business to individuals set out in the deceased owners will. The funding of such a purchase by insurance was important to avoid having to burden the business with the payment of the deceased owners equity interest to the owners estate. While death is still an important trigger, other transfers whether voluntary or involuntary may threaten the tax status of the business or the management of the business and generally will trigger the requirement that the owner, whose ownership interest is subject to such transfer, will be required to sell that owner’s ownership interest to the business or the other owners. The four most obvious triggering events are (i) bankruptcy of the owner, (ii) divorce of the owner, (iii) seizure of the owner’s interest by a creditor (either through a court or by the owner granting a security interest to a lender) and (iv) voluntary sale by the owner of the owner’s ownership interest.
Determining Extent of Ownership
It is crucial that any agreement by which an owner gains additional ownership interest either through a vesting schedule or exercise of a right to purchase additional ownership interest be very clear. The business formation documents need to make clear how each owner’s ownership interest is calculated upon the occurrence of each triggering event. The problem in many vesting situations is that a triggering event could be the departure of the owner from the active management of the business. Defining that event is much more difficult. This can be tied to actively coming to work, participating in a specific type of project, number of hours during the week the owner makes available to the business etc. There is no absolutely satisfactory way to define a departure (other than a voluntary departure), so the other owners have to understand the frailty of any definition they choose for a departure date. Unfortunately, the most difficult type of departure is one triggered by the other owners. This may involve an employment agreement with an owner that sets out the grounds for the business forcing the owners departure and the method of repurchasing the owners interest. This becomes a particularly thorny problem with a generous group of owners who give small amounts of ownership to employees and then have to subsequently fire that employee. Courts tend to protect the interest of minority owners and the grant of a small ownership interest to an employee without a method of repurchasing that interest can make management of business in the future very difficult.
Pricing Ownership Interest
There are a number of traditional methods to price the ownership interest of an owner being bought out after a triggering event. Since we are discussing smaller closely-held business, where there is no public market for the ownership interest, each of these methods rely on setting prices through mechanisms that have advantages and disadvantages. It was common in buy-sell agreements for the owners to agree to a set price for the ownership interest based on shares or membership interest or percentage of partnership, with a provision that that value would be reviewed periodically. The problem was that agreements were signed and the revaluation was promptly forgotten. This leads inevitably to disputes upon a triggering event over the failure to revalue, either up or down, and may involve the courts to set such value, override a clause that has not been observed or even liquidate the company in order to determine the value of each owners interest. To avoid that kind of mess, most buy-sells or other agreements requiring or allowing the purchase of ownership interest upon a triggering event rely on a formula or the use of professionals to determine the value at the time of the triggering event. This valuation mechanism can be something as simple as a multiple of earnings. It is common, however, to provide that buyer and seller of the an ownership interest engage, at their expense, a valuation expert and if the two experts do not agree then a third expert is engaged and that experts valuation is binding. None of these methods is without some controversy, but it is much better to have a mechanism in place , no matter how flawed, then leave it to the courts.
Who can Purchase the Ownership Interest
While it may be contentious, it is important that the buy-sell or other governing document make it clear whether the business and/or the other owners have the right to purchase the departing owners interest upon a triggering event. It would not be uncommon to provide for a different answer to the right to repurchase depending on the triggering event. In the case of death, it would traditionally be the business itself that would carry the life insurance policy on the deceased owner and would repurchase the ownership interest. In the case of other triggering events, because of the burden on the business to repurchase the interest, the individual owners may have an option or right to purchase the departing owners interest. The problem is that if there are multiple owners, an owner purchasing a departing owners interest would automatically increase that owner’s ownership interest and that may or may not be acceptable to the other owners. This issue must be discussed and properly reflected in the initial documents to avoid disputes.
Paying for the Ownership Interest
If the triggering event is death, then most businesses will have purchased life insurance to cover this eventuality. The problem is the other triggering events that cannot be covered by insurance, though I am certain a clever insurance agent may have products for some of them. If the buy-sell or other agreement provides for the mandatory repurchase of the ownership interest upon a triggering event, and if the valuation methodology is not litigated, then the initial decision is how to pay out the required payment. Whether the purchaser is the business or any of the other owners.It would not be uncommon to have the departing owner agree to take a note from the business or the other owner purchasing the ownership interest to be paid over a period of time with an interest factor. Sometimes that note is secured by a continuing lien on the ownership interest being sold in favor of the departing owner, but that may not be advisable if the triggering event is bankruptcy or divorce and the aim is to keep ownership within the remaining ownership group. A payment over time usually involves an up front payment in addition to the payment over time. While a triggering event may not be foreseeable, it is always prudent that the business understand the impact on the business if there is a triggering event and the ability of the business to meet its responsibility to make payment to the departing owner or the owner’s creditor, bankruptcy trustee or even spouse. If the business or the other owners cannot meet the burden of paying the departing owner, a court may force the business to accept a new owner or even liquidate the business so as to preserve the value of the departing owner’s ownership interest.
NOTHING IS PERFECT, BUT PLANNING AT THE BEGINNING CAN HELP AVOID A DISPUTE
Every decision that is made at the time of formation from require investment to vesting rights to triggering events for sale of ownership interest to method of payment to who can purchase is difficult and may be contentious, but if those decisions are made early and properly documented, they can make a big difference between plunging the business into litigation or handling difficult situation in accordance with an agreed method that preserve the business.
AS ALWAYS EACH POST IS AN ATTEMPT TO GIVE SOME GENERAL THOUGHTS ON THE SUBJECT COVERED. THESE POSTS MAY BE CONSIDERED LEGAL ADVERTISING.MOST IMPORTANTLY MAKE SURE THAT YOU CONSULT WITH YOUR OWN ACCOUNT AND ATTORNEY BEFORE TAKING ANY OF THE STEPS DISCUSSED IN THIS POST.