Neil Sedaka said it best in his song, “Breaking Up is Hard To Do.” Whether you are faced with the end of a marriage or the end of a business relationship, breaking up is, at best, a difficult process.
Like a husband and wife entering into marriage, business owners enter into a business relationship with high hopes for success. If the owners are well-matched and it is managed properly, the business will likely thrive. However, as reflected by the economy in recent years, even the most successful of ideas may fail. When a business begins to struggle, the owners may determine that it is time to part ways.
The structure of the business will, to some degree, dictate how the break-up or termination of the business is handled. For example, while a sole proprietor may have issues with respect to employees who will lose their jobs as a result of a business termination, the sole proprietor does not have to deal with a soon-to-be ex-partner/business associate. Conversely, when two or more individuals or entities are involved, the break-up/termination process can quickly become unpleasant. Accordingly, it is more critical than ever to plan ahead for the worst.
The “Business Prenuptial Agreement”
Business owners who fail to negotiate a well-crafted agreement with their business partners may later find themselves entrenched in the equivalent of a nasty divorce. However, instead of fighting over children and the house, the soon-to-be ex-partners fight over customers and other assets of the business. A business prenuptial agreement can be in the form of a partnership agreement (in the case of a general or limited partnership), a shareholder agreement (in the case of a corporation), or an operating agreement (in the case of a limited liability company). Regardless of the business structure, the agreement should address several important matters.
- Dissolution of the company. The agreement should include provisions addressing the percentage vote needed to affect dissolution of the company. The agreement should also include provisions addressing how the company’s affairs will be wound down, including the manner in which bills will be paid and remaining assets will be distributed. Statutes governing the various types of business entities contain default procedures to be followed in connection with dissolution of the company. The provisions can be expanded by agreement of the parties.
- Restrictions on sale or transfer of ownership interests. In order to provide continuity of ownership, the agreement must include provisions that dictate under what circumstances an owner may or is obligated to dispose of his or her ownership interest. The transfer may be voluntary (i.e. retirement) or involuntary (i.e. death). In any event, the agreement should contain provisions giving the company and the remaining owners the right to acquire a departing owner’s ownership interest. Generally, the remaining owners will have the right to acquire the departing owner’s interest on a pro-rata basis.
The agreement should also include provisions for the determination of purchase price of the ownership interest and establish how the purchase price will be paid. Typically, the purchase price will be tied to the book value or the appraised value of the ownership interest at the time of the transfer.
The following is a list of common situations that may arise with respect to transfer of ownership:
- Transfer to third party. The agreement should provide that prior to selling their ownership interest to an outside third party, an owner must give notice and a right of first refusal to acquire the ownership interest to the company and the other owners. If neither the company nor the remaining owners acquire the departing owner’s interest, the departing owner is free to sell his or her ownership interest to an outside third party.
- Redemption upon termination of employment. Whether an employee-owner leaves his or her employment voluntarily (i.e. retirement) or involuntarily (i.e. termination by a majority vote of the remaining owners), the agreement may provide that the company and its remaining owners have the option, but not the obligation, to reacquire the ownership interest. The company may desire to discount the value of an employee owner’s ownership interest if the owner voluntarily leaves his or her employment. Additionally, the agreement may provide for payment over an extended period of time, rather than requiring a lump sum payment at closing for purchase of the ownership interest.
- Redemption upon death or disability. The death or disability of a key owner is devastating to a business. Not only has the business lost the talent of an important person, but the business and remaining owners are now faced with the prospect of acquiring the disabled/deceased owner’s interest at a time when cash flow may be seriously impacted as a result of the loss. The agreement should give the company and the remaining owners the option, but not the obligation, to redeem a disabled/deceased owner’s shares. The agreement may provide for key person life insurance to fund the purchase of a deceased owner’s interest, and may provide for payment over time of any portion of the purchase price not covered by insurance.
- Involuntary transfers. In the event an owner is adjudicated bankrupt or a creditor attempts to attach their ownership interest, the company and remaining owners should have the option to reacquire the ownership interest. Similarly, in the event an owner divorces his or her spouse, the agreement should provide that if the ownership interest will be transferred to the ex-spouse as part of a divorce settlement, the company and the remaining owners have the option to reacquire the ownership interest.
While it may not be pleasant to plan for a business’ possible demise when it is just getting started, it is far easier to reach agreement when all parties are getting along than when the relationship has headed south. Accordingly, a well-drafted owners’ agreement can save many headaches and much expense in the future. iBi