The Business Prenuptial
By Kenneth W. Hart, Managing Member (KWHart@L-H-S.com)
Key Issues in Operating Agreements for Closely-Held Companies
In many ways, a business partnership is like a marriage, and as anyone who has been there can tell you, when things aren’t working, it can be just as painful and fraught with peril as any marriage gone bad. Of course, taking care to choose the right partner, whether in business or romance, is key to avoiding problems down the road, but often that is not enough. Circumstances change, people change and what may have looked at the start like a match made in heaven can quickly turn sour. Also, for reasons beyond anyone’s control, a relationship sometimes simply needs to end, say, in the event of untimely death, for example, or a financial downturn.
Good business people always have a plan, and if you are going to enter into a business partnership, you should plan to have a comprehensive written agreement that sets forth in detail what will happen if the relationship does not work out as hoped. Such an agreement is sometimes called a “business prenuptial,” which as the name suggests, is to be entered into before the business “marriage” is consummated, so to speak, or at least during the honeymoon phase of the new enterprise. It is far too late once the divorce proceedings are looming on the horizon, let alone once they are underway.
Depending upon the form your business organization will take, the business prenuptial could be a partnership agreement, a shareholders agreement, a limited liability company agreement, a joint venture or some variation of these agreements. Regardless what form the agreement takes, however, it should not only provide for how the company will conduct business, but also when and under what circumstances ownership interests in the business can, or must be, sold or transferred back to the company or to the other owners. The latter are commonly referred to as the “buy-sell” clauses.
In the next segment, we will briefly discuss some of the pitfalls of not having a comprehensive business prenuptial agreement in place. For ease of discussion, we will use the corporate model, since it is familiar to most people. However, the following issues can and do arise just as often in limited liability companies, general partnerships, and other types of business entities.
Sometimes The Other Shareholders Really Are Out To Get You.
The “freeze out.”
When disputes arise, the majority shareholders may use their position of control to take away all meaningful decision-making power from the minority owners, and effectively freeze them out. With majority voting power, they can dictate the agenda at shareholders’ meetings and elect all or at least a majority of their own directors to the Board of Directors. Freeze out tactics can take many forms. For example, if you are a minority owner, before you know it, you have lost your seat on the Board and the new Board has voted to cut your pay and move your office to the janitor’s closet down the hall. Or, the new Board might use its control to prevent dividends from being declared, and instead use what would be distributable profits to give bonuses or salary increases to loyal employees or to themselves.
The “squeeze out.”
The ultimate goal behind the “freeze out” might well be to squeeze a minority owner out of the company. Even if they cannot literally force a minority owner to leave, the majority owners might be able to make it too unpleasant to stay. Therefore, the freeze out may be used as a negotiation tactic to not only get the minority owner to sell his interest, but also to sell at a lower price or on better terms.
The Company’s Attorney Is Not Necessarily On Your Side.
When disputes arise among the shareholders of a corporation, the company’s attorney is often placed in an awkward position, not knowing whether to take sides in the dispute, and if so, whose side to take. Frequently, the attorney has represented a majority shareholder in various other matters, which is how he or she became the attorney for the company in the first place. The majority owner’s personal interests may or may not be aligned with the best interests of the corporation, which is what the company’s attorney has a duty to protect. Either way, the attorney may have competing loyalties, none of which may run to you as a minority shareholder. Therefore, you can not necessarily expect the company’s attorney to help you resolve disputes with the other shareholders, and you should consider consulting with outside counsel when problems arise.
How Can You Control The 800 Pound Gorilla?
There are some common devices that, depending on the circumstances, can be included in a company’s operating agreement to help level the playing field between the majority and minority interest owners.
Common Control Provisions. The agreement could include supermajority voting requirement for certain actions that would have a direct, adverse impact upon minority owners. These might include, for example, the admission of new shareholders or the issuance of additional stock, either of which could dilute current stock ownership and voting power for minority owners. In some situations, it might be appropriate to have two classes of stock, one voting and one non-voting. This allows income to be distributed according to equity ownership, while voting power is shared equally. That way, the majority owners enjoy profits in proportion to their ownership of the company, but everyone has an equal say in company affairs.
Voting Trust. Under a voting trust agreement, the shareholders could, for example, be bound to vote their shares to elect certain individuals, typically the founders, to the Board of Directors and to appoint certain individuals as officers. Voting trusts can also be useful in family owned businesses where, for estate planning purposes, the owners wish to gift stock to their minor children while maintaining control of the company.
