The principals of a company originally owned equally by four people were quite distressed. The company was burdened by an owner who had become addicted to illegal drugs. He was no longer performing any services for the company and his inappropriate comments to clients were damaging relationships. The wayward owner had to be removed – but how? The principals could terminate his employment, take him off of the board of directors and even remove him as an officer of the company, but one thing they couldn’t do was buy back his interests in the company. Not only would clients know of his continued association with the company, but the other three principals would be forced to work long and hard to compensate for their absentee peer, who would nevertheless be reaping the benefits of their labor. Unfortunately, the owners did not have any agreements in place to help them through this situation.
There are very few agreements as important for a closely-held company – and unfortunately, as often overlooked – as an agreement among the owners (an “Agreement”). Just as in a marriage, the initial relationships among owners are almost always harmonious. However, relationships can sour over time, differences of opinions often arise, and events may occur that change the dynamics of the team. An Agreement is therefore an effective way to provide in advance for how these situations will be handled. The following are some of the provisions a company should consider having in its Agreement.
Transferability and Right of First Refusal
This type of Agreement may restrict transferability of ownership interests without the consent of the board or other owners in order to avoid adding an undesirable owner to the mix. Whatever the restrictions on transfer, every agreement should contain a “right of first refusal” in case one of the owners receives an offer from a third party to purchase his or her ownership interest. Typically, if an owner receives a third party offer, the offer will trigger an option for the other owners – and sometimes the company as well – to purchase the selling owner’s interest on the same terms offered by the third party. Each non-selling owner may purchase his or her pro rata portion of the interests. The right of first refusal presents a fair and equitable way for an owner to cash out while still protecting the company and its other owners.
Transfer on Death, Divorce or Bankruptcy
The right of first refusal is triggered by a voluntary transfer of ownership interests, but there are instances when ownership interests may be transferred in an involuntary manner: an owner’s death might result in a poorly-qualified heir becoming a new – and unwelcome – owner while an owner’s divorce might leave a large part of his or her interests in the hands of a bitter ex-spouse. An owner’s bankruptcy may leave the interest in the hands of a trustee in bankruptcy. Clearly, none of these cases spell good news for a company. An Agreement can provide for these circumstances, stipulating that the ownership interests will be offered first to the company, and, if the company does not purchase them, to other owners on a pro rata basis, so that the interests might be purchased prior to being transferred.
A transfer on death, divorce or bankruptcy differs from the right of first refusal in that no value has been established for the ownership interests. A predetermined formula can have negative estate tax consequences, and accordingly, the Agreement ought to include provisions that the parties will seek to agree on a price, and, if there is a negotiating standoff, appoint an appraiser to value the ownership interests. This independent valuation requirement is essential to the success of the process.
Owners will often agree to a particular board composition. An Agreement may set out how many board seats there will be and who will be elected to these seats. Since owners elect the board members, if there is no provision on this subject, a minority owner will have no right to a seat on the board without the support of other owners.
A preemptive rights provision comes into play if a company is issuing additional ownership interests. It entitles each owner to purchase additional interests necessary to maintain his or her current percentage interest in the company, at the same price that the interests are being issued to third parties. This provision is of particular value to owners who do not have a say in whether additional interests are issued, as it ensures that their percentage interest won’t decrease as long as they are able to exercise their preemptive rights and acquire additional interests.
A buy/sell provision is sometimes included, and it functions like an umbrella against the proverbial rainy day when the owners just can’t get along. Buy/sell provisions generally provide that any owner or group of owners – or sometimes an owner who owns a particular percentage of the outstanding ownership interests – may establish a value for the company. The owner to whom this communication is directed then has the option to either sell his or her interests to the offering owner, or purchase the offering owner’s interests on the same terms proposed in the initial owner’s offer. Typically, if the owner receiving the offer does not exercise the option to purchase the interest, he or she must then sell the interest to the offering owner.
Purchase on Termination
If owners of the company also serve as employees, provisions for the company’s purchase of their interest if/when their employment ends (either voluntarily or involuntarily) are very important. If an owner-employee voluntarily leaves the company, the company typically will have the option to buy the owner’s interests at fair market value. However, if an owner is fired for cause, there may be an offset right for the damages caused by his or her actions.
Proprietary Information/Non Competes
Agreements should also require that all owners maintain the company’s proprietary information in confidence. In addition, a good Agreement should include a provision that all intellectual property created by the founders, either before or after the creation of the company, belongs to the company. Finally, an Agreement should prohibit the owners from competing with the company while they still own an interest in the company. Also, owners may wish to address whether the non-compete stipulation should extend to some reasonable period of time, scope and/or geographic area after the departure of an owner, or the sale of his interests and whether the departing owner should be prohibited from engaging the company’s employees for a specified period of time. (Non-compete provisions are difficult to enforce, but they may be enforceable in this context.)
There are numerous other provisions that specific companies may want to include in their Agreements. However, an Agreement containing most or all of the above provisions is absolutely essential for any closely-held business. If the Company mentioned in the introduction had entered into an agreement among its owners, it would have been much easier to deal with its errant owner. Instead, extended and expensive negotiations were required to resolve the problem.
Kathryn K. Lindauer has more than 30 years of experience in complex corporate, securities and business law. Her practice includes representation of closely-held companies, M&A, joint ventures, public and private securities offerings, and federal securities law compliance. She can be reached at firstname.lastname@example.org.
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