SPARK SERIESMay 20, 2013“PRE-NUPTUAL” AGREEMENTSControlling Transfer of Ownership Interestsin Corporations and Limited Liability CompaniesMarjorie M. DixonConlin, McKenney & Philbrick, P.C.Ann Arbor1. What is a ABuy-Sell Agreement@ and why do you need one?A Buy-Sell Agreement is a binding contract between co-owners of a business, which restricts each owner=s rights to transfer hisor her ownership interest in the business. A Buy-Sell Agreement generally provides what will happen to an ownership interest, if anowner wants to sell, or if an owner dies or becomes disabled.Usually, when a closely held business is formed, the original owners want to know that they are Ain it@ together. They want torestrict the ability of an outsider to buy into the business, and they may want to be sure that they will not end up in business with asurviving spouse or heir of an original owner.Other issues motivating a Buy-Sell Agreement include the desire to buy out the interest of an owner who is no longer working forthe business, the desire to avoid transfers through divorce, and the desire to provide controlled transfer of an ownership interest on thedeath of an owner.
2Owners may also benefit from a Buy-Sell Agreement that protects an S Corporation=s Sub-S Election (by prohibiting transferscreating an impermissible second class of stock), and by preventing distributions which would violate securities regulations.A Buy-Sell Agreement can also protect against dilution of an owner=s interest, by preventing the issuance of new shares.The Aownership interest Aat issue may be in the form of shares of stock held by a Stockholder (of a corporation) or shares/sharingratio or membership interest held by a Member (of a limited liability company). For purposes of our discussion, I will refer to all suchownership interests as AShares,@ the owner as the AShareholder,@ and the entity as the ACompany.@2. What sort of restrictions are common?A. ARight of First Refusal@ on Proposed Sale of SharesMost Buy-Sell Agreements restrict a Shareholder from freely selling his or her Shares to outsiders. To accomplish this,Buy-Sell Agreements commonly provide that a Shareholder can complete a negotiated sale of his or her Shares to a third-party only afteroffering the Shares to the Company and the other Shareholders at the price negotiated with the third-party buyer.This means that a Shareholder desiring to sell his or her Shares to a third party would need to market those Shares with the caveatthat any deal with the buyer is subject to the Company and the other Shareholders= right to Asteal the deal@ from the buyer. The buyerwould negotiate a price and terms with the selling Shareholder, with the risk that the Company or the other Shareholders would take thedeal that the buyer negotiated. As a practical matter, the existence of the Right of First Refusal may make it very difficult to eveninterest a third party buyer in negotiating a purchase. Shares which are subject to a right of first refusal are therefore often difficult tosell to an outsider.If despite these marketing difficulties, a third-party offer is made, the Right of First Refusal will allow the Company or theShareholders (or one first, and the other second, if the first does not exercise the option) to buy the Shares at the price and on the otherterms offered by the buyer. If neither the Company nor the Shareholders exercise their option to so purchase the Shares, then the sellingShareholder would be free to sell them to the third-party buyer, provided the sale is closed within a limited time after the expiration of theoptions.
3A typical Right of First Refusal is as follows:ARight of First Refusal. If any Shareholder shall desire to sell all of his/her Shares, and shall not have received aprior written consent of the other Shareholders to such sale, the Shareholder desiring to sell his/her Shares may sell theShares only after having offered the Shares to the remaining Shareholders and the Company in the following manner:(1) The party desiring to sell all of his/her Shares (the ASelling Shareholder@) shall notify the other Shareholders, byregistered mail, return receipt requested (the ANotice@), indicating that he/she has a bona fide offer for sale of suchShares (the ABona Fide Offer@). The Notice shall state the number of Shares to be sold, the name and address ofthe person desiring to purchase the Shares, and the sale price and terms of payment. The Notice shall alsocontain an offer to sell such Shares upon the terms and conditions as set forth in the Bona Fide Offer. A copy ofthe Notice shall also be served by registered mail, in the same fashion, upon the Company. Sale of part of theShares owned by a Shareholder is prohibited.(2) For a period of ten (10) days after the mailing of the Notice, the remaining Shareholders of the Company shallhave the option to purchase the Shares so offered. If the remaining Shareholders fail to exercise such option,then the Company shall have the option to redeem all of such Shares within ten (10) days after termination of theShareholders= option to purchase.(3) If neither the Company nor the remaining Shareholders exercise the option to redeem or purchase, then theShareholder desiring to sell his/her Shares shall be free to dispose of said Shares to the person named in the BonaFide Offer; provided, however, that such sale shall be at the price and upon the terms set forth in the Bona FideOffer, and that such disposition must be made within thirty (30) days following the termination of the option topurchase by the Company.(4) If either the Company or the remaining Shareholder(s) exercise their right to purchase the Shares of the SellingShareholder, said purchase price shall be paid in the manner set forth in the Bona Fide Offer.Endorsement of Stock Certificates.Upon execution of this Agreement, the Shareholders shall cause the Share Certificates to be endorsed as follows:
