Many businesses, whether they are closely held corporations, limited liability companies, or partnerships, face difficult issues when one of the owners leaves. Some of the reasons an owner may leave a business are: death, disability, retirement, or disagreement over how the business should be run. The best time to deal with these issues is before they arise--by having an agreement in place among the owners from the very beginning. This type of agreement is often referred to as a buy-sell agreement or a shareholder agreement, and can be a stand-alone agreement or be included as part of the corporate bylaws, limited liability operating agreement, or partnership agreement.
A carefully drafted agreement will spell out in advance how key issues will be handled upon the departure of a co-owner of the business, thereby helping all the owners avoid costly mistakes and unnecessary litigation. To be effective, the agreement should address, at a minimum, the following issues:
- Transfer Restrictions - The agreement should require that, upon the occurrence of certain events, a departing owner (or that owner.s estate) must offer to sell his or her share of the business back to the remaining owner(s). In conjunction, the agreement can require that the remaining owners buy the departing owner.s share of the business, or it can simply provide the remaining owners with a right of first refusal before the share can be sold to a third party. The events that trigger the buyout provisions of the agreement can include an owner.s acceptance of an outside offer for his or her share of the business, or the death, incapacity, or withdrawal of an owner. Without these transfer restrictions, the remaining owner(s) will have little or no control over who the new co-owner(s) might be.
- Valuation - In addition to specifying the triggering events and the buyout procedures, the agreement must specify how the selling price of the departing owner.s share of the business will be determined. There are several methods that are often used to determine the selling price. One is to set an initial price that is subject to periodic review by the owners. Another method is to provide for an appraisal of the business. This can be done on an annual basis or at the time of the sale of an owner.s share of the business. A third method is to employ a formula based on certain key financial indicators.
- Estate Values - The value of a deceased owner.s share of the business will be included in that owner.s estate for the purpose of determining estate tax liability. Therefore, the agreement must be structured in such a way that the selling price of the deceased owner.s share of the business will be respected by the IRS. Otherwise, if the selling price is far below the value ultimately adopted by the IRS, the estate tax liability could exceed the amount the deceased owner.s estate receives for his or her share of the business.
- Funding the Buyout - Another issue to be addressed in the agreement is how the buyout of a departing owner will be funded. This is necessary to ensure that the cost of the buyout does not unduly burden the business or cause it to eventually fail. Life insurance is an obvious funding mechanism where the death of a co-owner is the anticipated triggering event. In all other instances however, other funding mechanisms must be considered. One possibility is to provide for payments over time, with the departing owner receiving some form of security.
- Dispute Resolution - The agreement can be drafted to provide the exclusive means for resolving disputes among the co-owners over how the business will be run. Arbitration is an often used method because it tends to be faster and less expensive than litigation. Another, more straightforward, method of resolving management disputes is to require that feuding co-owners submit sealed bids, with the highest bidder buying out the other co-owner(s) at the bid price.
- Restricting Competition - The agreement can include restrictions on the ability of a departing co-owner to engage in the same business as his or her former company within a certain geographic area for a specified period of time.
- Other Issues - The agreement can also cover such important issues as voting rights, day-to-day management authority, and profit distributions.