Several posts ago, I discussed the importance of written agreements. For businesses with more than one owner, this is doubly so: an “ownership” agreement is essential. Depending on the type of business entity that has been selected, this agreement will be known as a Partnership Agreement (for a partnership), a Shareholder Agreement (for a corporation) or an Operating Agreement (for a limited liability company). These agreements are also often generically referred to as “Buy-Sell” agreements, though a good Ownership Agreements will address much more than the conditions under which an ownership interest can be sold.
Regardless of the type of entity, the business owners must have an Ownership Agreement between them as to how the business will be run. A business without an appropriate Ownership Agreement is like as a person without a Last Will and Testament: they have decided through inaction to let the state decide how their affairs will be governed. Actually it’s worse, because unlike dying without a will, the business owners who should have entered into an agreement may actually be alive to see the damage inflicted by their inaction.
Why is an Ownership Agreement so important? We’ve all heard the horror stories of marriages that end in divorce without a prenuptial agreement–lots of drama and fighting, and a small fortune spent on attorneys fees. Business disputes are no different, they can be nasty, expensive, and in the end, the litigants are at the mercy of the court to decide their future.
While no agreement can completely ward off the specter of litigation, a good agreement will narrow the issues that can be disputed and create disincentives for one party to sue the other. The first step to a harmonious business relationship is creating a map to guide the parties through the tough issues. With that in mind, the most important issues a good Ownership Agreement will cover are:
1. Authority. Who is going to be in charge of the day-to-day operations of the business and make the typical decisions, like the hiring and firing of employees, the signing of checks and the selection of the business’ accountant, attorney and other professionals? The company’s Bylaws or Articles of Organization may provide that the officers or managers of the business will have these powers, but the Ownership Agreement can provide who will be appointed to the officer and manager positions. More importantly, an Ownership Agreement can require that a vote of certain percentage of the owners is required to implement extraordinary actions, like selling or dissolving the company or borrowing money.
2. Sale of an Ownership Interest. Should the owners of the business be free to sell to their interest to whomever they please? Should the other owners be able to completely block a sale? Neither would seem to be ideal. In an Ownership Agreement, the owners can determine the appropriate measures to be taken if one of them wants to leave the company. A common solution is to give the remaining owners a right of first refusal to buy the leaving owner’s interest at either a set price or a price equal to the best outside offer. Such a provision permits the resigning owner to be paid the fair value of their interest, while protecting the remaining owners from having to accept a new owner with whom they are not comfortable.
3. Death and Disability. What happens when one of the owners dies? Will the surviving spouse and kids take over and become owners–with full voting rights and decision making authority? What happens if an owner who is also a key employee of the business becomes disabled and can no longer contribute? Like a Last Will and Testament, an Ownership Agreement can help provide a clear path in tragic times and help ensure that the business is only minimally affected by such circumstances. By integrating life insurance with an Ownership Agreement, the owners can ensure that the surviving owners have the financial means to purchase the deceased member’s interest without unduly taxing the company’s coffers, which also serves the purpose of ensuring that deceased owner’s family is financially protected.
4. Succession. Who will run the business when the current management either retires or needs to retire but refuses to do so? Will the children of the owners take over? Will the company be sold? Will independent management be hired? No one wants their business to wind up like the last few years of The Larry King Show–declining in market share, and at the mercy of a key employee whose best years are behind him and who is just going through the motions. An Ownership Agreement can provide for a smooth transition to a new generation of management, providing incentives for younger management to stay on board to reap the benefits of their loyalty.
5. Valuation. How will the company’s value be determined? Valuation is an integral component of any business and it is particularly important when an owner or an owner’s estate wishes to sell their interest. By working with the company’s accountant, the owners can establish an appropriate formula for determining the value of the business, such as a multiple of earnings, book value or other measure. By agreeing in advance how the business should be valued, the owners will avoid much grief and potential litigation down the road when it is time for someone to sell.
These are just some of the areas that can be covered in an Ownership Agreement. Others include covenants not to compete with the company, requirements for capital contributions in certain circumstances, and terms of employment for the owners. While all of these topics are important, perhaps the most important function of an Ownership Agreement comes from the planning that is required to draft and negotiate one. The process forces the owners to take a hard look at their business and determine the future path for their venture. By doing so, and by reviewing and revising their agreement every few years, business owners can minimize the risk of the unknown, provide a map for continuity and help ensure a peaceful transition to the next generation. Kumbaya!
Brady Business & Real Estate Advisor 
bradyadvisor
03/30/2011
Inc. Magazine has a good related article this month: Succession Stories: The Good, the Bad, and the Ugly
http://ow.ly/4pvuY