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Shareholder Relations, Buy-Sell

Buy - Sell Agreements

In this article I explain buy-sell agreements. Buy-sell protects a business from its owners, specifically their deaths, disabilities, divorces, disputes, bankruptcies and creditors. You find buy-sell provisions in a buy-sell agreement, a partnership agreement, a shareholders agreement (concerning a corporation’s shareholders) or an operating agreement (concerning an LLC’s members). FREELOADERS AND MALCONTENTS Your company needs a buy-sell agreement because change is constant, and your relationship with your fellow shareholders will change. Shareholders bicker, lose interest in the business, go away, die, get divorced, get run over by trucks, etc. Sometimes a shareholder gets a better job and stops putting time into your company. He’s now a freeloader, and you don’t want him to enjoy the benefits of your hard work in building up the business. Sometimes a shareholder is such a malcontent that you must be rid of him. Or a shareholder might get divorced, in which case you don’t want his spouse to take over his shares and become your partner. Or a shareholder might go bankrupt, and you need to protect the business from his creditors. In all these cases and other cases, the company needs a structure for the orderly and fair removal of shareholders. If you don’t have a good buy-sell agreement, usually the only way to resolve shareholder disputes is through the courts; see my article Using Involuntary Dissolution to Resolve Shareholder & Partner Disputes. THE ECONOMIC DIVORCE Enter the buy-sell agreement. When changes among the shareholders put your company in danger, the buy-sell agreement forces a fair resolution. I call this the economic divorce – if the company cannot survive a particular shareholder, the buy-sell agreement gets you a divorce on terms that are fair to everyone. 4 D’s & 2 B’s Traditional buy-sell involves what I call the 4 D’s– death, disability, divorce and dispute. I add a couple B’s to the mix – bankruptcy and bad transfers. Death. If a shareholder dies, the company buys his shares from his estate. This is fair to the surviving family because they usually want money, not shares in an illiquid small business. This is fair to the company because you don’t want the deceased shareholder’s spouse or son to show up and announce himself as your new partner. Usually you pay a death buy-back in one lump-sum using the proceeds of life insurance. Disability. Similar to death (except without the finality) if a shareholder becomes disabled, the company buys his shares. The company can pay a disability buy-back using a promissory note. Divorce. The divorcing shareholder buys out his spouse’s entire community property interest in the company’s shares. This is done in the divorce proceedings. Disputes. Sometimes two shareholders just can’t get along. To deal with this situation, you use “shotgun” procedures. This means that, between the two warring shareholders, the first shareholder offers to buy out the second shareholder, and the second shareholder has the choice, either be bought out or turn around and buy out the first shareholder on identical terms (i.e. I cut, you choose). Either way, a price is fixed for the buy-out, and one of the warring shareholders leaves the business. Bankruptcy; Bad Transfers. If a shareholder transfers shares in violation of the shareholders agreement or goes bankrupt, the company can purchase all of his shares to keep the shares away from his creditors. This serves an asset-protection function. BUY-OUT PRICE The buy-out price is crucial. A high buy-out price gives the exiting shareholder a windfall. A low buy-out price is unfair and leads to litigation. The trick is finding a procedure that ensures a fair price – for example, using a neutral appraisal process to fix a price. Payment terms are almost as important as the price itself, because payment up-front in one lump sum is much better than payment by promissory note over a long period of time. VARIATION FOR A REAL ESTATE VENTURE For some businesses, instead of a traditional buy-sell, it’s easier just to liquidate the entire business. This can be true where a business does not have good-will. For example, the value in most real estate ventures is the real estate. There is neither goodwill value in the venture nor sentimental value in the real estate. With this in mind, if the shareholders can’t get along, it’s easy to liquidate the assets, distribute the profits and let the shareholders go their separate ways. This is pure economic divorce. For more on structures for real estate ventures, read Structuring Real Estate Joint Ventures. WILDCARD- PERSONAL GUARANTIES As a final note, be careful regarding personal guaranties. These are the wild cards in an exit structure. An effective exit structure must fairly compensate and/or protect shareholders for their guaranties. I’ve tried to make buy-sell easy in this article. But that doesn’t mean you can do it yourself. Get a competent business attorney to help you.

