Posted on Jul 08, 2015 by Jeffrey L. Payne
Every business relationship eventually will lead to a parting of ways. Investors or business partners retire or are slowed by health issues, die, disagree about the future course of the business, or simply decide they want to do something else with their time and money.
We often deal with “corporate divorce,” and it’s surprising how many people go into a business relationship without giving sufficient thought to their exit strategy. If you’re forming a new business or investing in one, you need a buy-sell agreement that anticipates the end of the relationship and sets terms that will help you avoid hurt feelings, protracted and unpleasant negotiations and even litigation.
Here are some of the factors you will want to discuss with your legal counsel.
It’s about the money
While it’s impossible to know what your business ownership or investment will be worth years from now, you can determine the process that will be used to determine its value. We usually recommend turning the valuation process over to an accounting firm that all parties trust, and allow a valuation expert to set a price. If the parties don’t mind the additional expense, they may get more peace of mind by averaging the valuations of two accounting firms.
I would caution against using the “book value” of the company to determine its value. The experts will consider many other factors, such as the business’ current profit (or loss) margin, the value of real estate, inventory and other assets, and the offers the business would attract on the “open market.”
Consider life insurance
Small businesses sometimes purchase life insurance on the life of each owner, with the company designated as the beneficiary, and with the understanding that the insurance proceeds will be used to buy the interest of the deceased. This ensures that the surviving business owners won’t have to go into debt to purchase their former owner’s business interest, and it also provides an easy way for an owner’s family to receive the value of his or her portion of the business.
Minority shareholders should protect themselves
In many small businesses, each owner also is an employee. For any number of good and bad reasons, the majority owners may terminate the employment of a minority owner, leaving that person with an investment tied up in a business where he or she can no longer participate. Conversely, a minority owner may not want to sell an interest or relinquish the benefits of working in the company if it is likely to be worth a lot more in a few years.
We recommend that minority owners have an agreement that protects their interests. This might include the requirement for a super-majority shareholder vote to oust them as an employee, identifying the type of conduct that justifies termination and the terms of a buy-out.
LLCs have special obligations
LLCs have many advantages in business formation, but one potentially problematic area of the law is that the company must purchase, at “fair value,” the interest of a “disassociated” member if the operating agreement doesn’t set out other terms. A family member or heir can’t simply assume that the interest of an LLC member who dies can be purchased at a fair price, absent an operating agreement that sets out terms for transferring an interest.
The South Carolina LLC statute doesn’t provide guidance on determining fair value or payment terms, but it’s clear that an LLC could be dissolved eventually if the parties can’t come to terms following a death, a result that likely will please none of the parties.
Avoid this potential impasse by drawing up an operating agreement that anticipates all of the situations that disassociate an LLC member, which include becoming a debtor in bankruptcy.
Unwanted business partners
Unlike LLCs, a corporation’s shares can pass to an heir and the business continues to operate without a blip. But, it does mean you can suddenly find yourself in business with people with whom you don’t really want to work.
As an example, the surviving spouse in a small, incorporated business may not understand that his or her income from the business is now limited to dividends, rather than the salary that the deceased spouse earned while working for the company. In such cases, the spouse likely will want to sell the interest, which may lead to an unwanted partner if the proper restrictions are not in place.
Buy-sell agreements often give other shareholders or the company the right to redeem a shareholder’s interest, at a pre-determined price or formula, before it can be offered to others. This protects those remaining in the business from all of the headaches that may attend suddenly finding yourself in business with someone you don’t know.
Most of these considerations can be addressed in an LLC operating agreement or in a separate shareholder agreement in a corporate business formation. Take the extra time to discuss what should go into such an agreement for your business, and you’ll likely protect yourself from aggravation, emotional distress and considerable expense down the road when an owner’s interest in the business must change hands.
Jeffrey L. Payne is a shareholder in Turner Padget’s Florence, S.C., office. He focuses his practice on commercial litigation, with an emphasis on business torts, construction, commercial collection, eminent domain, foreclosures, banking and probate disputes. He may be reached at (843) 656-4432 or by email at firstname.lastname@example.org.