Often in our legal practice, we represent clients who are successful business
owners. Many of those clients usually own their businesses with one or
more co-owners. Often, clients either have no agreement in place with
their co-owners, or they have a written agreement that is unfortunately
insufficient to cover the nuances that involve the relationship among
The forms of these agreements are many, in the case of a general partnership,
we often see a partnership agreement. In the case of a limited liability
company, we see an operating agreement or a membership interest agreement.
And, in the case of a corporation, a shareholder’s agreement or
a buy-sell agreement. Regardless of the name of the agreement, which we
will call an “Ownership Agreement” for purposes of this article,
having this type of arrangement set up with your partners in advance of
any problems between owners can be extremely beneficial not only to the
owners, but it can be imperative to the ultimate survival of the company itself.
In a nutshell, an “Ownership Agreement” is an agreement among
the company and the company owners that, among other things, establishes
clear protocols as it relates to the continued ownership and management
of a company, restrictions on
who can be an owner in that company as well as
how owners can transfer or otherwise assign their ownership interests to others.
Among the many reasons why business owners should consider having this
type of Ownership Agreement in place, here are five major reasons your
company needs this agreement:
- Providing Clear Terms of Management and Control of the Company
In an Ownership Agreement, the owners can establish a set of rules as to
how the company will be managed. This is especially important if those
owners also possess any roles as officers and/or directors of the company.
A range of issues can be covered, such as voting rights, how to resolve
deadlocks among the owners, dispute resolution process for owner disputes,
and what events require majority or even unanimous approval of the owners
(e.g., merging with another company, selling the company, authorizing
major loans, or other extraordinary events outside the everyday business
affairs of the company).
If such rules and protocols are not put into place, then the company’s
rules often default to statutory provisions under State law, which means
that the owners will have to look to relevant law to determine their relative
rights instead of being able to point to a single document signed by all
parties. Furthermore, and even perhaps more so troublesome, the co-owners
will not have a clear set of rules and understandings between them as
it relates to the company. We find in our practice that misunderstandings
are what often lead to disputes and, even worse, litigation amongst the parties.
An Ownership Agreement can attempt to mitigate these concerns and provide
clarity to the owners on a moving forward basis.
- Ensuring Ownership Stays Within Select Hands
Another important issue to consider is commonality of ownership. In other
words, co-owners have usually hand-picked their business partners and
want to provide necessary obstacles before outsiders can come into the
picture and own a piece of the company.
One way to mitigate this risk is by placing transferability restrictions
on stock. For example, an owner cannot sell or transfer his or her stock
to any third party before getting approval from the company (e.g., the
board of directors) and the other owners. There may be exceptions that
the company and co-owners are willing to entertain, such as the ability
to transfer shares into a personal or family trust. However, this is a
determination that must be made at the drafting stage, and the owners
should consult with legal and tax counsel to ensure that any such transfers
do not affect the company’s tax status (i.e., if the company is
taxed as an S Corporation, to make sure any such transfers would not negatively
affect such tax status).
Co-ownership in a company is somewhat like a “business marriage.”
If a co-owner decides to leave the company, it is somewhat like a “business
divorce.” Even worse, if that co-owner can freely sell his or shares
to some outside third party, then the remaining owners, and the company,
may now be stuck with some stranger in a “forced business marriage”
scenario. An Ownership Agreement can attempt to prevent this by, among
other things, allowing the company and/or other owners a “right
of first refusal” to buy out the departing shareholder at some fair
value agreed to by the parties (see below) before such ownership can be
transferred to an outsider.
- Accounting for Unexpected Contingencies and/or Life Events
Perhaps one of the more uncomfortable topics to consider is what happens
if, for instance, an owner dies or becomes disabled? Alternatively, what
happens if an owner gets convicted of a felony? These are merely examples
of the sort of unexpected contingencies and/or life events that the company
and its owners may want to address.
An important question to ask is what happens to the affected owner’s
ownership interests under such circumstances? A well drafted Ownership
Agreement addresses these concerns. For instance, there may be provisions
that state if an owner dies, the company and/or other owners have a “right
of first refusal” to buy the deceased owner’s shares at fair
value (see below) from the deceased owner’s estate. Otherwise, under
the laws of intestacy and/or probate, the deceased owner’s shares
might pass to his or her next of kin. In such a case, the surviving owners
and the company may yet again be faced with the another “third party”
(i.e., the deceased owner’s family) now being a co-owner in the company.
Caution: Some Ownership Agreements contemplate a
mandatory (rather than
optional) buy-out of an “affected” owner’s stock. This could
present a problem with the cash flow of the company and/or other owners,
especially if they are obligated to buy a deceased owner’s stock
when that deceased owner’s stock is highly valuable. California
law (Sec. 500-511 of the Corporations Code) also presents certain restrictions
on a company’s ability to buy back or redeem an owner’s shares;
namely, if the redemption of such shares would cause the corporation to
be “likely to be unable to meet its liabilities… as they
mature.” One way to attempt to mitigate this is for the company
to consider taking out insurance for one of these contingencies. There
are life insurance and disability policies out there that attempt to alleviate
this concern so that the proceeds of such insurance can be applied to
the buy-back of such stock.
- Preparing Exit Strategies
Another important factor to consider is what if an owner wishes to quit
the company or otherwise retire? What will happen to that owner’s stock?
Again, this is where the Ownership Agreement can account for such a contingency
by putting in place a provision by which the departing or retiring owner
might be able to sell his or her stock back to the company or to the other
owners. This can be done with either
mandatory buy-out provisions, as noted above. Again, the same concerns arise as
to the feasibility of buying such stock and thereby triggering the consideration
of whether or not insurance might be considered as a backup plan.
- Establishing a “Value” to the Company
Last, but certainly not least, owners in a company want to know what the
company, and more importantly their share of the company, is worth. In
our experience, this is perhaps one of the most contested issues among
owners in a company.
An Ownership Agreement can attempt to mitigate this by putting in place
one of several methods to value such ownership interests. One method might
be establishing a “fair value” (often called a “fair
market value”) for such shares. This is often difficult to determine
with a privately-held company as there is technically no readily available
market for the shares to be sold.
Instead, the Ownership Agreement can attempt to establish a “Fair
Value” or an “Agreed Value” that is basically a value
set by the owners based on either some appraisal process or some formula
(e.g., some multiple of the company’s EBITDA – earnings before
interest, tax, depreciation and amortization) that the owners agree upon.
In any such event, it is highly recommended that the company and co-owners
come to some mutually acceptable resolution on exactly
how to value the company and each owner’s interests therein. This can
be done through an experienced CPA or valuation expert agreeable to all
An Ownership Agreement can allow a company and its owners flexibility to
craft terms and conditions of ownership that are based on what is mutually
acceptable to all parties involved. The above issues are simply important
factors to keep in mind as to why the Ownership Agreement should be considered.
As with any important contract that affects a party’s rights and
proprietary interests, legal and tax counsel should be consulted before
any such agreements are signed.