By Steven Keeler
We are all familiar with “prenuptial” agreements and estate plans between spouses which set out the terms of property ownership rights in the event of divorce or death. Planning for a possible break-up before or during the honeymoon is never fun, but it can make life easier for everyone and even provide more piece of mind. This is equally, and perhaps more, true with business partnerships.
Like a marriage, an owner’s death, disability or retirement, a company sale or even an owner “parting of the ways” will eventually end every business partnership. Planning for the owners’ and their families’ rights in these events is not about a lack of trust. It acknowledges that things will change and the owners, and their company, deserve predictable and fair treatment. A business break-up can seriously damage the value of the business if the owners cannot agree on what’s “fair”. It is usually easier to decide what would be fair in various circumstances when the relationship and business are strong.
Many company deadlocks, disputes and lawsuits arise from 50-50 ownership scenarios where there is either no “buy-sell” agreement (which can be incorporated into a corporation’s stockholder agreement, an LLC’s operating agreement, or a freestanding agreement), or an agreement that does not address owner fallouts or departures. Having to negotiate a settlement when one owner has died or become disabled, or between owners whose relationship has become strained, or worse, having to file or defend a lawsuit, is, more often than not, expensive and potentially damaging to the company and its relationships. Honest planning ahead avoids the risk of “killing the goose” (the company) and de-valuing the “eggs” (the owners’ equity in the business).
Be Thoughtful About Ownership Percentages
A surprising number of startup companies have two or more founders with equal equity ownership, because it was the easiest and most comfortable thing to do. And many later-stage family and other businesses have two equal owners or owner groups none of whom alone control the board or owner votes. 50-50 or other equal ownership structures can often make sense and reflect a fair sharing based on the past and future contributions of, risk appetite and financial goals of the owners. Good equal partners can be a sounding board and check on each other, and allow the partners to allocate company management responsibilities between them in a manner that’s consistent with their talents and experience.
The primary risk of a 50-50 partnership is that each owner requires the consent of the other to take major company actions. This can work well if the owners’ chemistry and trust level are strong. If that changes over time, the company may struggle if individual responsibilities and authority, voting rights and dispute resolution are not spelled out in the bylaws or an owner agreement. A 50-50 or other equal ownership structure can avoid one owner taking advantage of the others or becoming overhanded. But whenever co-owners begin to have different visions for the business or want to change their personal work commitment due to personal preferences or life circumstances, the 50-50 or equal equity and voting arrangement can begin to create more business risk than benefits.
Whether a company is being newly formed, or it’s time to re-evaluate the contributions and responsibilities of the owners and perhaps change their ownership, the owners should seek to arrive at a fair allocation of equity ownership rather than an “easier”, arbitrary one. If 50-50 is ultimately determined to be right for the company and the owners, then the company’s legal documents need to address future, unanticipated events and potential changes or even breakdowns in the relationship. Even good people and their objectives and motives change with time.
Don’t Become a War Story
Like marital divorces, in the event of a 50-50 partner deadlock or dispute, lawyers end up using valuable company and owner money, resources and time to resolve the dispute and work out a fair break-up. Failing an amicable resolution, state “judicial dissolution” and other legal remedies are an expensive and impractical option if the owners want to preserve their equity value through a continuation of the business or a sale. Filing for dissolution and ultimately litigating a settlement or buy-out of one owner can be very unpredictable and damaging to the company and the morale and trust level of its management, employees, customers and suppliers. To avoid this and preserve the owners’ equity value, the owners should seriously consider spending earlier (and usually less) money (as compared with resolving a dispute) to develop a well-thought-out buy-sell agreement.
The Beauty of a Buy-Sell Agreement
A buy-sell agreement should be thought of as an insurance policy that will more than pay for itself by providing the owners with more certainty of outcomes and avoiding protracted settlement negotiations or litigation. The agreement should be viewed as a company value enhancer, as it will provide a more clear business and ownership succession plan in the event of a required change in ownership or a major company transaction. The owners can always agree to not follow the buy-sell agreement based on changed circumstances. But having a well-tailored agreement will make future negotiations and discussions more smooth and predictable.
Company Governance and Voting. Economic ownership and voting rights need not be in the same percentages, and the owners should consider mechanisms that will allow them to move forward in the event of disagreement. Ideally, the owners might consider having a board that permits “tie-breaker” votes when the owners disagree. The company’s organizational documents and a buy-sell agreement can address board and stockholder or member decision-making deadlocks and how they are to be resolved. These governance rules of the game can go a long way to avoiding disputes and the need for ownership changes. Also, voting rights might be split 51-49 even if ownership is 50-50, thereby giving one owner the right to avoid a deadlock. If there are owners other than the equal controlling co-owners, a majority vote mechanism can also avoid tie votes or deadlocks.
