CHAPTER 31

Co-Owner Transfers

At times, it becomes necessary to buy out a partner's interest. The methods available for purchasing other shareholder's interests are known as co-owner transfers. This discussion covers acquiring both equal and unequal partner interests. In the absence of a written ownership agreement, a minority interest holder is at the mercy of the controlling shareholder. Further, 50/50 partners without a buy/sell agreement will not have the tools to settle serious disputes. This chapter discusses buy/sell agreements, first refusal rights, and other techniques available to transfer shareholder interests to partners.

BUY/SELL AGREEMENTS

A buy/sell agreement among the owners of a business fixes the owners’ rights with respect to each other and the business. A buy/sell agreement is important to the owners of a private business because it can serve the dual purposes of restricting the transfer of stock to undesirable parties and providing a ready market for the stock sale. If the agreement provides a practical framework for owners, it can resolve a number of issues that might otherwise lead to later conflict. The primary purposes of buy/sell agreements are to:

• Transition business ownership while continuing the operation of the business.
• Create liquidity and a market to sell a business interest.
• Determine the triggering events that will activate the buy/sell.
• Set a price, or formula for determining price, for the business interest.
• Protect against unwanted new partners.
• Provide for dispute resolution procedures prior to disputes occurring.
• Determine the payment terms once the buy/sell is triggered.

A well-constructed buy/sell agreement is similar to a premarital agreement because it is uncertain when one of the partners will want to part company. Dispute resolution procedures are relatively easy to agree on prior to the appearance of a dispute, but they become much more difficult once a dispute arises. Every business with multiple owners should have a buy/sell agreement.

A buy/sell agreement can establish the estate tax value of a private stock only if it satisfies specific conditions as set forth in Internal Revenue Service regulations. The regulations provide that agreements entered into before October 9, 1990, and not substantially modified thereafter will be considered in valuing the decedent's stock for estate tax purposes if both of these conditions are met:

• The agreement is a bona fide business arrangement.
• The agreement is not a device to pass the decedent's shares to the natural heirs for less-than-adequate consideration.

Insubstantial modifications include: those required by the agreement; discretionary changes, such as a company name change; modification of capitalization rates due to specified market interest rate changes; and adjustments to produce a closer approximation to fair market value. The decision whether to modify a grandfathered buy/sell agreement is important. It should be undertaken only with professional estate planning advice.

A decision hierarchy can be used to construct a buy/sell agreement properly. Exhibit 31.1 shows this process. The flow of decision making in the hierarchy indicates that the type of buy/sell agreement must be chosen before decisions are made regarding any corresponding provisions.

EXHIBIT 31.1 Buy/Sell Decision Hierarchy

Provisions are then negotiated between the parties, reflecting the participants’ intentions. Valuation mechanics are then constructed and applied in support of the provisions. These valuation mechanics are described in Chapter 11 and are not repeated here. Finally, buy/sell triggering events are defined, and appropriate funding techniques are chosen. This hierarchy forms the basis for the remaining discussion of buy/sell agreements in this chapter. Exhibit 31.2 provides the transfer matrix for buy/sell agreements.

EXHIBIT 31.2 Transfer Matrix: Buy/Sell Agreements

BUY/SELL TYPES

There are several types of buy/sell agreements.1

• Repurchase agreements. The entity (corporation, partnership, limited liability company, etc.) buys the interest from the exiting party.
• Cross-purchase agreements. One or more other individuals buy the interest from the exiting party.
• Hybrid agreements. Normally allow the founder first priority to buy the interest and other owners or partners the second option to buy.

The exiting party for all three types of buy/sell agreement may be the estate of the deceased party. There is flexibility surrounding the creation of an agreement. For instance, the agreement may or may not apply to all of the owners. It is fairly common for noncontrolling owners to be subject to the agreement while the controlling owner is not. Also, it is possible for the agreement to have one set of buyout options during an owner's lifetime and another set of options for a decedent's estate.2

Buy/Sell Provisions

Provisions of the agreement should be designed to meet the needs of the parties. Because provisions are negotiated, there is no one right answer for all situations. Rather, consider a palette of choices, with colorful monikers. And while it is not this book's purpose to impugn any nationality, some of these provisions are discussed in the next sections.

Russian Roulette

In a Russian roulette buy/sell provision, sometimes called a mandatory buy/sell, the exiting party sets a per share price for the stock.3 The other party either acquires the stock at the offered price or sells out at that price. Assume that John Ambitious, PrivateCo's president and minority shareholder, wishes to withdraw from the company. He sets a price of $100 per share for his stock. The other owners have a certain period, say, 90 days, to respond with an election to either buy Ambitious out for $100 per share or to sell their shareholdings to Ambitious for the offered price. This either-sell-or-buy process forces the exiting owner to set a reasonable price.

