When two or more individuals start a new business venture, often
the last thing they think about, or want to think about, is the day
when they will no longer own the business together. The
unfortunate reality is that business owners can never start exit
planning too soon, despite the need to have difficult and sometimes
uncomfortable discussions.
Wise owners will recognize that co-ownership, at least by the
founding individuals, cannot last forever. They will address, come
to an agreement on, and document their agreement on three important
questions:
1) Under what circumstances will an owner have an option or
obligation to sell his or her ownership interest?
2) If an ownership interest is to be sold, how will the purchase
price be determined?
3)After the purchase price is determined, where will the money
come from to pay it?
Trigger Events
Events giving rise to an option or obligation to sell an ownership
interest are often referred to as "trigger events." The
most common trigger events are death, disability, and termination
of employment in the business, whether by retirement or
otherwise.
If the termination of an owner's employment in the business
will be a trigger event, then the owners should discuss whether the
circumstances of termination should affect the purchase price or
terms of payment. For instance, should an embezzler who is fired be
paid as much for his or her ownership interest, and as quickly, as
an employee who retires at age 65 after giving a year's notice?
In cases in which an owner quits without cause, is fired with
cause, or retires without adequate notice, the owners often agree
that the departing owner will be paid a fraction of the purchase
price that would otherwise be payable for his or her ownership
interest.
Determination of the Purchase Price
At the outset, owners should determine the value of the business
and an appropriate methodology for a periodic redetermination of
value. In most cases, owners lack the objectivity or expertise to
determine value in the way the marketplace would. Owners will
sometimes apply a simple formula to calculate a value, such as a
multiple of revenues or profits. Such formulas rarely reflect the
marketplace. An objective determination of value is in almost all
cases best left to a valuation professional.
A good shareholders' agreement will establish a mechanism for
the periodic revaluation of ownership interests. My preference is
for owners to engage a valuation professional annually to
redetermine the value. The redetermined value then becomes the
purchase price for any transfers during the following year.
Owners are often unwilling to invest the time and money necessary
for an annual redetermination of value. Therefore, a good
shareholders' agreement should require a current revaluation if
a trigger event occurs more than a year after the date of the most
recent valuation. This safety net will help prevent a selling
shareholder from receiving inadequate value or a windfall on the
sale of his or her ownership interest.
Funding the Purchase
Owners should recognize at the outset that the funds required to
make a purchase will, under a shareholders' agreement, almost
certainly have to come from the business. Small business
owners' personal finances are generally too intertwined with
the business' finances to make self-funding realistic.
An ownership interest transfer triggered by death or disability
can often be funded with insurance proceeds. To accomplish this,
owners should purchase insurance as soon as possible after a
shareholders' agreement signed. If future revaluations
determine increased value, the owners should consider whether to
purchase additional insurance to keep pace. At some point
additional insurance might become unavailable or unaffordable;
therefore, the shareholders' agreement should address how any
uninsured portion of the purchase price will be paid.
The purchase price to be paid after an uninsurable trigger event
(e.g., retirement) occurs is most often paid with a combination of
an up-front payment and a promissory note. The shareholders'
agreement can provide for different payment periods, depending on
the amount of principal to be paid. The owners should be realistic
about the amount they will need to live on post-departure, as well
as the business' ability to pay that amount.
The law does not prescribe an orderly method for the acquisition
of a business owner's interest after his or her departure from
day-to-day operations of his or her business, which can at times be
rancorous. Wise owners will plan for the inevitable at the first
opportunity. Although they will incur up-front expenses to do that,
advance planning can spare owners great future expense and
heartache.
Tony Delyani is a director in the Corporate Department at the law firm of McLane, Graf, Raulerson & Middleton, Professional Association.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.