4>NOTICE IS HEREBY GIVEN that the sale, assignment, transfer, pledge, or other disposition of the Shares representedby this Certificate are subject to a certain Buy-Sell Agreement effective _______, 20__, a copy of said Agreement beingon file in the offices of the Corporation.=The parties hereto agree that all Shares to be issued hereafter shall be subject to this Agreement, and haveendorsed thereon the appropriate notice contained in this paragraph. No additional Shares shall be issued without theconsent of all of the Shareholders.@B. Restrictions on Transfers That Would Violate Sub-Chapter S ElectionIf the Company is an AS Corporation@ (qualified under Sub-Chapter S of the Internal Revenue Code), the Buy-Sell Agreementshould restrict transfers which would cause loss of S Corporation status, such as transfers to a foreign individual, an ineligible trust, or toa new Shareholder, if the transfer would bring the total number of Shareholders above the permitted number.C. Restrictions on Transfers That Would Violate Securities LawTypically, a new closely held Company will not got through the somewhat cumbersome and expensive process of registering itsShares under the Securities Act of 1933 or State Securities laws. Most Buy-Sell Agreements thus restrict transfers which would triggerthe need to go through the registration process.A sample provision is as follows:ATHESE SHARES ARE NOT REGISTERED UNDER THE SECURITIES ACT OF 1933 OR ANY STATESECURITIES ACT. THEY MAY NOT BE SOLD, OFFERED FOR SALE, TRANSFERRED OR OTHERWISEDISPOSED OF UNLESS AND UNTIL THEY ARE REGISTERED UNDER ALL SUCH APPLICABLE ACTS ORSUCH TRANSFER SATISFIES APPLICABLE REGISTRATION EXEMPTIONS THEREUNDER. THE COMPANYWILL NOT TRANSFER THESE SECURITIES ON ITS BOOKS AND RECORDS UNLESS IT HAS RECEIVED ANOPINION OF COUNSEL, SATISFACTORY IN FORM AND SUBSTANCE TO COUNSEL FOR THE COMPANY,THAT SUCH TRANSFER DOES NOT VIOLATE THE SECURITIES ACT OF 1933 OR ANY STATE SECURITIESLAWS.@
5D. Permitting Transfers to Certain Trusts.Many Buy-Sell Agreements allow a Shareholder to transfer his or her Shares to an estate planning Trust, where the Shareholderis the grantor and trustor of the Trust during his or her lifetime. This allows the Shareholders to meet their estate planning/tax planninggoals without needing to go the other Shareholders for approval of this sort of transfer.E. Drag-Along/Tag Along RightsSome Buy-Sell Agreements will address what happens if a majority of the Shareholders decides to sell their Shares to athird-party buyer. Sometimes, the majority wants to make sure that they can force the minority to go along with the sale (the buyer maywant to buy all of the Shares). These are called Adrag-along@ provisions, and generally read along the lines of the following:ANotwithstanding anything to the contrary, if at any time one or more Shareholders who, at the time, own individually ortogether more than fifty (50) percent of the total Shares outstanding (a >Controlling Interest=) receive a bona fide offer topurchase the Controlling Interest, then the Shareholders representing a Controlling Interest shall have the right to requireall the other Shareholders to sell all of the their Shares to the person making the bona fide offer, on the same terms andsubject to the same conditions of the bona fide offer. On receiving such a bona fide offer, the Controlling Interest shallimmediately provide the Company and all other Shareholders with written notice, together with a copy of the bona fideoffer and all related agreements and documents.@In a similar vein, the minority Shareholders may desire to be able to Atag along@ on a deal cut by the majority. These Atag-along@provisions generally read along the lines of the following:ANotwithstanding any other provision of this Operating Agreement to the contrary, if a Controlling Interest desires totransfer, pursuant to a bona fide offer, Shares constituting more than 50 percent of the total Shares outstanding, theremaining Shareholders will have a co-sale right as set forth in this section. On receiving a bona fide offer, theControlling Interest shall immediately provide the Company and all other Shareholders with written notice, together witha copy of the bona fide offer and all related agreements and documents. For sixty (60) days following the receipt of thewritten notice and documents, the other Shareholders shall have the exclusive right and option, but not the obligation, toelect to cause the person making the bona fide offer to purchase any other Shareholder=s Shares by delivering writtennotice to the Controlling Interest. The Controlling Interest may not sell their Shares unless and until all of the Shares ofthe other Shareholders electing to participate in the sale are purchased on the same terms and conditions.@