Removing a Shareholder from a Business

Here is the flow of issues when a shareholder is removed from a business: Termination of employment → Buy-back of shares → Non-competition → Claims for unfair oppression. Let’s start at the beginning, which is the end of employment. TERMINATION OF EMPLOYMENT The controlling owners of the business usually can fire shareholders who lack control, and remove them from the board of directors. If there’s an Employment Agreement with the departing shareholder, the controlling shareholders must comply with that contract in firing the departing shareholder. If there’s no Employment Agreement, the controlling shareholders will rely on the at-will status of all employees in California to terminate employment. Getting fired hurts, because most shareholders who are active in a business depend on their salary from the business. This is why, notwithstanding an Employment Agreement or CA’s at-will policy, the controlling partners need a good reason to fire the departing partner. Courts generally recognize a partner’s reasonable expectation of continued employment by his business. Courts will protect a shareholder from being unfairly terminated and losing his salary (see below re “oppression”). BUY-BACK OF SHARES After termination of employment, the next issue for the controlling shareholders is whether to buy-back the departing shareholder’s shares. If the departing shareholder keeps his shares, then he’s still around — he can vote the shares at any meeting of shareholders, including to elect directors, and he can receive his share of dividends. The controlling shareholders only have a right to buy-back the departing shareholder’s shares if a contract gives them this right. The law does not grant this right to the controlling shareholders. Usually you find a buy-back right in a Shareholders Agreement or a Buy-Sell Agreement. The contract might trigger the buy-back right at termination of a shareholder’s employment, or perhaps upon mere dispute between shareholders. I talk about Shareholders / Buy-Sell Agreements at length on my website. These contracts are very important because they structure the buy-back process. Absent these contracts, the process devolves into an expensive free-for-all. Now think about the buy-out price. A high buy-out price gives the exiting shareholder a windfall. A low buy-out price is unfair and leads to litigation. The trick is, in the Shareholders / Buy-Sell Agreement, to use a procedure that ensures a fair price – for example, a neutral appraisal process, or an accounting formula. Payment terms are important too, because payment up-front in one lump sum is better than payment by promissory note over a long period of time. NON-COMPETITION Non-competition clauses follow on the buy-back of shares. The controlling shareholders may only impose a non-competition covenant: (1) if a contract provides for it, and (2) only after the bona-fide buy-back of shares pursuant to that contract. Once again, the Shareholders / Buy-Sell Agreement is the contract that creates the non-competition right pursuant to the buy-back of shares. If a business does not demand a non-competition clause, it should at least regulate the process by which the departing shareholder leaves. The business should control how the shareholder communicates with referral sources, employees and customers. The business needs an orderly and professional process for removing the shareholder. You don’t want either side (whether the departing shareholder or the controlling group) to poison the other’s well. OPPRESSION NOT PERMITTED In CA, controlling shareholders must treat minority shareholders fairly, and they may not use their corporate power to benefit themselves alone or otherwise unfairly hurt the minority. The legal term of art is the oppression of minority shareholders. For example, for a founder / shareholder who earns his living through the business, a court might consider it oppressive if the controlling shareholders fired the shareholder for no good reason thereby depriving him of his salary. Courts also don’t like the unfair dilution of a minority shareholder’s equity (called a squeeze-out). Controlling shareholders need legitimate business reasons for their actions against minority owners. When oppressed by the majority, the minority shareholders have two legal remedies: (1) a tort cause of action for breach of fiduciary duty, and (2) involuntary dissolution. As to the latter, shareholders owning 1/3 or more of the stock can sue for involuntary dissolution. Minority shareholders will allege that a majority, controlling group of shareholders is committing unfair acts that cause financial loss to the minority. In most cases, a court will resolve an involuntary dissolution case by having the controlling group buy-out the minority, or by dissolving the business.