Deadlock Provision. In companies where ownership and/or control is divided evenly, or when certain important decisions require a unanimous vote, the possibility of a deadlock is always present. An impasse among the shareholders can stymie the ability of the business to move forward on key issues. For those situations, your agreement should include some sort of tiebreaker provision. Some agreements, after setting out a work definition of a deadlock, then require mediation followed by arbitration as a means to reach a decision on the dispute issue. The prospect of having to go through a lengthy and potentially expensive process to resolve a deadlock is sometimes enough all by itself to promote compromise.
Sometimes A Shareholder Just Needs To Leave.
Sometimes a shareholder loses his or her ability to continue to effectively function within the organization. This might be due to a physical or mental disability, alcohol or chemical dependency or a criminal conviction. In these situations, your agreement should provide for the right to force the sale of the affected shareholder’s stock to the company or to the other shareholders. An issue that is often overlooked is whether or not a shareholder who is also an employee of the company should be allowed to continue to own shares if they quit their job. Sometimes that is appropriate, but not always. Also, an owner’s personal bankruptcy has the potential for involving the company in protracted, invasive and expensive bankruptcy proceedings, so that possibility should be discussed and planned for before it happens. And, of course, since we are all mortal, the agreement should include provisions for the re-purchase of stock from the heirs or the estate of a deceased shareholder. In all of these buy-out situations, careful thought needs to be given to how the departing shareholder’s stock will be valued, and how that amount will be paid.
Do Not Forget Why You Invested In The First Place.
Most people invest in a business to make money. It is surprising, however, how often people will put money and time into a business without a clear plan of how they are going to realize on that investment. It is important, therefore, to have some understanding of how corporations and other types of entities can be structured to return profits to the owners. For example, if you invest in an enterprise as a “silent, minority owner,” expecting to receiving dividends, you could find that that the company never pays dividends, and instead, the majority owners take all of the “profits” for themselves as salary, benefits and bonuses.
Phantom Income. Perhaps the only thing worse than losing your money or not receiving a return on your investment in a company, is having to pay income taxes on your share of the companies “profits” that you never received. It is not uncommon for a company to earn a profit for tax purposes, but to have no actual cash to distribute as dividends to its shareholders. Maybe the money went, instead, to fund capital improvements or to payoff debt. If the corporation has elected to be taxed as a flowthrough entity under Subchapter-S of the tax code, you will owe income tax on your share of the company’s “paper profit” even though you never received a distribution.
When you combine that possibility with the fact that, as a minority owner, you may have no say in whether or not the company distributes available cash to its shareholders, you can find yourself in the worst of all worlds. This problem of “phantom income” can be solved, however, by including what is sometimes referred to as a “gross-up clause” in the shareholder agreement, requiring that the company distribute at least enough to its shareholders to cover their taxes.
Cash Call. Most shareholders agreements include what is known as a “cash call” provision, which requires each shareholder to contribute his or her pro rata share of capital needed by the company to meet emergencies. It is important that you understand how these provisions work, and to be aware that, depending upon the circumstances, it might be appropriate to negotiate for limitations upon, or your exclusion from, any requirement to meet cash calls.
Avoid Unintended Consequences.
After you have done your homework and have put in place a well thought out business prenuptial agreement, you still need to take care not to unwittingly undo or undermine important provisions of that agreement. Many business owners, who have shown the foresight to create a comprehensive operating agreement, then fail to follow it. As a consequence, when a dispute arises, the argument is made that, by their course of conduct, the shareholders have modified or even abandoned the shareholder’s agreement. Adapting to business and personal needs is normal and often necessary, but you need to be sure that you modify your operating agreement as the need arises, both in writing and with the help of an attorney.
Here is one example to consider. Imagine that you and your shareholder partner each have agreed to equal 50% control and ownership in your business, and your business prenuptial gives effect to that split ownership. Later, you bring in a new shareholder, who now has a 33% share of the business, but has not agreed to be bound by the original control provisions. You have as a result unintentionally invalidated, or at least called into question, the validity of the control provisions.
Shifting the balance of power – supermajority. Many state statutes include provisions that require a specified percentage of shareholder approval for certain corporation actions, which apply by default if the shareholders have provided otherwise in their agreement. In the State of Washington, for example, the statute requires, by default, a two-thirds majority vote for the following actions in a privately owned company: Merger, Share Exchange, the Sale of all or substantially all of the company’s assets and Dissolution. These default provisions may be fine for your purposes, but they can be modified by agreement, so a business prenuptial allows you to come up with a plan that may better suit your specific needs. For example, if you plan to own less than one-third of the stock in a Washington corporation, you may want provisions in the agreement that set the required shareholder approval for one or more of the four items listed above at a level that would require your vote.