63. How do you control the transfer of Shares upon death, disability, termination of employment and divorce?Shareholder agreements typically provide that upon the occurrence of certain triggering events, the Company or otherShareholders may have the option or the obligation to repurchase the Shares of the impacted Shareholder. Commonly, a Buy-SellAgreement will address transfers upon death, total and permanent disability and termination of employment with the Company.A. Option vs. ObligationIn negotiating the Buy-Sell Agreement, you will need to consider whether the Company or the remaining Shareholders will havethe option to repurchase the Shares, or whether they will have the obligation to do so.An optional repurchase constitutes a Acall@ on the Shares, in which the Company or the remaining Shareholders can require theexiting Shareholder (or his/her heirs) to sell the Shares. The Company or the remaining Shareholders are not, however, obligated to buythe Shares. A call option favors the Company and the remaining Shareholders, who may not wish to buy the Shares. It is oftendisfavored by the heirs of a deceased Shareholder, who would often prefer to cash out the interest. It is also often disfavored by aShareholder who is leaving the Company=s employment (by choice or not), who might also prefer to cash out. In both cases, thepreference for cashing out is, of course, dependent on the price to be paid for the Shares.A mandatory repurchase constitutes a Aput@ on the Shares, in which the deceased/disabled/unemployed Shareholder can requirethat his or her Shares be repurchased by the Company or the remaining Shareholders. This gives the exiting Shareholder the right todemand the buy-out. This is often considered particularly appropriate in the event of the death of a Shareholder.In determining whether the purchase will be obligatory or optional, each Shareholder will want to be mindful of the fact that he orshe may end up on either side of the equation. Each Shareholder will need to consider that it may be he or she who experiences thetriggering event, or it may be another Shareholder. The goal should be a fair end result for both sides.B. Triggering Events(1) Death. Generally, the remaining Shareholders do not want the heirs of a deceased Shareholder to step into theshoes of the deceased Shareholder. Typically, the heirs also want to sever ties. Mandatory buy-out is common. Insurance fundingshould be considered, as will be discussed by other presenters.
7(2) Disability. Buy-Sell agreements also commonly call for a mandatory buy-out upon permanent and totaldisability. A buy-out gives the disabled Shareholder some cash in what may be a time of financial crisis. It also gives the otherShareholders the right to move on without the inactive Shareholder.(3) Termination of Employment. Most Buy-Sell agreements provide for a buy-out upon termination ofemployment. The Shareholders should consider whether the process that applies in the case a Shareholder voluntarily leaves theCompany will also apply if the Shareholder is fired by others in control. If the Company or the remaining Shareholders have the right tobuy out a Shareholder who is fired, there is greater risk of manipulation. Depending on the price to be paid, the buy-out rights maycreate motivation for the firing. On the other hand, should a Shareholder who quits his or her employment have the right to demand tobe bought out? What about situations where there really is good cause to fire a Shareholder employee? Usually, in these situations, theShareholder has more limited or no rights to a buy-out. Sometimes, the agreement may allow for the buy-out, but at a discounted price.These distinctions often lead to the need to define what constitutes termination Afor cause.@ This must be very carefully defined, andeven when well drafted likely increases the risk of litigation over whether the termination was Afor cause.@(4) Voluntary Withdrawal B ACake Cut@. In some Buy-Sell Agreements, particularly where there are only tworelatively equally situated Shareholders, it may be appropriate to consider a ACake Cut@ provision. This is designed to be used when oneof the Shareholders wants to withdraw his or her ownership in the Company. With this provision, the Shareholder wanting to leave canmake an offer to the other Shareholder to buy the other=s Shares (the one who wants to leave makes an offer to be the one who stays).The Shareholder who receives that offer can either accept it (and leave) or reverse it (and stay). The Shareholder making the offer hasevery incentive to offer a fair price, since the deal may be reversed on him.This harkens back to two brothers being asked to share a piece of chocolate cake. One brother is given the knife, with theknowledge that it is his brother who is watching him cut who will choose which piece to eat. If the brother cutting the cake does notslice it right down the middle, his brother will surely take the bigger piece.This is not a perfect solution, but it does offer at least one option to break up two Shareholders who cannot get along. If oneShareholder is well funded and the other is not, this provision may not be fair. The underfunded Shareholder may not be in a position tooffer to buy out the other at fair value.(5) Divorce. Owners of closely held businesses rarely want a former spouse to become a Shareholder. Mostagreements provide that the Company or the remaining Shareholders will have the right to purchase the Shares which would otherwisepass pursuant to a divorce to a former spouse.