Owner Hats. The main owners are controlling stockholders or members of the company, but they are also usually officers and employees. The more clearly defined the individual owners’ responsibilities and authority for different aspects of company management and operation, the better. These can always be changed, but this division of authority can strengthen the owner relationship and provide more certainty to employees about where each “buck stops” on various day-to-day and more significant company decisions and actions.
Alternative Buy-Sell Agreement Terms.
Death, Disability or Retirement of an Owner. A buy-sell agreement usually addresses what happens on the death, disability or retirement of an owner. Many buy-sell agreements provide for the purchase of the equity of a deceased owner with company cash, notes or life insurance. Voting rights may be altered when one owner becomes disabled or retires, and a similar equity buyout might apply. On the other hand, the owners may decide that a deceased owners’ equity should pass to his or her family. In this case, voting rights and governance by the remaining owner should be addressed and preserved to avoid the involvement of less knowledgeable owners in the company’s management.
Other Common Buy-Sell Agreement Terms. Every buy-sell agreement is a little different, and none is perfect, as they cannot predict every future occurrence. But most, even and especially in non-50-50 situations, will include (i) “preemptive rights” provisions that allow each owner to maintain his or her ownership percentage by purchasing any additional shares sold by the company, (ii) “rights of first refusal” permitting an owner or the company to purchase the shares of another owner if the other owner desires to sell, (iii) “tag-along” rights allowing an owner to sell some of his or her shares in connection with a sale by the other owner, and (iv) “drag-along” rights permitting some controlling portion of the owners to approve a sale of the company’s equity or assets and force the other owners to sell at the same price and on the same terms. The advisability and structure of each of these terms will depend on the company’s ownership.
50-50 Owner Deadlocks or Disputes. The steps described in items 1 and 2 above may avoid decision-making deadlocks or disputes that adversely affect company operations and major transactions. However, the owners should consider buy-sell agreement provisions that permit an owner to leave or which enable a company sale if that is advisable. A so-called “push-shove” or “Russian Roulette” mechanism allows either owner who desires a break-up to name a price, and the other owner can then elect to sell or buy at that price. A “Texas Shootout” allows either owner to require that each owner submit a sealed or confidential bid price, and the one that submits the higher price is then entitled and obligated to buy the other owner out. These types of provisions are intimidating and can favor a wealthier owner. A “Forced Sale” mechanism allows either owner to force the company to be sold. This is rare and even more intimidating. But these rather common mechanisms are thought to make each owner consider the best interests of the company and each owner. Of course, these mechanisms may not be necessary or appropriate if the ownership is not 50-50.
Coordinating Buy-Sell Planning with Owner Estate and Company Tax Planning
The owners should seek to ensure that their personal estate, retirement and financial plans work with or anticipate the terms of any buy-sell agreement or ownership succession plan. If the company is an S corporation or LLC, the buy-sell, stockholder or operating agreement should provide for distributions to enable the owners to pay their income taxes on allocations of company income, and should prohibit any actions that might result in the termination of the company’s intended status as an S corporation or LLC taxed as a partnership. The owner agreement should also address the tax impact of owner equity sales on the company and the owners.
Take Aways
50-50 company ownership, or any company ownership structure that gives any one owner individual approval or “veto” rights on company actions, may be the right approach for a business. If it is, the company’s legal documents should anticipate future events, provide for resolution of board or stockholder decision deadlocks, and seek to avoid expensive negotiations, settlements or litigation when the owners’ relationship might have changed or be strained. Many companies and owners may never need to re-read or enforce their bylaws, buy-sell agreements or other organizational legal documents. Their relationship will hopefully have been characterized by a high level of trust, common vision and thoughtful discussion of major decisions. Each significant owner, regardless of their role with the company, should be given full visibility into the company’s books and records and operations and should be expected to be an active board member and manager who is aware of what is going on at the company. This will avoid breakdowns in trust, misunderstandings and disputes. But death, disability, a parting of the ways or the need to execute a company financing or sale will eventually happen. A well-thought-out buy-sell agreement and other company organizational documents, while never perfect, should attempt to address each of these “what if’s” so that the owners and the company will at least have a road map for eventually confronting future events in a manner that is fair to all owners and preserves the value of the business.
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