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 owners.
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 when and 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:
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.
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.
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.
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 optional or 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.
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 parties involved.
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.