Avoiding Co-Owner Disputes So You Can Transition Successfully
Sam and Louie had been in business for about ten years, operating a chain of retail clothing stores. They were 50/50 owners in the corporation. When Sam approached us he had already been working for about 9 months to try to come up with a proposal which Louie would accept for dividing up their operations.
While they had gotten along well in the early years, Louie's hidden substance abuse problem had gotten the best of him. He wouldn't consider any type of reasonable purchase by Sam or a sale by Sam to Louie. Sam and Louie had never entered into any type of a Buy-Sell Agreement, based on the belief that they would always be able to work things out. No type of mediation was successful. Louie was simply unreachable regarding any type of purchase and the two were deadlocked and unable to reach agreement on any operational issues that needed to be dealt with.
The Next Step Program identifies the top 12 principal reasons which have caused business owner transitions and exits to be unsuccessful. Each of these reasons impacts the company's ongoing annual profitability as well as an owner's transition and future exit results. This article addresses the 5th of these 12 reasons:
Reason #5. Co-Owner Issues and Disputes. You have failed to utilize a Buy-Sell Agreement and a Business Continuity Agreement to pre-decide how ownership will be bought and sold (and funded) between partners upon death, disability, divorce, disputes, and retirement and how to avoid or resolve co-owner disputes due to future disagreements.
In order to protect your ownership, it's critical that you take the following two actions:
- Establish A Business Continuity Agreement
- Establish a Buy-Sell Agreement
Businesses, regardless of age and size, are often damaged or torn apart due to lack of a well-conceived system for avoiding and/or resolving disputes. These disputes can arise between co-owners, the spouses of co-owners, and/or co-owner families.
The potential for disputes can become even more acute upon the death or disability of a key owner. The role of a spouse or other family member may take on a new significance when the other co-owners attempt to work out issues with the spouse or family member who may not be familiar with some of the innerworkings and understandings of long-term business partners. This issue can be just as problematic for a one-owner business which now finds itself being owned by a surviving spouse or surviving children.
In addition to issues regarding regular company operations, disputes can arise as to how family salaries are to be set, how dividend distributions are to be determined and paid, and who is to run the business as your successor. The risk involves not only adverse financial impact to the company, but also can pose a threat to the harmony within a family. Various matters which functioned well when you were around as the "traffic cop" to avoid or resolve disputes might no longer function nearly as well. This can occur despite the best intentions and simply be caused by a difference of opinions.
In order to help minimize, avoid, and resolve possible disputes amongst co-owners and family members, a well-conceived and thorough Business Continuity Agreement should generally be implemented. This type of agreement should operate in addition to a well-conceived Buy-Sell Agreement. The Business Continuity Agreement should address issues other than buy-sell obligations such as Board approved actions; right to engage in competing businesses; confidentiality provisions; required resignation; financial statement requirements; Subchapter "S" protection; tax payment dividends; stock redemption provisions; annual dividend payments; non-solicitation of customers; non-solicitation of employees; Board of Directors composition; job retention guidelines; family employment policy; Advisory Board; corporate formalities; and conflict of interest policy.
A Buy-Sell Agreement is a contractually binding agreement amongst the co-owners of a business which addresses the times and the terms for the future purchase or sale of stock of a company. In a sense, this type of agreement is your own private stock market.
Unlike a public stock exchange, under this private stock market, you and other co-owners are not necessarily free to buy and sell stock to whomever you may please. However, this type of private stock market does create the ability to have some circumstances in which your stock can be purchased or in which you can cause the purchase of another co-owner's stock.
In addition, this type of agreement provides the ability to restrict co-owners from selling their shares to an outside party which the core owners do not want to share company ownership with. In this sense, it also acts as a very solid protective measure for the business operations.
A Buy-Sell Agreement is most commonly used when the company is owned by unrelated co-owners. However, it is also very frequently used when the company is owned by family members. This enables the family members to have a pre-agreed understanding amongst themselves as to how, when, and under what terms stock will be purchased and sold upon future events and conditions.
The Buy-Sell Agreement has historically been less frequently used when there is only one present owner of the company. However, this does not mean that the agreement should not be used under that circumstance. Upon the death of the sole owner, that owner's stock would typically be distributed according to the terms of the owner's Estate Plan. The executor or trustee charged with handling the estate or living trust of the owner does not necessarily have the authority to add stock restriction or Buy-Sell Agreement provisions before distributing the stock to family members pursuant to an Estate Plan - if those ownership restrictions were not already in place at the owner's death.
In the absence of such an agreement, after the owner's death, the stock could be owned by multiple family members, some of whom might find themselves in disagreement as to the company operations or stock ownership going forward.
Therefore, it's prudent for even the sole business owner to enter into an agreement before death. Since it takes two parties in order to have a binding agreement, this agreement would be between the sole owner and the company and would be binding on successors to the stock ownership pursuant to an Estate Plan distribution.
Buy-Sell Agreements are prepared based on the needs and objectives of the co-owners. The various types of provisions which should generally be included, or considered for inclusion in a Buy-Sell Agreement include: stock transfer restrictions, purchase upon death, purchase upon total disability, termination of employment, purchase upon bankruptcy, purchase upon divorce, Texas shootout, drag-along option, and tag-along option.
The Next Step Transition Growth and Exit Planning program has been specifically designed to address and overcome each of the 12 principal reasons for failure. This program consists of 12 critical building blocks. We are using this program to help business owners design and implement their Transition Growth Plans for accomplishing their transitions and exits successfully.
Nicholas K. Niemann, Esq., is a transition and exit planning advisor and a partner in the law firm of McGrath North. The firm's website is www.McGrathNorth.com.
Andrew D. Horowitz, CPhD, is a wealth advisor and president of The Estate Management Group. The firm's website is www.EMGPlanning.com.