8(6) Other. Other events that may require repurchase of a shareholder=s stock under a shareholder agreement mayinclude bankruptcy of a shareholder, adjudication of mental incompetence or other operation of law.C. Determining the PurchaserIn addition to determining what events may trigger the acquisition of a shareholder=s shares and whether the acquisition isoptional or mandatory, the Shareholders should consider who will be the purchaser: the corporation, the other shareholders or somecombination of the two.(1) Corporation. An agreement between a shareholder and a corporation for repurchase of shares is a redemptionagreement. Redemption agreements are sometimes simpler to fund (the Company may have the funds and the life insurance mechanismsare simpler).(2) Other Shareholders. A repurchase agreement between or among Shareholders is called a Cross-PurchaseAgreement. This is usually advantageous from a tax perspective (which will be addressed by subsequent speakers).(3) Either/Or. It is common to provide that the remaining Shareholders will have the first option to buy the Shares,but if they decline to exercise it, the Company will have the option to buy the interest. This may complicate life insurance funding,because it uses a Await and see@ approach as to which party will be the buyer.D. Establishing the price of the SharesIt is common for a Buy-Sell Agreement to set a price for the Shares which is dependent upon the triggering event. For instance,in the case of third-party offer to buy the Shares, the price is the price offered by the third-party (see Right of First Refusal). In thecase of death, the price is generally the full fair market value of the shares. Sometimes that fair market value is set by previousagreement of the parties. Other times, it is an appraised value. If the buy-out is triggered by a Shareholder who chooses to leave orquit, the price may be discounted. In some situations, the (usually low) book value of the Shares may be used.(1) Third Party Offer PriceAs discussed above, the price in the case of the exercise of a Right of First Refusal is usually the price and terms offered by thethird-party.
9(2) Agreed-Upon ValueOften, a Buy-Sell Agreement will provide that the Shareholders are to meet on an annual basis (most often as part of the annualShareholders meeting) to reach agreement on the fair market value of the Shares as of the date of the meeting. The Shareholders mayknow the Company better than anyone else, and may be capable of arriving at the most Afair@ market value of the Shares. Theydocument the agreed value, with the signature of each Shareholder. They should be inclined to be fair in most cases, since nobody canbe certain that it will not be them that experiences the triggering event.Almost always, the agreed value is valid for only 12 - 18 months. An agreed value that is older than that is generally viewed astoo stale to be binding. If the Shareholders forget to update the agreed value, or cannot reach agreement the next year, then analternative valuation method will need to be used. This is usually an appraisal, but could be a formula. A simple provision mightspecify:AThe purchase price for the Shares to be purchased from any Shareholder under the provisions of Article ___, shall bebased upon the valuation agreed upon by the Shareholders. Simultaneously with the execution of this Agreement, andno later than the 15th day of March of each year thereafter, the Shareholders shall execute a Certificate of Value settingforth the value of the Shares of the Company as of the date of such Certificate.@(3) AppraisalIf the Shareholders have not established fair market value within 12 - 18 months prior to the triggering event, then they will likelyneed to turn to an independent source to determine value. Some businesses are easier to appraise than others. New and newlydeveloping businesses in untried markets may be particularly difficult to appraise. The Buy-Sell Agreement will address the necessaryqualifications of the appraiser, how the appraiser is to be chosen, what factors he or she will take into account (minority discounts, andthe like), and who will pay the cost of appraisal.Shareholders of an established business who are belatedly entering into a Buy-Sell Agreement may wish to consider having anappraisal done prior to signing the Buy-Sell Agreement. By doing so, they can work through the details of who will conduct theappraisal, how the appraisal will be conducted, and what factors will be taken into account. Subsequent appraisal necessitated by atriggering event would be an update of the earlier appraiser, using the established appraiser and appraisal process. New businesseswith no track record will be difficult to appraise, and do not lend themselves well to this pre-appraisal process.In discussing determination of the price, the Buy-Sell Agreement might provide:
