Private Client Services Update – Stuff Happens
When parties get together contemplating a proposed new venture, it is similar to a new marriage. They are very excited about the future opportunities but have not really thought through the issues if events do not go as anticipated. Whether the venture takes the legal form of a corporation, limited liability company or partnership, many issues are common with each. While the parties may recognize that it is appropriate to have a buy-sell agreement, operating and/or partnership agreement depending on the particular entity (collectively “entity agreement”), at the initial stages of the venture they may not have either the resources or the historical perspective to appreciate and plan for what is going to or could happen down the road as their circumstances change. As they continue to make money and develop the business, one of the last things with which they typically wish to deal, is updating the entity agreement or dealing with problems for which there may be no easy solutions. Unfortunately, when one party later wishes to retire or has a terminal illness, they may find that their lack of planning not only puts their future but also that of their family in a situation that was never contemplated. The consequences can be even more significant if the business interest represents the major asset of the owner’s estate.
Parties should periodically review and update their entity agreement to reflect changes that have occurred as the entity and their personal situations evolve. Some of the issues to consider in this process are outlined below.
- First Right of Refusal or Opportunity. The agreement should normally contain a first right of refusal or a first right of opportunity, so that if either party wishes to get out of the business and sell their interest to a third party, the remaining owner will not have to deal with a new owner, if they want to own the business by themselves. The advantage of the first right of refusal is that the remaining owner will know who that new owner is going to be, while the right of the first opportunity merely sets forth the terms upon which a sale may occur if the remaining owner chooses not to purchase the interest offered.
- Tag Along and Drag Along Rights. When there are multiple owners, these types of provisions can allow the majority owner in the “drag along” situation and the minority owner in the “tag-along” situation to make sure that they are protected or have the ability to control their own destinies. In the drag-along situation, the majority owner can require the minority owner to be dragged along in any sale upon the same terms and conditions as the majority owner obtains, therefore allowing for a sale of 100% of the ownership interests to a new party. However, the minority owner should first have the right to buy out the majority owner, on those same terms, before the drag along occurs. In the tag-along situation, in the event that the minority owner does not wish to buy out the majority owner, they would have the right to tag along under the same terms and conditions as the majority owner is obtaining.
- What events would allow an owner to purchase or require an owner to purchase the interest of another owner’s interest? These could include (a) retirement, (b) death or (c) disability. Each of the above events would have separate conditions and terms for such a sale or purchase and may be influenced by what funding mechanisms are to be used to purchase the interest. In this way, upon the specified events, the parties would know what rights and obligations they would have.
- Valuation of the Business. In the event of a requirement to purchase from or sell to the other owner under the entity agreement, what will be the value of that interest? Usually, parties will agree to a certain value or a formula upfront when they form the entity. However, the agreement should contemplate a periodic review and an update of that value and if one does not occur, an adjustment based on a formula or business valuation at the time such event occurs. Many times the value of the business will increase over time and the agreement should reflect this change. In addition, an entity agreement among family members must comply with certain tax requirements under the Special Valuation Rules of IRS Code Section 2700 or there could be adverse tax consequences.
- Mechanism for Buy-Out. In the event a buy-out does occur, how will one party buy the other party out? Is the purchase price to be paid in cash or upon terms, and if upon terms, will there be collateral for the obligation? Also, will the owners purchase life insurance on each others’ lives to fund the buy-out upon a death? If so, will the agreement be a cross-purchase agreement that may have different tax effects versus a redemption agreement vehicle? In the event insurance is to be utilized, the parties should periodically review the value of the business to determine whether there is sufficient insurance. If there is not sufficient insurance to fund the buy-out, the agreement should contemplate how any excess portion of the purchase price is to be paid, either through cash or by a promissory note and if so, what duration? The selling party or their estate may prefer the term to be a shorter period and would like to have collateral, while the buying party would like a longer-term with less collateral.
- What happens to Guaranteed Debt? During the term of an entity, the entity usually needs to borrow money and the owners frequently are called upon to guarantee that debt. Upon an event in which one owner sells their interest, what happens to their guarantee on that debt? Is there an obligation on the buyer to refinance the debt and remove the liability of the selling owner? While in concept this sounds fine, it may not be very practical since the lender may not be willing to permit a refinancing without the selling owner’s continued guarantee. If this release is not possible, should there be a separate indemnification for the benefit of the selling owner by the buying owner of the debt for which they have guaranteed? If the indemnification were to occur, should that be a reduction in the purchase price to reflect the added benefit to the seller? Without the release of the guarantee, a consequence may be that an estate may not be permitted to distribute assets to its beneficiaries and may ultimately find itself having to pay off part or all of the guaranteed debt, thereby imposing unexpected financial burdens to a surviving spouse or family.
- Push-Shove and Deadlock. What happens when the parties just cannot get along as owners, such as in a bad marriage? Normally under the law, there is not a unilateral right to terminate the entity and therefore the parties must live with each other for some period of time usually not on the best of circumstances. A “push-shove” or “deadlock” provision in the agreement would allow one owner to set a price and give the other owner the option to the right to either buy or sell at that price, which may be a solution to the deadlock without having to go to court. Such a provision can be fair if both parties are in somewhat equal parity financially. How to deal with the payout and how to deal with existing debt also become very important issues to resolve in these push-shove situations.
While sometimes there may not be simple solutions to all issues involving owners of a business, it is important that the parties periodically review their entity agreements to make sure they are up-to-date based on the evolving nature of the business and their personal circumstances, or they, their estates and families may find themselves in a position no one ever contemplated.
James G. Steiger is a partner at Kaufman & Canoles, in the firm’s Norfolk office. His practice focuses on business and estate planning, wealth transfers with an emphasis on closely held businesses and planning for executive professionals. He can be reached at (757) 624.3234 or email@example.com.
The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2023.