Everyone will exit their business at one point or another. Whether you shut the business down, sell your interests, or pass away, someday, you will no longer be in your business. The same goes for your business partners. One day, they will no longer be in the business.
Some basic questions will help frame the issues:
- If your business partner dies, do you want to be partners with their spouse or heirs?
- If you die, will your own spouse or heirs want, or be able, to take over your place? Would they prefer to receive the cash value of your business interest?
- What happens to you, your business partner, the company, and your families if one of you becomes disabled or incapacitated?
- If your business partner goes through a divorce, can you prevent the ex-spouse from gaining an interest in the company?
- If your business partner decides they want out of the business, can they sell their interest to someone you do not know?
- If you wanted to retire, could you sell your business interest for a sufficient amount?
It is possible, and often very important, for business owners to specifically address whether, and how, ownership interests will be treated in years to come. It is not simply a matter of whether an owner can sell or buy an interest, but how they will be able to do so, how the value of the ownership interest will be determined, whether the company or owners have cash flow to fund a transfer, and similar issues. A comprehensive plan, which is beyond the scope of this post, will address more than just emergency situations like when an owner dies or is incapacitated, but also how an owner can retire, how the business can be self-sustaining, and succession issues.
Here, we will hit a few of the fundamental issues and legal tools available.
Closely Held Businesses
Most small businesses are closely held by a family or business partners who know each other fairly well. The owners select each other, and they most often only want to work with other owners they select themselves. In short, the owners want to keep control over who is, and who can be, an owner.
Ownership Interest versus Employment Interest
Owners who are directly engaged in the business need to recognize that part of their compensation is related to the value of the work they do, and part of their compensation may be related to the value of owning the business. The two are not the same.
A simple way to think about this is as follows: The company will need to be able to replace the employment part of the owners work when they leave. If the owner does $50,000 worth of work in a year, when they leave, the company will still have to have someone do the work, and will presumably have to pay someone $50,000 to do the work.
The ownership interest is the value of the company in generating profits above and beyond costs. When the owner sells their ownership interest, they are selling the right to the profits, not to the salary for the work they do. Accordingly, if the owner only receives $50,000 each year from the company, and it would cost the company $50,000 to get someone else to do the work, there are no profits. The value of the ownership interest the owner has is $0. Put another way, the owner is selling a job. While this can be done, it is not that valuable.
However, if the owner receives $50,000 for employment, and $50,000 in profit distributions from the company, there is a value for the ownership interest above and beyond the cost of finding a replacement so the company can keep making money.
Businesses are not just the owners. They have suppliers, vendors, customers, clients, and employees. In addition, owners have families who are depending on them and their income stream. When an owner dies or is disabled, the business needs to have a strategy for addressing its responsibilities and obligations to all of the third parties depending on the business and the owner
Buy-Sell Agreements are a contract between owners which dictate whether, and how, ownership interests may be transferred. Owners can agree to a whole host of different provisions. Owners can agree to require each other, or the company, to buy their respective interests if there is a death, specify terms for when an interest is to be bought if there is a disability, or dictate that the company or other owners have a right of first refusal of any sale of an ownership interest. Buy-sell agreements can address life and disability insurance issues, and can specify payment terms to ensure that the company or remaining owners have the necessary cash flows to fund a purchase.
Shareholder or Operating Agreements
Owners can enter into contracts with each other to specify how they will work together in the control of the company. Successive owners will be required to comply with such agreements ensuring a level of certainty in the way a business is operated. Often such agreements can be used to make sure minority shareholders have a say in the board of directors, or address how deadlock’s in decision making will be resolved. Many times, buy-sell provisions will be included in such agreements.
Owners can better manage their own roles, and that of key employees in the business, by creating employment agreements which specify the roles, the responsibilities and expectations of the roles, and the compensation for the work done. Employment agreements may provide for deferred compensation to create incentives for an employee to perform or remain in a key position. Employment agreements for owners may help to distinguish between the ownership and employment roles, can make employment conditioned on continued ownership, and can address benefits or disability situations.
As every business owner will be exiting their business at some point, steps should be taken to address how the exit will be handled, whether due to unforeseen emergency, or as a deliberate plan for voluntary retirement. The various legal tools available can be used to great effect to address these issues and accomplish the goals of the owners. When there are multiple owners, legal contracts can be extremely important in securing the interests of the owners, maintaining the control and security of the company, and in increasing and prolonging the value of the business.