10AIf the Shareholders have failed to execute a Certificate of Value within eighteen (18) months prior to the TriggeringEvent, then the value of the Shares of such Shareholder shall be determined by a Board of Appraisers selected as follows:1. one such appraiser shall be selected by the Corporation;2. a second appraiser shall be selected by the Shareholder or the personal representative of a deceasedShareholder; and3. a third appraiser shall be selected by the first two appraisers so appointed.This Board of three (3) appraisers shall conduct a reasonable investigation into the assets and liabilities of theCompany, its profitability, and all other items which they deem to be significant to the fair determination of market valueof the Company=s Shares. The value of the Company shall not include the amount of any life insurance proceeds payableto the Company by reason of the death of the Shareholder whose Shares are being repurchased or redeemed under thisAgreement, but shall include the cash surrender value of any life insurance owned by the Company. No discount shallbe applied by the appraisers in the event that the Shares in question represent a minority of the total issued andoutstanding Shares of the Company. The decision of a majority of said appraisers concerning said market value shall befinal and binding upon the parties, and such decision shall be reached as soon as possible following the date the appraisersare selected. The Company and the Shareholders shall fully cooperate with the appraisers and shall provide theappraisers with any documentation or other information requested.@(4) Formula ValuesGiven the difficulties of accurate appraisal, some Shareholder agreements provide that fair market value will be determinedpursuant to a formula based on prior company performance. These provisions may require a valuation professional. Formula valuesmay include multiples of earnings, multiples of EBIT (earnings before interest and taxes) or EBITDA (earnings before interest, taxes,depreciation and amortization), discounted cash flow multiple of sales revenues, or a multiple of anticipated contract revenues fromcertain specified types of contracts in existence at a specified time.(5) Book ValueBook value may be specified as the purchase price, because it is easy to determine, based upon the Company=s financial records.
11Book value simply reflects historical cost. If a Company holds depreciated assets, the book value may be considerably lower thanactual fair value. Often, the actual value of a Company simply is not accurately reflected by book value. Recognizing this, manyBuy-Sell agreements use book value for purchases arising out of events deemed to be the fault or responsibility of the sellingShareholder (such as the voluntary termination or the involuntary termination for cause of the Shareholder=s employment, andbankruptcy). Setting the price at book value provides a disincentive or punishment of sorts for such activities. Book value is not oftenused in the event of death or disability.(6) Discounted ValueSome Buy-Sell agreements provide that full fair market value will be paid in the event of death or disability, but that a discountwill apply if the Shareholder voluntarily leaves the Company or is fired for cause. (Again, it can be difficult to adequately defineAcause.@ Disputes over such terms have led to litigation.) Often, the Shareholders are relying on the continued support and activeparticipation of the other Shareholders. They may deem that it is fair to penalize a voluntarily exiting Shareholder by discounting theprice paid for his or her shares.E. Payment Terms(1) Cash at ClosingTo minimize the risk of nonpayment, a selling Shareholder will almost always prefer all cash at closing, rather than taking aportion of the price over time. The purchasing Shareholders or the Company may not be able to, or may not want to, come up with allcash for a substantial purchase.(2) Promissory NotesOften, the Buy-Sell Agreement will provide that 10 B 20% of the price will be paid in cash, with the balance paid in accordancewith the terms of a promissory note to the selling Shareholder. There is interest due on the Note. The agreement may address whetherthe Note is secured with any collateral of the purchasing parties. Usually, the Note is secured with at least the Shares themselves, so thatin the event of non-payment, the selling Shareholder can take back the Shares. There is risk to the selling Shareholder, however,because the Shares may not be worth much at the time he or she takes them back. If the Note is not being paid because the Company isnot successful, taking back the Shares may be of little value.
12(3) InsuranceThe Shareholders should consider funding obligations to purchase on death and disability with insurance. Usually, lifeinsurance for these purposes is much more affordable than disability insurance. Subsequent speakers will address insurance funding inmore detail.NOTE: The information and sample provisions in this outline are provided for informational purposes only, and do notconstitute legal advice offered by the author. The information is not intended to create, and receipt of this information does notconstitute, an attorney-client relationship. This information is only provided as general information whereby businessentrepreneurs may familiarize themselves with issues that might affect them and their businesses. Readers should not actupon this information without seeking legal advice from a qualified attorney.K:SPARK BUY-SELLAGTS WRITTENMATERIALS.1.LANDSCAPE.DOCX