In an earlier installment
of A Legal Moment
(May 2014), I discussed the benefits of limited liability protection
available from operating a business as an entity such as a corporation
or limited liability company. In both entities, if there are
multiple owners, it is critical to have solid agreements among the
owners regarding the operation of the business.
In corporations, such agreements are called “shareholders’
agreements,” and in limited liability companies, such agreements are
called “operating agreements.”
Owners’ agreements essentially operate as “business
pre-nups” and are an invaluable planning tool. For example, our
firm represented a start-up business in which the owners themselves,
without the assistance of an attorney, wrote a series of poorly drafted,
contradictory, and ambiguous owners’ agreements. When the
business achieved success, a large multinational corporation purchased
its assets for a substantial sum. After the closing of the sale, a
dissenting shareholder sued the business and all of his co-owners,
claiming he deserved a higher percentage of the sales proceeds.
The business and the co-owners successfully defended themselves, but
spent tens of thousands of dollars on legal fees in the process.
An early investment in a properly drafted owners’ agreement would have avoided this dispute and its expense.
Owners’ agreements cover all manner of issues
relevant to business ownership and are very flexible to meet the desires
of the owners and the needs of the business. What follows is a
checklist of terms to consider including in an owners’ agreement with
brief considerations for each item.
- Owners’ involvement in day-to-day management of the business
- To what extent will each owner be involved in day-to-day management of the business
- Will each owner expect to be on the board of directors or other management body?
- Voting power of owners
- Does each owners’ voting power match her
capital investment, or might some owners have a voting preference, or a
- Will all decisions be made by majority
vote? Many operating agreements require a super-majority, or even
unanimous, vote for major decisions such as selling the company, merging
with another business, ending the business, declaring bankruptcy, or
confessing a judgment.
- Form of dispute resolution if owners’ deadlock on a decision?
- If it is possible for the owners to create a tie when voting on a management decision, then it is possible they will deadlock.
- Possible solutions are: forcing a
buy-sell event to transfer ownership to one or more remaining owners
from a departing owner or requiring a dissolution of the business.
- Restrictions on the sale of ownership interests
- Because owners go into business with each other, this term is one crucial feature of an owners’ agreement.
- Typically, an owner is not allowed to
sell his interest to an outsider without first offering it to other
owners of the business.
- There may be exceptions allowing free transfer to spouses or children.
- Loss of control of ownership interest
- What happens to the interest of an owner
who loses control of his or her interest through death, bankruptcy,
divorce, litigation, or otherwise?
- Most commonly these events trigger a buyout option by the remaining owners so they can purchase the troubled ownership interest.
- The agreement may include provisions for life insurance on the owners in order to fund buyouts.
- Establishment of price in buyout scenarios
- Whenever a buy-sell event is triggered,
there must be a procedure for setting the price. There may be
different procedures for sales to new owners and sales to existing
- Possible mechanisms include: book value, formula, appraisal, or agreed value.
- Cash flow and profits and losses
- How will profits and losses be allocated? How often?
- How will cash flow be distributed? How often?
- Do any members receive preferential payments or allocations of these amounts?
- Capital structure
- What will the capital structure be? Direct investment, loans from owners, or a combination of both?
- What happens if the company needs more cash? Can the owners require additional capital contributions from all owners?
- Is the capital investment supposed to earn a return?
- How are owners’ loans to the company or
from the company to an owner agreed to or resolved in a sale or
dissolution of the company or its assets?
As you can see, there are many concerns to address in
an owners’ agreement. Business owners will serve themselves and
their business well by discussing these issues at the creation of their
company, and routinely at the annual meetings of the company, and by
seeking professional assistance from their legal and financial advisors
to formulate a solid owners’ agreement to meet their goals. When
agreement is reached, or when issues remain unresolved, I strongly
recommend that the owners and the company seek legal counsel to assist
them in either drafting the agreement or working through the issue.
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