Powered for Business Success
PLDO’s “Powered for Business Success” series of essays, prepared by our team of experienced business lawyers, provides information and practical tips to help entrepreneurs and business owners survive and thrive in today’s business environment. If you would like to learn more about any of the topics covered below or have questions about other business matters, contact Managing Principal Gary R. Pannone at 401-824-5100 or email [email protected].
BE PREPARED WITH A BUYOUT PROVISION IN YOUR BUSINESS AGREEMENT
It is not unusual for disputes to arise upon the death of a business owner, and if one of the owners is involved in a divorce it could create a strain on the business enterprise. The owners may avoid the issues that could otherwise exist by including a buyout provision in the agreement for each event.
If an owner dies without the appropriate mechanism in a written document, his interest would normally pass to the beneficiaries of his estate. Whomever receives the interest from the owner’s estate could take any one of the following positions: (i) retain the interest and become involved in company’s business affairs; (ii) retain the interest but remain uninvolved in the business; (iii) transfer the interest to a third party. Any one of the above courses of action will undoubtedly create issues for the remaining owners. It is likely that the remaining owners will not want to be co-owners with the spouse or child of a deceased owner since he or she may not have the skills, knowledge or desire necessary to become actively involved in the business, or the parties may lack the necessary personal compatibility.
From a financial perspective, a closely-held business generally does not pay dividends and, therefore, an individual holding onto a deceased owner’s interest will not usually receive any regular income stream from the investment, which could create pressures on the remaining owners that are not in the best interest of the enterprise.
If the beneficiary desires to sell the deceased owner’s interest and keep the proceeds, there may not be a market for the interest, or the remaining owners may not want outside third parties to become new owners of the company. Including a mandatory buyout provision in the operating agreement can resolve these situations by requiring the company, or individual owners, to buy back the interest of a deceased owner at a pre-determined fair price. The provision should further provide the means by which the company will fund the buyout such as by purchasing life insurance on the deceased owner.
Other circumstances the owners should address in writing include retirement, disability and personal bankruptcy. Additionally, the owners should anticipate an event in which one of the owners or parties in interest fail to adequately perform at a required level or engage in business directly in competition with the company. All of the above circumstances should be addressed in writing at the time the enterprise is formed through buyout provisions similar to what would occur in the event of the death of one of the owners.
Dealing with the abovementioned issues prior to an event will avoid costly disputes and possible litigation that will be damaging to the business and owners.
Buy-Sell Agreements: How They Protect You and Your Business
It is certainly understandable that the founders of a new company are more focused on building the brand than they might be in what happens if one of them dies; however, the event of disability or premature death is an event that must be contemplated and committed to in writing by and among the parties. When two or more owners each own fifty percent (50%) of a company, a mandatory “buy/sell” provision is extremely important, particularly in the event of a deadlock or other situation where the parties cannot agree and the business of the company is impacted. This structure provides an opportunity to avoid a deadlock by creating an opportunity for one owner to give the other owner a buyout offer at any time. The recipient of the offer must either accept the offer and be bought out, or conversely, purchase the interest of the first owner on the same terms and conditions as the first owner’s offer.
The use of this mechanism to resolve a dispute preserves the enterprise; however, it must be well-thought-out and fair to both parties in order to be effective. This type of arrangement should result in a price and terms that are considered fair by both parties, since the owner initially making the offer may be forced to sell on the terms and conditions of the initial offer he makes. A buyout provision can create a mechanism with which the owners can terminate an unhappy business relationship with a buyout that is fair.
The method by which a buyout is to be effectuated should be included in the agreement to provide fair pricing and an orderly transfer of the departing owner’s interest. The method outlined in the agreement should create a procedure by which a transferring owner is to give notice of the transfer and initiate any right of first refusal. It should also set out deadlines for the exercise of options and specify a pricing formula, or a fixed price as well as the payment terms for a mandatory buyout or optional buyout, without which disputes may arise between the company and the owner or the estate of the departing owner. A properly crafted pricing mechanism is essential to achieving the initial goals of the founders and will enhance the opportunity for a smooth and fair buyout of the remaining owner(s).
Determining a fair price for the seller’s interest may be accomplished with any one of the following methods, and should include an appraisal from an outside source at the time of the buyout:
- Yearly valuation of the interest, set by the owners of the company on an annual basis;
- Percentage of gross income;
- Book value, determined by deducting the company’s liabilities from assets and dividing the figure by the number of outstanding owner’s interests; and
- A formula based on a multiple of earnings, which multiplies the company’s last year of earnings by a fixed number, and divides the figure by the number of outstanding owner’s interests.
It is important that the founding owners contemplate a possible buyout and take considerable time in developing a fair mechanism to accomplish the buyout and determine the price of the seller’s interest.
When Trust Isn’t Enough
It is not uncommon for friends or family members to form a business. These organizations are shaped in many ways. However, the notion that “we will work it out…” will become the beginning of the end when friendship leads to a business relationship that is not properly documented. Regardless of the reason for joining forces; i.e., to form a large new business, invest in real estate or open an ice cream store, the founding members should always begin the relationship with a carefully crafted binding agreement outlining the scope of the relationship, ownership percentages, control of the enterprise, and how to resolve disputes if the venture does not work out as contemplated.
The agreement should address among other things, “what happens if a third party wants to purchase the business” and “how do we resolve disputes.” These matters should be discussed in detail and memorialized in a binding document executed by the parties when entering into the formation stage of the business. Many individuals tend to overlook or downplay the real possibility of potential conflicts and problems that may arise in the future. Addressing issues such as these when considering starting a business with family or friends will limit risk and uncertainty.
Put It In Writing: Ownership Agreements for Closely Held Businesses
When two or more individuals join forces to form a business, other than making certain the name is available, the parties must first address ownership of the enterprise in a shareholder agreement for corporations, or an operating agreement for limited liability companies.
If the entity is an S corporation, which provides for a single level of taxation at the shareholder level and is a fairly common corporate structure, profit and loss must be split in accordance with the stock ownership of the company. The limited liability company structure provides greater flexibility. In this structure, the agreement should carefully outline each owner’s initial capital contribution to the company, his or her relative ownership interests and share of profits and losses, and the order of preference or priority in making distributions. If it is contemplated that the limited liability company may require additional capital, it is important that the operating agreement also provide what each owner is required to contribute and under what circumstances. Thus, it is common for a limited liability company’s operating agreement to include a contingent requirement of additional capital contributions, which helps to ensure the company’s financial security and assure its continuance.
The shareholder agreement and/or operating agreement should also include specific provisions addressing who will manage, operate, and control the company. In an S corporation, the board of directors and officers are charged with operating the business, while in a limited liability company, managers or the managing members typically control the operations. In either case, the agreement often provides that major business decisions, such as the decision to acquire a new business, sell substantially all of the assets of the company, or to enter into loan agreements, will require a majority or a super-majority (i.e., something more than 51%) of the owners to approve before such action may be taken. Whatever is agreed upon by the founders must be carefully drafted and clearly stated in order to resolve disputes, and avoid litigation, if at all possible.