It has always been wise for any business entity with two or more shareholders, partners, or members to adopt an agreement among all owners to retain closely-held ownership and to provide a reliable process for the transfer of equity interests upon certain events, particularly death or withdrawal. These owners’ agreements are commonly referred to as “buy-sell” agreements, although their purpose is more often to restrict the buying and selling of interests, rather than to facilitate a buying or selling.
While it is always advisable to provide for the process, price, parties, and payment terms of transfers upon significant events such as the death, disability, or withdrawal of an owner, there are many other equally important and often overlooked matters that can be addressed in an owners’ agreement. A thoughtful and well-crafted owners’ agreement can assure the smooth operation, seamless transition, and long-term viability of a business entity.
Among the issues that can and often should be addressed in a comprehensive owners’ agreement, consider:
Restrictions on Transfer – Under what conditions can a new owner come into the business? The agreement should provide how an equity interest might be acquired by a new owner. Perhaps there should be restrictions on who can be an owner? Should ownership be limited only to certain persons, such as licensed professionals or employees active in the business? Certain professional entities are required by law to have a requisite percentage of licensed persons. Should an owner’s heirs or descendants be given preference to acquire the owner’s interests? An agreement can establish the qualifications and conditions for becoming an owner.
S Corporation compliance – If the entity is taxed under Subchapter S of the Internal Revenue Code, there should be provisions in an owners’ agreement to prevent a transfer that would cause the entity’s S Corporation status to terminate. A termination of S status, whether intentional or inadvertent, could result in significant tax costs to owners.
Rights of First Refusal or First Offer – The agreement might provide that all owners have an equal right (in proportion to current ownership percentages) to purchase available interests, or perhaps it is desired that certain owners have the first right to purchase interests. Give thought to providing an exit path for the departing owner, but also to assuring future ownership that will be in the best interests of the business.
Triggering events – What events should trigger a right – or requirement – of an owner to transfer interests? Under what circumstances does one owner have a right to purchase interests of another? Death? Disability (and how is disability determined)? Retirement (at what age)? Commission of a crime (how is that defined – a felony, any misdemeanor, only certain egregious crimes)? Termination of employment in the business (for “cause” only? for any reason? voluntarily by the employee? or only if involuntarily terminated)? Bankruptcy? A court ordered sale (such as incident to a divorce in which the interests are a marital asset or a judicial sale to enforce a judgment)?
Valuation and Payment Terms – What is the best way to determine the changing value of the business over time? An annual agreement among owners? Third party appraisal? What factors should a business valuation consider? What is the best method of valuing the business? A multiple of EBITDA? Adjusted book value? How and when will the agreed value be paid? All due at once? In installments over time? At what interest rate? It may be desirable to have different payment terms for different triggering events. In the event of death, the estate needs liquidity for taxes and expenses. Extended payments to an estate over many years can create problems in the administration and settlement of an estate. What if an owner leaves to start a competing business? Consider whether you might want the option to stretch out the payments. You do not want the business’s resources to provide ready start-up capital to create a competitor.
Funding of redemptions – If the company is going to be required to purchase ownership interests, how will it pay for it? What happens if the company does not have the funds at the time? If payments are deferred does the intended recipient have any protection to assure payment in the future? A promissory note? A lien on company assets?
Tag along – A tag-along right gives the owner of a minority interest in a company the right to be paid the same purchase price per unit of interest that a majority owner is to receive in the sale of her shares. This right protects the minority against the majority selling out control for a premium price, leaving the minority with a reduced value of her equity and a new co-owner not of her choosing.
Drag along – A drag-along right gives the owner of a majority interest in the company the right to require the minority owner to sell his interest at the same time (and usually at the same price as the majority). This right eliminates the risk that a minority owner can thwart a sale of the interests in a business by holding out against the sale.
Board or manager positions – Do the owners desire to establish provisions as to how directors and officers will be elected? Are certain owners entitled to have a representative on the Board?
Decision making/Tie breaking – Providing the means to break a deadlock, especially in businesses with 50%/50% owners, could make the difference between a company surviving and one forced into dissolution when owners cannot agree.
Tax elections/Dissolution – Entities taxed under Subchapter K (most partnerships and many LLCs) have several important elections that can be made that will impact the entity’s and the owners’ taxes. An agreement can address these at the outset, avoiding disputes later.
Employment – Some businesses require that only employees can be owners. That arrangement assures that all owners have a stake in the business and avoids the disparity of a few owners working to grow the value for all, including those who are passive investors. What happens to ownership when an owner/employee is unable to work, quits, or is fired?
Estate planning tools – An owners’ agreement should be integrated with each owner’s estate plan. Tying the provisions in an owners’ agreement on transfer and payment on death to the owner’s overall estate plan can avoid costly mistakes and delays. The estate may need liquidity for taxes, but if the interests cannot be converted to cash the funds to pay inheritance and estate taxes may not be in existence. Should life insurance be purchased to fund a buy-out on death? If so, who should own the policies?
Section 2703 – The Internal Revenue Code significantly restricts the owners of a closely held business from establishing a value for business interests passing at death at any price other than fair market value as determined for federal estate tax purposes. If the owners’ agreement does not comply with these requirements, the estate of a deceased owner may have a large tax bill but no funds to pay the tax.
Amendment – How can the owners’ agreement be amended if and when desired? Does an amendment require the agreement of all owners? A majority of owners? A super majority? How will the rights of the majority to effect changes and of the minority against unwanted changes be protected?
A properly drafted owners’ agreement is more than a “buy-sell.” It is a comprehensive roadmap that assures the continuation of closely held ownership, while also enabling smooth transition of ownership interests over time. An owners’ agreement that addresses how to handle the consequences of both anticipated and unanticipated changes can avoid costly disputes, and will enhance long term viability as ownership evolves. For assistance at implementing or improving your business’s owners’ agreement contact the Business Group attorneys at Stock and Leader, LLP.