What’s Your Exit Strategy?
The time may come when you want to take your investment somewhere else or relax and play some golf instead. Unless you plan ahead, here are some the obstacles you may face in trying to withdraw from the corporation.
Lack of Liquidity. Unlike a publicly traded stock, you can not simply liquidate your position in the company with a call to your broker.
Lack of Marketability. Although the shareholders agreement may allow you to sell to a third-party, there is not likely to be anyone outside the company interested in buying it, particularly if your’s is a minority interest in a small or family owned company. If you do find someone who is interested, most buy-sell provisions will require that you first offer your stock back to the company and/or to the other shareholders. Depending upon the particular agreement, that process can be complicated and time consuming, and by the time the other shareholders have decided they don’t want to buy your shares after all, your potential buyer may have gone elsewhere.
Minority discounts. Unless your shareholders agreement provides otherwise, the sale of a minority interest, because it is not a controlling interest in the business, may be subject to a “minority discount,” even when it is being sold back to the company or to the other shareholders. So, for example, a 20% shareholder, rather than receiving 20% of the company’s fair market value when it is sold back to the company, may be offered only 15%.
What Is It Worth Anyway?
Uncertainty about the value of the company’s stock may give rise to a dispute at the most awkward of times. It is crucial to know ahead of time how the price of the shares will be calculated, so there are no surprises when a shareholder wants or needs to sell his or her interest. There are many valuation methods. These include the book value of the company’s asset, weighted average profits, periodic valuation by agreement, professional appraisal and, when in doubt, an agreement to agree, followed by arbitration if all else fails. Some agreements will even include provisions that affect the value depending upon the circumstances. For example, there may be price penalty if a shareholder withdraws in advance of some pre-determined date.
Where Is The Money To Pay For The Shares?
A very important consideration is where the funds will come from if the company has to buy out a shareholder. An unexpected and un-funded obligation could financially cripple the business.
Key-Man or Cross-purchase Insurance. Life insurance can be purchased to provide the funds needed to buy back the shares of a deceased shareholder. It is important, however, that you consult an insurance professional to structure the plan so that the company is allowed to deduct the expense of the insurance for tax purposes and ensure that the estate of the deceased shareholder does not have to pay tax on the insurance proceeds.
Structured Buy-Outs. A structured buy-out could give the shareholders an opportunity to purchase the interest of a selling shareholder even when they do not have enough cash at the time of the sale. The operating agreement can set out the terms and framework for a payment plan, including a down payment and the payout term and interest rate for the balance of the buy out price.
Protecting The Company’s Value.
You should always include provisions in your business prenuptial to protect the intangible value of the company.
Non-Disclosure Agreement. The shareholders should be required to keep confidential the business secrets and other proprietary information of the company, not only while they are shareholders, but also after they leave the company for some reasonable period of time, if not indefinitely.
Non-Competition Agreement. You do not want to be in the situation of having bought out a shareholder only to have them compete with the company after they leave. Therefore, an agreement not to compete should be a condition of any buy out. To be enforceable, however, these types of agreements must be reasonable in scope, geographic area, and time.
Trade Secrets Act. Some states have laws designed to protect business trade secrets even in the absence of a confidentiality agreement. The Washington Trade Secrets Act, for example, protects from disclosure to third-parties company information that derives its value from the fact that it is not generally known or generally knowable outside the company. This might include a customer list and certain unique ways of doing business.
Planning For The Next Phase Of Life.
An Estate Planning Tool. In the event of a shareholder’s death, the sale of stock can help create liquidity in the decedent’s estate, as well as fix the value of the decedent’s shares in the company for estate tax purposes. From the standpoint of estate planning, therefore, the buy-sell provisions in a shareholders agreement may be key to ensuring there is a ready purchaser for an asset that might otherwise be very difficult to sell when the time comes.
Business Succession Planning. Small business owners might want to have their successors contribute start-up funds at the time the business is formed. The initial capitalization is usually minimal, and successors could own a significant portion of the business that will not be taxable upon the death of the business owner. Unfortunately, most of the time an estate planning attorney is contacted well after a business is established, which is too late for a successor to buy inexpensively.
The author of this article, Ken Hart, is a founding partner of Larson Hart & Shepherd. The article was adapted from the course materials that Ken and firm partner Mike Larson developed for use in several business lectures they presented in 2006 and 2007. This is merely intended to provide the reader with an outline of some of the various issues and considerations in planning and drafting a business operation agreement, which only be undertaken with the help of an experience business attorney.
