In this series of articles, we are discussing the seven gaps or “holes” that Exit Planning advisors find in their clients’ buy-sell agreements.
The prior two articles described the failure of most buy-sells to address the challenges to a business caused by the Loss of Financial Capital and Loss of Talent. Today we turn to the failure of most agreements to address events, other than the death or disability of an owner, that can trigger a transfer of ownership.
Ideally, a buy-sell agreement ensures the continuity of ownership of the business regardless of the event triggering the ownership transfer, yet, in practice, most:
- Deal only with two events: the death and disability of an owner.
- Provide a right of first refusal to the remaining owners when an owner wishes to sell his or her ownership interest to an outside party.
But what about the other transfer events that are either more likely or potentially more harmful to remaining owners? Do your clients’ buy-sell agreements cover:
- Involuntary transfers caused by personal bankruptcy or divorce?
- Forced termination of an owner’s employment?
- Irreconcilable differences between owners?
Let’s examine each.
Involuntary transfers caused by a co-owner’s bankruptcy or divorce
In either of these situations, an owner could be forced to transfer his or her ownership interest: in a bankruptcy, to the bankruptcy trustee or creditor; in a divorce, to the former spouse.
A buy-sell agreement should simply give the business the opportunity to acquire an owner’s interest in the event of an involuntary transfer—whether threatened or actual. Perhaps the only thing worse than having your client’s ex-spouse own part of the business is having someone else’s ex‑spouse own a part of the business.
Of course, there are nuances in drafting these provisions because a divorcing spouse’s attorney or bankruptcy creditors may well argue that these types of provisions are not enforceable with respect to their rights. On the other hand, these parties may be much more interested in the cash that the business will pay to the unfortunate owner for his or her ownership interest than they are in an illiquid ownership interest in a company. We suggest you discuss these risks with your clients and refer them to well-experienced legal counsel.
Forced termination of an owner’s employment
Businesses with one or more controlling owners and one or more minority owners must deal with the fact that, in the absence of an agreement to the contrary, the controlling owner can fire the minority owner. Similarly, if there are three (or more) equal shareholders, two of whom would generally have the power to fire the third.
Unlike death and disability transfer events, there are no “boilerplate” provisions that deal with these situations. Instead, advisors must help owners weigh the alternatives.
For example, controlling owner(s) might want the ability to purchase a terminated owner’s interest. The fired owner may want the ability to sell his or her ownership back to the company or the other owners. Or all owners may simply want the agreement to require a mandatory purchase of ownership in the event of termination of employment of an owner for any reason, whether voluntary or involuntary.
Again, when any involuntary transfer occurs (and they are not infrequent), the scene is likely acrimonious and hostile. Litigation is threatened or initiated. In these situations a buy-sell agreement that has determined a fair value for the business, carefully considered buyout terms and conditions, and all parties have agreed to can truly be a Godsend.
Irreconcilable differences between owners
When there are two or more non-controlling (usually equal) owners, neither may be able to fire or get rid of the other(s) in the absence of a provision in the buy-sell agreement. A buy-sell agreement can be most valuable when these owners become locked in a bitter dispute with respect to the future course of the business enterprise. The agreement resolves the dispute by forcing one or more disgruntled owners to sell their ownership and get out of the business.
A buy-sell agreement can stipulate that either owner may offer to purchase the other owner’s interest. The second owner must then either accept the offer and sell his or her ownership interest or purchase the first owner’s interest for the same price, terms and conditions spelled out in the offer. In other words, the second owner has two choices: either accept the offer and sell his or her ownership interest or turn the tables and buy the offering owner’s ownership interest.
At the conclusion of this buyout process, one we call “The Texas Shootout Provision,” there will be only one owner. While you may have a different name for it, it is a painful remedy undertaken only when there is no alternative that the parties can agree to. We suggest that you include this provision in buy-sell agreements because it tends to encourage owners who are not getting along with one another to agree to a buyout by one party or the other without having to invoke the provision. If they don’t agree, a foot-dragging partner cannot prevent the eventual buyout of his or her ownership interest.
This provision can offer a third choice: It can allow either party – if both parties can’t get along – to dissolve the business, pay off its debts, distribute the assets, and start over.
Advisors who explain these three not-at-all-infrequent events to owners often find that owners are more motivated to update and revise their buy-sell agreements.
Explain that it is much, much better to discuss, agree upon, and draft provisions dealing with involuntary lifetime transfers when they are theoretical, could apply to any of the owners and long before any of these situations arise. Suggest that they retain the best legal counsel available to explain and draft appropriate provisions that protect all of the owners.
Finally, your Exit Planning advisory team should include a business attorney who knows whether state law precludes certain approaches. Find the best attorney you can because whenever involuntary transfers occur you can be certain the “other side” will retain the best legal counsel they can find to represent them. Get yourself and your clients there first.
Ultimately, the advice you give and your intervention in this area may well make the difference between a business that survives and thrives, and one that blows up. And as an owner’s trusted advisor, isn’t that your job?
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