Updated: Jan 31, 2019
A Necessity for Closely Held Businesses
Closely held companies have many agreements, but one of the most important is a buy/sell or shareholders’ agreement.
These agreements are designed to protect not only the business owners, but also the investors by providing agreed upon arrangements. Arrangements which must be followed in the event of certain triggering events, such as: death, disability, bankruptcy, insolvency or the desire of one shareholder to sell. These agreements help avoid the potential disagreements between the various shareholders at the time of these events. If these important events are not addressed ahead of time through the form of an agreement, then the likelihood of a smooth transition is doubtful.
It has been my experience in working with new or start up companies, that the shareholders do not feel or believe they will ever disagree, or that such events if and when they occur, can easily be resolved between the families. Another reason given for not having an agreement is many shareholders are afraid to address the required issues for fear they will disrupt smooth waters.
What they fail to recognize is that shareholder litigation is extremely expensive and often several times the cost of preparing an agreement. A well-drafted agreement avoids fights over the valuation of shares if a stockholder decides to liquidate their interests in the company. Additionally, it can avoid the shares being owned by strangers, or even competitors who do not have the best interest of the company in mind.
If the reason for avoiding an agreement is due to the fear of addressing various issues when the company is being formed or when everybody is on good terms, imagine the difficulty the stockholders will have addressing them years later, when the company is highly profitable and the various stockholders have different objectives and desires. When designing a buy-sell agreement, the shareholders must consider the unintentional shifts in control of a company. By way of example, this can happen when two shareholders, each owning 50 percent, later bring in an investor for 40 percent. The initial stockholders can continue to feel comfortable, since together they own 60 percent of the company. However, at a later date, if one of the original stockholders should sell and the company should be the buyer, the result would be the new 40 percent shareholder will now become the majority stockholder, definitely an unintended event.
For the most part, death is the obvious reason for creating an agreement. However, what would happen if the shareholder became disabled? Would his objectives not differ from that of the other shareholders? What if an employee/stockholder is fired, or wishes to sell his stock, or even becomes insolvent or files bankruptcy, which in turn can result in creditors taking control or ownership of the stock? All of these possibilities must be addressed in the agreement, or disputes may lead to unnecessary litigation, or even the possibility of liquidation of the corporation.
Once the agreement is in place, the continued updating of the valuation is paramount. It is conceivable that at the time of the initial agreement, the company could be worth $2,000,000. However, 10 years later, at the time of a triggering event, the company stock could be worth $10,000,000. If the agreed upon price were not updated regularly, then the leaving shareholder and/or shareholder’s family would not receive the fair value for their stock.
In an effort to help guarantee a fair stock value for all of the shareholders, it is desirable to include either: 1) a formula to determine the price, 2) periodic valuation updates, or 3) provide an alternative valuation method if the updates are not made.
Buying the stock of a departing shareholder does not protect the company from a seller who creates a competing business and then solicits the very customers, clients, and employees whom the departing shareholder once serviced. In order to protect the business from this event, it is important to include a covenant not to compete. This is a significant issue, since the former partner does not have to violate any laws for soliciting customers and employees, or infringing on trade secrets. He or she may still take away much of the business. As part of the agreement, the departing stockholder should be required to execute covenants not to compete in non-solicitation agreements.
If your business currently does not have a buy-sell agreement, this is the time to seriously consider drafting one.
No matter how smoothly your relationship with your co-shareholders may seem, there are usually unforeseen events that in the end will make you wish you had entered into an agreement. The uncomfortableness to discuss some of these issues may not be desirable, but the litigation that could ensue, is far worse