In Part 1 of this series, I discussed concepts that balance the interests of the company and its owners through voluntary transfer mechanisms like the right of first refusal and permitted transfers. You can read Part 1 here. In this second article, I cover involuntary transfer circumstances, things to consider, and potential action steps to take.
TABLE OF CONTENTS:
- How Buy-Sell Agreements Can Help if One Business Owner Passes?
- How Buy-Sell Agreements Can Help With Disability or Incompetence?
- What to Do With Business Equity If You Divorce Your Business Partner?
- How Buy-Sell Agreements Can Help With if One Owner’s Employment is Terminated?
- Concluding Thoughts on Buy-Sell Agreements and Business Ownership Transitions
Involuntary transfers occur when the shares of an owner are transferred as a result of the occurrence of any event that is unexpected or outside of the control of the owner. The typical circumstances that trigger involuntary transfers include the (i) death of the owner, (ii) disability or incompetence of the owner, (iii) termination of marriage of the owner, and (iv) termination of the owner’s employment.
When a person passes away, his assets (including the shares of the company) will be transferred to his estate or a designated third party (like a foundation or non-profit organization). Thus, the transferee will have full voting rights and the rights as an owner.
If the company and the other owners are interested in being able to control who ends up acquiring the shares, then a provision that grants the company and/or the other owners the ability to buy the shares can alleviate this concern. On the other side, if an owner is interested in being able to cash out of the shares or being able to allow his estate to retain some of the shares, then the same provision can be negotiated to address these concerns.
Typically, this provision grants the company and/or other owners the right to purchase some or all of the shares of the deceased owner. It binds the owner’s estate to sell those shares. The company and/or other owners have to exercise this right to purchase within a certain period of time (usually 60 to 90 days), and the purchase price and payment terms are agreed in advance.
The purchase price can be set in the agreement as a fixed dollar amount or can be determined based on a formula that is applicable at the time of death or based on a valuation of the company at the time of death. The purchase price can be paid at the closing or over time under a promissory note structure which bears interest and can extend over a period of years.
When drafted and executed properly, this provision creates a liquidity event for the estate and allows the company to retain ownership. The company and the owners may consider obtaining life insurance on the key owners in order to fund this buy-back situation. The company usually funds and owns this policy, and the proceeds can be used to pay for some or all of the purchase price. If the insurance proceeds are not enough to cover the purchase price, then the remainder can be paid either in cash or over time under a promissory note.
Disability or Incompetence:
The disability or incompetency provision works similar to the death provision. Upon the disability or incompetency of an owner, the company and/or the other owners have the right to buy some or all of the disabled owner’s shares. Unlike in the death scenario, the owner may still be alive and may be functional enough to make decisions affecting the shares. Thus, the parties should consider whether it is appropriate to include this provision, and if so, what constitutes disability so as to trigger the provision. For example, should disability be defined to be inability to use limbs, inability to perform daily job functions, inability to make decisions or control mental faculties, etc.
Also keep in mind that if there is a provision addressing death, then even if a disability provision is not available, eventually the death provision will apply and address the ownership issue at that time. Similarly, if a termination of employment provision is available (see discussion below), then it may not be necessary to include a disability provision because if the owner is no longer able to perform his or her job duties, then the employment provision may be triggered.
The parties have the option of funding the buy-out through permanent disability insurance, which the company can pay for and which can help pay for some of the purchase price. However, the parties should understand the mechanics of permanent disability insurance, as they are not the same as life insurance.
Termination of Marriage:
If an owner lives in a community property state, then his/her spouse owns half of the shares that the owner owns unless there is an agreement otherwise. An owner’s marriage can be terminated either through divorce or the death of the spouse. If either of these events occurs and the owner does not end up owning all of the shares (either because in the divorce context the spouse claims some portion of ownership of the shares or in the death context, the spouse left his/her portion of the shares to someone else through a will or other mechanism), then this type of buy-sell provision ensures that the owner, the company and/or other owners can retain ownership of the shares.
In the event one of these instances occur, the spouse or his/her estate is required to first sell all of the shares he/she owns (or claims an interest in) to the owner. And if the owner does not purchase all of the shares, then the company and/or the other owners have the right to purchase the shares. These rights must be exercised within a certain period of time.
The purchase price can be determined in advance, through a valuation process or a valuation formula. The payment terms can be set as a lump sum payment or over time through a promissory note structure. Some buy-sell provisions addressing these scenarios even go so far as to substantially discount the purchase price payable to the divorcing spouse to disincentivize him/her from seeking ownership of the shares.
The key thing to remember about all involuntary transfer provisions, but in particular ones addressing termination of marriage, is that the spouse must consent and agree to these provisions in advance to be binding on the spouse and his/her estate. Thus, there is usually a spousal consent that the spouse must sign when the buy-sell agreement is signed.
Termination of Employment:
If an owner’s employment with the company is terminated, then the company may have an interest in obtaining the shares, especially if the termination is for cause because most likely there will be some sort of animosity. Similarly, the owner may have an interest in cashing out of the company if he/she is no longer working for the company and has no control over its growth and direction.
A buy-sell provision can address these interests. Under this provision, upon termination of employment, the company and/or other owners have the right to purchase the departing owner’s shares. Oftentimes, the company’s exercise can be structured to require approval of the majority of the remaining shares, which sets a higher bar for the company’s exercise of this right.
The purchase price for the shares can be determined in advance or pursuant to an independent valuation or a predefined formula. The payment terms can be lump sum or over time pursuant to a promissory note.
Oftentimes, this provision will distinguish between termination at-will vs. for cause, where a for-cause termination will see a substantially reduced purchase price as a means to disincentivize bad behavior. Thus, one of the key concepts in this provision is the definition of “for cause” termination and what processes and/or mechanisms may be involved in determining “for cause” and related termination of the owner.
It is possible that some or all of these voluntary and involuntary buy-sell provisions may not be applicable to the company and its owners. However, it is still a useful exercise to have a discussion among the ownership of the company to determine whether a buy-sell agreement is appropriate. The last thing business owners want is a difficult ownership situation that could have been avoided with just a bit of planning ahead.
Parts 1 and 2 of this article are intended to provide an overview of the various types of buy-sell provisions. If we at Tri Nguyen Law Office can provide a complimentary initial call to better understand your business situation, please do not hesitate to call us at 844.9BIZLAW or schedule your complimentary call here. All business owners should consult with an experienced attorney to address their specific situation.
About the Author:
Tri Nguyen has served as general counsel and company lawyer to businesses, executives, startups and entrepreneurs for over 18 years. He particularly enjoys helping companies grow and achieve their strategic plan, and believes that every business needs a Chief Legal Advisor. He can be reached at www.trilawoffice.com.