Using Involuntary Dissolution to Resolve Shareholder Disputes

Shareholders and partners are like married couples: they fight. It makes no difference that the dispute is between deadlocked equal partners, or between minority and majority shareholders. In both cases, the shareholders and partners need a divorce. Enter involuntary dissolution, which is your nuclear (that is, your final) resolution. Involuntary dissolution is a judicial process where the court separates the warring partners by forcing a sale of ownership from one to the other, or by forcing a sale of the entire business. You use this process when all else has failed for a dispute between owners of a corporation or an LLC in California. FIRST - CHECK YOUR BUY-SELL AGREEMENT Before you do anything else, check your buy-sell or shareholders agreement to see if it has provisions that control the dispute. [That’s why all businesses should have a buy-sell agreement – to control over shareholder disputes; see my article, Buy-Sell Agreements.] In this article I assume that no buy-sell agreement controls the dispute. SECOND - SETTLE Before going to court, try to settle the dispute. The parties should negotiate their divorce, perhaps by one shareholder buying out the other or the sale of the entire business. Mediation is a good place to conduct the settlement negotiation. Only consider going to court for the involuntary dissolution when all else fails. Litigation is very expensive and after the payment of lawyers like me, everyone else is a loser. THIRD - INVOLUNTARY DISSOLUTION As mentioned, you obtain involuntary dissolution through the courts. Who can sue for involuntary dissolution under California law? – 1/2 of the directors, or shareholders owning 1/3 or more of the stock can sue for involuntary dissolution. Usually the grounds for dissolution are deadlock on the board of directors, or that a majority, controlling group of shareholders is committing bad acts to the detriment of minority shareholders. In California, a judge, not a jury, decides the involuntary dissolution. The judge can decide the matter early in the case at a hearing, before trial. Once the judge decides to dissolve the business, the board of directors of the company go about winding up its affairs and liquidating its assets, subject to the court’s supervision. The court can order the sale of the business as a going concern, or by piece-meal liquidation. At the end of the winding-up process, the court declares the dissolution of the corporation and a copy of the order is filed with the California Secretary of State. BUY-OUT RIGHTS The holders of 50% or more of the voting stock of the company have the statutory right to purchase for cash the shares owned by the plaintiffs in the involuntary dissolution. This avoids the dissolution of the company. Note that the party who files for the dissolution does not have a statutory buyout right. The court determines the purchase price using a panel of 3 appraisers, who fix the price at liquidation value as of the date of filing of the dissolution complaint. The appraisers are another reason to settle early. You’re stuck with the value they put on the business, and worse, you must pay their appraisal fees no matter how crazy you think their value is. That’s adding injury to insult. ANCILLARY CLAIMS FOR DAMAGES Although the process for involuntary dissolution is simple, the warring partners make things complex. Each warring partner usually has a related claim for damages against the other, for example fraud, embezzlement, etc. These ancillary claims for damages bring risk and pressure to the process. First, these claims require more legal procedure, time and money. Second, they can be decided by a jury (as opposed to a judge alone) and no one can predict what a jury will do. Third, all of the parties’ anger and spite are tied up in the ancillary claims. I’ve noticed over the years that the warring partners get so wrapped up in their claims for damages that they lose sight of the big picture, that being how to separate themselves ASAP with minimum loss. Partners who maintain a broader perspective don’t even go to court – they settle their problems early and save a lot of money.

