Plan For the Worst
When there are multiple owners of a business, one of the most important legal concepts you will need to consider is the buy sell provisions and other provisions that govern ownership in the company. They are used to determine if and when any interest in the company can be transferred.
Why Buy Sell Provisions?
Buy sell provisions and other provisions that govern ownership in the company are important in order to allow the owners of a company to control who owns the company. Typically in our industry, two people will come together to form a limited liability company or a corporation, each owning fifty percent of the company. In that instance, the parties are usually comfortable working with each other, but do not want to be subject to one of them selling out and then the other person being stuck with a buyer they do not know or want to work with. That is where these provisions come in. They restrict who can become an owner and also can be triggered if something happens to one of the owners to allow the other owner to buy the other owner out.
Buy sell provisions are usually an important part of other documents. In a limited liability company, they are typically found in the operating agreement that sets forth the rules governing the LLC. In a corporation, a shareholders agreement is the place for the these provisions. They can also be found in partnership agreements for general or limited partnerships.
Right of First Refusal:
The first part of the these provisions is the right of first refusal. If an owner wants to sell it can solicit offers from third parties. But once it has such an offer, it must inform the company and the right of first refusal is triggered. Typically the company has the right to buy the interest on the same terms and conditions as the offer from the third party buyer. If the company does not want to make the purchase, then the shareholders that are not selling also get a right to make that purchase. Only if the shareholders and the company pass on making the purchase, can the seller sell to the third party that made the original offer.
Even if the third party is allowed to make the purchase, there are also additional restrictions. The third party must agree to be subject to the same restrictions as the previous owner of the interest. In addition, many times the buyer is not allowed to be part of the decision making for the company. The sale of the interest is limited to the right to be paid whatever amount of money the owner is entitled to, but nothing more.
Buy Sell Provisions:
The most important provisions are the ones that can be used to force an owner to sell their interest in the company routinely, referred to as the buy-sell provisions. These provisions can be mandatory in that the company must buy out the owner or can be optional in that the certain events that occur only give the company the right, and not the absolute obligation, to purchase the owner’s interest in the company.
There are a number of different scenarios that often are used as trigger points for the buy sell provisions. The one almost always used is death, so that if an owners dies then the company must purchase the interest of the deceased owner. This is done in order to allow for the continued operation of the company without having to worry about having the decedent’s heirs trying to influence how the company is run. Since this purchase can be funded by life insurance, it is a very commonly used trigger point for the buy sell provisions.
Another trigger point that can be used is if the owner becomes disabled. This would be more appropriate for an owner that is actively involved in running the business. The same is true of using continued employment with the company as a trigger. If someone is no longer working for the company often this can trigger a right for the company to purchase that owner’s interest. But, that would not be used as a trigger for people who are just investors and not involved in the day to day operations of the company.
Other triggers commonly considered are divorce and bankruptcy. The issue here again is control. In the event of a bankruptcy there is the possibility that the trustee put in charge of the bankrupt owner’s property would want to exert authority over the company. Same in a divorce proceeding if an owner’s spouse is awarded ownership in the company by the court, now that spouse has a say and can vote on items requiring ownership approval. Small companies generally want tight control over the decision making process so they set up buy sell provisions to allow the company to keep control in the event of a bankruptcy or divorce effecting the ownership interest of an owner.
One other important consideration is what happens in the event of a deadlock. As I said many of the companies I set up have 2 owners that each own 50% of the company. If majority rules for decision making, since no one is a majority if the two owners cannot agree on a course of action for the company, the company cannot move forward. In order to avoid that owners should consider a “Dutch auction” provision.
A “Dutch auction” provision is triggered when there is internal dissension in the company and two or more factions of voting owners of the company are so deadlocked that its business can no longer be conducted. In that case either faction may require a sale of the ownership owned by one of the factions in the following manner.
The faction of owners electing to invoke the process notifies the other faction of an offer to purchase or sell to the other faction. The offer is in writing and specifies the terms, conditions and price which the electing faction is willing to either sell their ownership interest to the other faction or to purchase the other faction’s ownership interest. The other faction typically has 30-60 days to consider the offer and decide if they want to purchase the electing faction’s ownership interest on the terms, conditions and price set forth in the offer.
If the other faction fails to notify the electing faction of the other faction’s election to purchase the ownership interest within the 30-60 day period or provides notice from the other faction that such election will not be made, the other faction is bound to sell their ownership interest to the electing faction on the terms, conditions and price set forth in the offer. Otherwise the other faction notifies the electing fashion that the other faction will purchase the electing faction’s ownership for the offer price. This offers the parties an efficient way to end the dispute for a fair price and without having to engage in a lengthy court battle.
By providing for an orderly change of ownership, the company and the owners can save time, effort and money. If you have more than one owner for your company, you need to have these provisions in place sooner rather than later.
The information contained herein is for informational purposes only and should not be relied upon in reaching a conclusion in a particular area. The legal principles discussed herein were accurate at the time this article was authored but are subject to change. Please consult an attorney before making a decision using only the information provided in this article.