Owners with no intention of selling can employ the Russian roulette provision by initiating the process with a high per share price in order to buy out another owner. However, if the owner wants to be bought out she will initiate the buy/sell with a low-share price.

A Russian roulette provision gives an advantage to the wealthier owner because greater resources can be used to control this process. For example, a wealthier owner can trigger a buyout at a bargain price knowing that the weaker owner will be unable to buy out the more affluent owner. To even the playing field, the use of a promissory note to purchase the shares is sometimes allowed.

Dutch Auction

In a Dutch auction provision, any owner can offer to buy the others’ shareholdings. The responding owner must either accept the offer or make a counteroffer to buy at an even higher price. Assume once again that John Ambitious offers to buy out the other owners of PrivateCo for $100 per share. The auction provision indicates the minimum increase in price of the counteroffer. The minimum addition can be a fixed amount, a percentage of the initial offer, or some other valuation formula. In this case, assume the other PrivateCo owners must respond within 90 days of the original offer and either accept Ambitious's offer, or counteroffer with a minimum increase of 120% of the original offer, or $120 per share. Normally, the counteroffer must satisfy the payment terms of the original offer.

One variation of this provision requires the initiating owner to accept the counteroffer without change. Following the example, this encourages Ambitious to offer a fair price on his first bid.

Right of First Refusal

The right of first refusal is another buy/sell provision. Under this practice, an owner must offer to sell his shares to other owners before selling shares to an outsider. The terms at which the current owners are entitled to buy the shares are predetermined. Generally a formal right of first refusal process is defined in one of the ownership agreements. Exhibit 31.3 is an example of the process.

EXHIBIT 31.3 Right of First Refusal Example Process

A right of first refusal severely interferes with an owner's ability to sell the affected stock. Few outsiders will knowingly spend the time and effort to negotiate a stock purchase agreement if they have to wait and see if the existing owners are going to exercise their right of first refusal.

TRIGGERING EVENTS

A buy/sell agreement might sit idle for years until a triggering event occurs. A variety of triggering events activate the buy/sell agreement, including:

• Death
• Long-term disability
• Retirement with notice
• Voluntary termination
• Involuntary termination
• Third-party actions, such as personal bankruptcy or divorce

Other than death, these events need some further explanation. Typically someone is deemed to have a long-term disability according to the definition used in the disability insurance contract in force at the time of the disabling event. A typical disability insurance policy pays as long as the insured cannot perform the material duties of any occupation for which he or she is suited by training, education, or experience for some continuous period of time, say, six months. For example, if a night stockperson for a grocery store suffers injuries that prevent her from performing that function, she may collect disability payments only if she takes a position at less than 60% of her predisability income within 12 months of returning to work. This is called the any occupation definition, and many policies have a provision that limits payments in a variety of ways. In many cases, legal advice is necessary to create a disability definition that is appropriate to the user's circumstances.

Employee-owners who give at least one year's notice are said to retire with notice. As Chapter 11 describes, typically the retiring owner does not suffer a discount if he or she gives proper notice.

When the employee-owner freely chooses to quit or retire, this is known as voluntary termination. The board of the company may vote to purchase the shares of the exiting employee. The shareholder's ownership agreement will control the board's decision-making latitude regarding this purchase option.

Involuntary termination occurs when an owner, who is also an employee, is terminated against his or her will. This termination can be for “cause,” meaning the owner violated the employment agreement, or “at will,” meaning the employee was terminated without a specific reason. In either event, the ex-employee also becomes an ex-owner. This buyout frequently makes business sense because the employee may have become an owner originally because of employee contributions. Once these contributions cease, all attachments to the company also stop.

Third-party actions, such as a personal bankruptcy or divorce, also may trigger a buy/sell action. Most private company owners do not wish to have outsiders as owners, and this trigger protects the company against that kind of incursion. Again, it is typical for the board to vote on whether to call the shares, but the tenets of the ownership agreement should help decide this issue.

The triggering actions are also important because they may help determine value for the shares. For instance, if an employee-owner decides to quit without notice, thereby triggering the buy/sell agreement, the question arises of whether he or she should receive full value for owned shares. Many companies link the triggering event with both the value received and payment terms. This is illustrated in the next example.