How to Structure a New Business Venture

In this article I explain how to structure a new business venture. I focus on small businesses that have only a few shareholders or partners. I discuss four important issues for the structure of the business: share ownership, compensation, control rights, and lastly the shareholders’ exit from the business. NEGOTIATE You must negotiate the business structure with your partners. Discuss everything upfront – by this I mean put everything on the table and be petty. Don’t be embarrassed to talk money and negotiate for what you need. If you don’t resolve these issues now, you’re planting a timebomb in your business. Start negotiations with a term sheet that fully discusses each of the four items below. Once you’ve agreed at term-sheet level, you can draft final documents. A Shareholders (Buy-Sell) Agreement most likely will be the document that covers the issues in your term sheet. Word to the Wise: Don’t commit yourself or your resources to the business until the contracts are signed. There is no deal until the documents are done. Each commitment of resources weakens your position in the negotiations. This is especially true if you give up your current gig for the new venture, because you have nothing to go back to (hence no bargaining leverage). FOUR THINGS TO NEGOTIATE 1. Contributions & Shares. All contributions made by the partners should correlate directly into ownership. That is, ownership of the business should correlate 1:1 with the partners’ contributions of cash, assumed liabilities, equipment, real estate, intellectual property etc. *** For example, assume there are two partners, and the first contributes $600,000 in assets while the second contributes $400,000. Shareholder #1 should get 600 shares while shareholder #2 gets 400 shares, for a 60/40 split. If a shareholder will receive shares based on future labor to be performed, then the shares should be subject to vesting. It’s common (and OK) for a shareholder to get his shares up-front based on the promise of future labor, but the shares must vest so that if the shareholder fails to perform the services, he loses the unvested shares. To the extent possible, match the value of the services with the value of the shares, to maintain the 1:1 correlation between contributions and ownership. 2. Compensation. A business is only worth the money it puts in the owners’ pockets. For most small businesses, this means the business is only worth the salary and dividends it pays to the owners. A business first pays salary, then pays the remainder of net profits to the shareholders as dividends and distributions based on their share ownership. A business must maintain a balance between the two forms of compensation (salary and dividends) so that both active and passive shareholders receive a fair return. A business should pay salary based on work actually performed. It’s fair for partners who work more to get paid more. In fact, it’s healthy for a business to reward those who do the work, otherwise no one will do the work. For more on this topic, read Compensation Structures for a Group Medical Practice. 3. Control. I prefer that share ownership percentages determine control within a corporation, because it’s simple and transparent. Many businesses use a one-man one-vote system, however, and that’s OK. Determine who has the number of shares needed to elect directors and how this power is distributed among the shareholders. This tells you who can control the board of directors. Then be careful to understand the nuances of your board of directors and the natural coalitions that exist among them. For more, read Corporate Control – Levels of Legal Control over a Practice. 4. Exit. All businesses need an exit plan. When disputes among the owners put the business in danger, they need a structure that ensures a fair resolution without having to go to court. I call this the economic divorce – if the business cannot survive a particular shareholder or partner, the buy-sell agreement gets you a divorce on terms that are fair to everyone. Usually you have buy-back provisions that cover the 4 D’s – a shareholder’s death, disability, divorce and disputes. The result of buy-back is that one or more shareholders keep the business, and the exiting shareholder gets a payoff. The buy-out price is crucial. A high buy-out price gives the exiting owner a windfall. A low buy-out price is unfair and leads to litigation. The trick is finding a procedure that ensures a fair price – for example, using a neutral appraisal process to fix a price. A business also can use an accounting formula to fix the buy-out price. Read Buy-Sell Agreements for more on exits.

