By Erin K. Tenner, Partner, Gray Duffy LLP
This is Part IV in a five part series on buy/sell basics. Part I examined the three different types of buy/sell agreements. Part II discussed the basics of one of those: Asset Purchase and Sale Agreements. Part III discussed the basics of Stock Purchase Agreement.
This article will discuss Shareholders’ Agreements, Operating Agreements and Partnership Agreements, which are three different kinds of agreements among owners that typically include Buy/Sell provisions. They differ only by the type of entity for which they are used.
Why should you care about these details? Because they can keep you from ending up from being partners with someone you might not want to be partners with, for example, your partner’s ex-spouse!
Shareholders’ Agreements are agreements between owners of corporations; Operating Agreements are agreements between owners of limited liability companies; and Partnership Agreements are agreements between partners in a general or limited partnership.
All three agreements typically include the same basic provisions. They include: A provision that restricts transfers of interests by the other owners except in limited circumstances so that the owners always know who they will be partners with; owner or company options to buy the interests of the other owners under certain circumstances; a right of first refusal; and a provision for purchase of life insurance to pay for the buyout of an owner who dies.
They also include: Provisions for how the purchase price will be determined, and how it will be paid if an option is exercised; and, often, provisions regarding whether the owners have the right to take opportunities for themselves that might otherwise be of interest to the entity or business they own.
The restriction on transfer of interest typically allows transfer to a revocable Living Trust controlled by the owner. When the owner dies, the agreement typically provides that the company or the other owner(s) have a right to buy the interest of the deceased owner so the owners don’t become partners with a spouse or children or other heirs of the owner.
The agreement will often require the company — or more often, for tax reasons, the other owners — to purchase life insurance on each other and require the proceeds from the life insurance be used to buy out the interest of the deceased owner. Similar provisions are usually included for long term disability if the owner is actively working in the business.
However, disability insurance to cover the cost of the buyout is not as easy to find. If disability insurance cannot be found or is not wanted to cover the cost of buyout upon permanent disability, then the other owners will more often have an option to buy, rather than an obligation to buy out the disabled owner. The option usually lasts for 3-9 months and typically allows the buyer(s) to give a promissory note for most of the purchase price if no insurance is available. The promissory note must bear interest to avoid tax issues.
Other circumstances in which the owners typically have the option to buy the ownership interest of another owner are if the owner is an employee and the employment is terminated, if the owner loses their interest to a creditor, or if the owner’s interest is lost in a divorce to a spouse.
These provisions are all designed to protect the other owner(s) so they don’t end up becoming partners with someone they do not know and have not agreed to be partners with, or who do not know the business.
The options to purchase an owner’s interest upon divorce typically go to the divorcing partner first and then to the other owner(s) if the divorcing partner does not exercise it. Spousal consents to the owners’ agreement must be signed when the agreement is signed or the option will be unenforceable if an owner later goes through divorce.
Whenever a minority owner is buying a partial interest in a business, they will usually be asked to sign a purchase agreement and an owners’ agreement. Whether buying the entire business or just a minority interest, a buyer should be asking all the same questions and doing all the same due diligence that the buyer would be asking and doing if buying all the capital stock of the business.
These questions were discussed in more detail in article III in this buy/sell series. Often these questions are not asked because the buyer of a partial interest usually already works in the business and feels like they know what they need to know.
That is a risky strategy, but it is a risk often taken by buyers. The risk is that the buyer ends up an owner of a business that has not been properly maintained and subsequently goes out of business. The owners become personally liable to the creditors of the business when there should be limited liability to prevent that.