The PrivateCo ownership agreement might contain a great deal of flexibility regarding the discounting issue. For instance, the agreement might let the noninvolved owners decide the level of discount in the triggering events, rather than enforce a hard and fast rule. An example of applying discretion is a third-party action that immediately gets resolved without the threat of an outsider wresting control of the involved owner's stock interest. In this case, the noninvolved owners might not even purchase the shares. Because of this, the buy/sell tenets cannot be viewed in isolation.

FUNDING TECHNIQUES

A company may choose to fund various triggering events differently. In the preceding example, death and disability of an owner may be funded in cash at the time of the event. All other triggering events may be paid over time. It is typical that payments are made monthly over three to five years at a market rate of interest. Generally a process is selected to vary this interest rate over time, such as using the rate set each January 1 as the Wall Street Journal prime rate plus some premium. For example, an involuntary termination payout of $200,000 would lead to monthly payments of $3,960 assuming a fixed 7% interest rate with 60 equal monthly payments.

Life insurance may be a source of funding for buy/sell agreements. Insurance provides liquidity, so the estate may be paid in cash without causing financial harm to the company. Also, if permanent life insurance is used, the cash value of the insurance becomes a valuable business asset.

To stay current with insurance needs to fund a buy/sell agreement, owners set an annual equity enterprise value. Without proper precautions, a death might trigger a buy/sell valuation that far exceeds the insurance in force, causing the company to borrow or sell assets to satisfy the claim.

The type of buy/sell agreement may determine how the insurance is paid. The company is the beneficiary of a repurchase agreement. Meanwhile, various stockholders are the beneficiaries in a cross-purchase agreement. Disability cases can be funded through the use of permanent disability insurance coverage or through the annuity or cash value of the life insurance policy.

WAYS TO HANDLE DEADLOCKS

A problem occurs when equal partners in a company need to settle disputes. This may involve two shareholders, each owning a 50% interest, or multiple shareholders polarized into two equal voting blocks. There are five possible ways to handle deadlocks regarding joint control of a company. In order of severity of the solution, they are:

The process for settling disputes works best when it is stipulated and described in the buy/sell agreement. For instance, some agreements spell out the mediation and arbitration procedures, including the firms that will be hired. Other agreements stipulate formulas for dispute resolution.

WHEN NO BUY/SELL AGREEMENT EXISTS

Many companies do not have buy/sell agreements. Surprisingly, this situation is prevalent even in companies with 50/50 ownership. Fortunately, buy/sell agreements can be created at any point in a corporation's life. Readers in a no-buy/sell situation should drop what they are doing and start working on this serious oversight immediately. Once a dispute arises, it is extremely difficult for the parties to agree on a resolution process. Minority holders are especially vulnerable to a bad outcome because they have little or no leverage on the controlling shareholder. If the majority is oppressing the minority, or if the minority dissents from a majority decision, a fair value lawsuit may develop. This is discussed in Chapter 9.

TRIANGULATION

Ownership agreements such as buy/sell agreements provide a unique method of controlling the process of triangulation. When properly drawn, they stipulate the value world and methods to be used in arriving at a value. They also should incorporate the method of financing the transfer. Finally, they dictate the transfer method. In short, they can be used to integrate effectively all three legs of the triangle in a controlled process. Professional buyers, such as private equity groups, always use such agreements for their simplicity and power. Individual business owners seldom use these agreements.

The involved parties are primary authorities in co-owner transfers. The parties pick the value world. Sometimes this is chosen for them by the insurance company's involvement; however, for uninsured triggering events, the parties choose how to value a transfer. Since the deal is created while the parties are still civil and communicating with one another, valuation tends toward the friendly end of the spectrum.

The parties also choose the capital structure to support a transfer. Depending on the motives of the parties, they may require all-cash deals or engineer a financing solution. Defining capital structure for a buyout is especially important when 50/50 ownership is concerned. The 50/50 partners of a screen printer recently experienced the hazards of an ill-designed buy/sell agreement. The partners decided to divorce and agreed to let the tenets of the buy/sell settle the issue. While the agreement helped the partners determine a buyout price, it was silent as to the payment terms. Neither partner had the financial capability to use cash to buy out the other, yet neither would finance the purchase. Ultimately, the company was liquidated due to this impasse.

NOTES

1. Shannon P. Pratt, Robert F. Reilly, and Robert R. Schweihs, Valuing a Business, The Analysis and Appraisal of Closely Held Companies, 4th ed. (New York: McGraw-Hill, 2000), p. 624.

2. Ibid., p. 625.

3. A good source of information regarding buy/sell provisions is the Corporate Partnering Institute, “Shareholder Buy/Sell Agreements,” www.corporate-partnering.com/info/shareholder-buy-sell-agreements.htm.