Negotiate an Operating Agreement in California

In this article, I explain the basic negotiation points for an LLC Operating Agreement in California. I focus mainly on control and on exit (buy-sell). CONTROL Control starts with voting percentages, meaning, who has sufficient votes to control the LLC’s decision-making? If the LLC has a board, control means the number of votes on the board. The member with control likes simplicity. Since it already has control, it wants to end the discussion there. An Operating Agreement drafted by the controlling member frequently has a short section on management that states the percentages or votes (i.e. control) and nothing else. The members without control want complexity, that is, they want the Operating Agreement to have provisions that restrict the controlling member. Minority, non-controlling owners need to protect themselves from majority action. Protection usually comes in the form of veto votes, which give the minority a right to stop a particular action proposed by the majority. Consider these veto rights (and their rationales): Hiring, firing, replacing the manager or officers ⇒ Although the minority won’t run the operations of the business, they want some control over who will. Salaries & bonuses for management ⇒ Minority owners should prevent control persons from siphoning off substantial salaries and bonuses, leaving no profits for anyone else. Affiliate transactions ⇒ This veto vote guards against the manager entering into sweetheart deals with its affiliates thereby redirecting profits to itself. Distribution of profits ⇒ This veto vote helps minority members ensure some minimum distribution of profits to themselves. Transfer of ownership interests ⇒ If the majority wants to sell their ownership to a third party, the minority might want to reject that third party as their new partner. Issuing ownership interests to existing or new members ⇒ This veto vote guards against the unfair dilution of the minority owners, including when the majority sells ownership to themselves or friends at sweetheart prices. Selling the business or merging ⇒ The minority wants some level of control over its ultimate exit, including to prevent the majority from selling the business in a sweetheart deal that primarily benefits the majority. Amendments to the Operating Agreement ⇒ The minority doesn’t want the majority to unilaterally change the terms of the deal. EXIT, A.K.A. BUY-SELL Every Operating Agreement should have provisions for the buy-back of a member’s ownership. I call this the economic divorce; others call it buy-sell. If the business, for whatever reason, needs to remove a particular owner, the Operating Agreement gets you a divorce on terms that are fair to everyone. Triggers for Buy-Back. Traditional buy-sell involves what I call the 4 D’s & 2 B’s. The 4 D’s are death, disability, divorce and dispute, and the 2 B’s are bankruptcy and bad transfers. I talk about these buy-sell trigger events at length in the articles under the heading “Shareholder Relations; Buy-Sell” at right. Other buy-back triggers may include a litany of “for cause” events, and they essentially give the control persons a number of vague and open-ended reasons to remove an owner. Some LLCs just cut to the chase, without need for pretext, and permit the control group, at-will without-cause, to buyback a member’s ownership. This latter expulsion can be important to the continued, smooth operations of the business, but it’s clearly dangerous to the minority owners who are subject to removal. Buy-Back Price. The buy-back price is the crucial term for all buy-sell events. A high buy-out price gives the exiting owner a windfall. A low buy-out price is unfair and leads to litigation. The trick is finding a procedure that ensures a fair price – for example, using a neutral appraisal process or accounting formula to fix a price. Next look at payment terms, because payment up-front in one lump sum is much better than payment by promissory note over a long period of time. Non-Competition Covenant. In California, it’s legal to apply a non-competition covenant to a minority owner who has been bought out. Most non-competition clauses are for a period from 1 to 3 years, and cover the region in which the business is active.

