In the final post in this series, we’re going to discuss some key terms in an ownership agreement – called an “Operating Agreement” for an LLC or a “Shareholder Agreement” for a corporation. One of the most important reasons owners of a business want to have an ownership agreement is to set out the procedures for how and when an owner can sell his or her interest in the business.
No one wants to own a small business with someone they don’t know. That could happen if one of the owners decides to sell his or her interest in the business to someone else. Without an ownership agreement, there’s really nothing to prevent that from happening. From the perspective of the remaining owner, this situation can be quite scary.
On the flip side, from the perspective of an owner who wants to get out of the business, it can be too restrictive if he or she is not allowed to sell the interest at all. For example, after years of building a successful small business, one of the owners could decide to move on to another project or retire. Without the ability to sell his or her interest, the owner would be stuck in the business indefinitely.
Neither of those situations is acceptable for most business owners. That’s why it is important to have the following provisions in an ownership agreement. These provisions strike a middle ground that allows for an owner to sell his or her interest in the business under certain circumstances but also allows the remaining owner to have some control over who can purchase that interest.
Situation: An owner wants to sell his or her interest in the business.
Problem: The remaining owner may not know or like the person buying the interest from the departing owner.
Solution: Have a provision in the ownership agreement that allows for an owner to sell his or her interest under certain conditions (i.e. the company and/or the remaining owner have the right to purchase the interest before any other third party).
Situation: An owner gets divorced.
Problem: Sometimes a spouse has indirect ownership rights in the business. During the divorce process, the business interest could be divided up between the owner and his or her ex-spouse, or the business interest could be completely allocated to the ex-spouse during the division of assets.
Solution: Have a provision in the ownership agreement that keeps the interest in the hands of the owner (i.e. the owner and/or the company have the right to purchase the interest from an ex-spouse).
Situation: An owner dies.
Problem: Upon the death of an owner, his or her ownership usually passes to his or her heirs. The remaining owner could end up co-owning the business with the deceased owner’s spouse, children, or extended family. For the deceased owner’s heirs, it may be burdensome to own a business and they may not want the interest.
Solution: Have a provision in the ownership agreement that allows the company and/or the remaining owner to purchase the deceased owner’s interest from the heirs.
Situation: An owner who is active in the business becomes disabled.
Problem: The remaining owner is left with the burden of running the business.
Solution: Have a provision in the ownership agreement that allows the company and/or the remaining owner to purchase the disabled owner’s interest.
Situation: An owner is involved in bankruptcy proceedings.
Problem: An owner’s interest in the business could be transferred during bankruptcy to one of the owner’s creditors or it could be sold to pay the owner’s creditors.
Solution: Have a provision in the ownership agreement that allows the company and/or the remaining owner to purchase the bankrupt owner’s interest.
Most of the solutions discussed above are more complex than they seem. To achieve the proper balance, the language in the ownership agreement must be specific and at the same time allow for variances in the situation that may arise over time. There also needs to be provisions for the amount of the purchase price, the timing of the closing, and deadlines for getting the deal finalized. All of these types of provisions are called “buy/sell provisions” and business owners should seriously consider getting an ownership agreement in place to address these situations.