Structuring Real Estate Joint Ventures & Syndicates

Real estate investors work together all the time. More and more, we see combinations of brokers, money investors, contractors and other folks flipping or developing properties. As members of a real estate venture, these folks need a formal structure to govern their relationships within the venture. In this presentation, I hope to give you a brief but condensed outline of the issues to think about when forming joint ventures for real estate investments. There are three key concepts in structuring your joint venture: control, splitting up the profits, and exit. First, you need to think about who will control the venture, including the votes needed to make decisions, and day-to-day operational control. Second, think about how you will split the profits of the venture, including how you compensate those members who contribute their time (for example, contractors). Third, think about your exit – before you enter any business relationship, you need to have your exit locked down. One last introductory thought: At a later stage in their evolution, to handle more projects and bigger projects, real estate investors and developers start looking for money, that is, for passive investors. Essentially they start to build real estate funds for the purpose of raising capital. This will be the topic of a later presentation – the building of real estate funds. LEGAL ENTITY You should always operate a joint venture through a legal entity, whether a corporation or an LLC. Without a legal entity, the members will be partners in a general partnership. A partnership is about the worst structure possible, because it makes all partners personally liable for the partnership’s debts. CONTROL The concept of control generally includes board / member voting, and veto rights. Voting Power. Generally, you make decisions about projects and other matters based on a vote of members. In a corporation, this is done through the board of directors. It is very important that you think through who will be on the board and how the directors will get along and ultimately line up in voting coalitions. An LLC works about the same, except you count member votes instead of director votes. LLCs also can have managers, who are given varying degrees of operational control. Veto Rights. For specified operating decisions, the parties can require a certain percentage (e.g. 75% or 100%) of the votes. These decisions can include purchasing or selling properties; budgets; hiring contractors; salaries & bonuses; affiliate transactions; bringing in new members; distributions; loans; etc. Veto rights generally help minority owners, because a minority can use a veto right to block company action. This can lead to deadlock. DISTRIBUTIONS A venture throws off money in various ways, including the sale of properties, lease rentals, interest payments to lenders, compensation to contractors, and compensation to the venture’s employees. You need to clearly provide for the splitting of profits among the members based on such factors as money invested, time and labor spent in fixing up properties, and time spent in management. Remember that managing owners can siphon off substantial salaries and perks, but absent mandatory distributions, passive owners might get no return on their investment. Consider how salaries and related party contracts will pull pre-distribution income out of the venture. EXIT Before you enter, always know how you will exit a business venture. You need a structure that permits an economic divorce among the members in a venture. Essentially, if the venture or the relationship among the members falls apart, all members should receive their fair share of the venture. No one should be able to short-change anyone else. Trigger Events. The precondition for the economic divorce is some bad event. Examples of bad events are irreconcilable dispute among the members, the need to remove a member from the venture, or the death of a member. These bad events trigger the economic divorce. The economic divorce can either be a complete liquidation of the venture, or for individual members, the buy-back of the member’s shares. Liquidation of the Venture. The value in most real estate ventures is the real estate itself. There is little goodwill value in the venture, in contrast to other types of business. Nor is there much sentimental value in the real estate – the venture holds the real estate on a short-term basis with an eye to flipping it for profit as soon as possible. With this in mind, if the members cannot get along, it is very easy to liquidate the venture’s assets, distribute the profits and let the members go their separate ways. This is the economic divorce. Buy-out of Individual Members. Sometimes you only need to deal with one member and don’t want to liquidate the whole venture. For example, an individual member might get a better job and stop putting time into the venture. This member becomes a freeloader, and the other members might decide to remove the freeloader to prevent him from benefiting from their hard work in building up the venture. Or for example, a member might be such an irritating malcontent that the other members decide to be rid of him. Or a member might die, in which case the venture will want to distribute cash to the deceased member’s estate in a fair amount equivalent to the deceased member’s stake in the venture. Or a member might go bankrupt, and the other members will want to protect the venture from his creditors. In all these cases and other cases, the venture needs a structure for the orderly and fair removal of members. Note Regarding Disputes. Sometimes two members just can’t get along. To deal with this situation, you can use “shotgun” procedures. This means that, between the two warring members, the first member offers to buy out the second member, and the second member has the choice, either accept being bought out, or turn around and buy out the first member on identical terms (i.e. I cut, you choose). Either way, a price is fixed for the buy-out, and one of the warring members leaves the venture. BUY-OUT PRICE The buy-out price is crucial. A high buy-out price gives the exiting member a windfall. A low buy-out price is unfair and leads to litigation. The trick is finding a procedure that ensures a fair price – for example, using a neutral appraisal process to fix a price. Further, deciding to buy out a member is the easy part – paying the purchase price is harder. You will need cash to pay off the member. There are many methods to handle these problems, and ultimately all methods derive from the specific structure of the venture. Here are some general concepts, however: Liquidation of the Venture. A straight liquidation of the venture can be clean and simple, because the real estate will sell at its fair market value and thereby produce cash profits. The members will distribute the cash profits per their ownership percentages and dissolve the venture. That’s the end of it. Buy-out of Individual Members. If you only want to buy out a single member without liquidating the venture, you will need a source of funds. From whence the money? One structure that I use is to make the buy-out price the net equity value of a member’s interest in the venture. The other members then finance this amount. As another example, for buy-outs upon death, the venture can put in place life insurance on the life of the deceased member, then use the proceeds to fund the buy-out. This is classic buy/sell work. In any case, your structure will have to handle these issues down to the last detail. PERSONAL GUARANTIES Be very careful regarding personal guaranties. These are the wild cards in an exit structure. An effective exit structure must fairly compensate and/or protect members for their guaranties. This presentation only gives a brief outline of some issues involved in a real estate joint venture. There are a lot more issues and details to worry about. I strongly urge you to get competent legal and tax counsel when you set up a venture.

How to Bring a New Partner into Your Business (Short Version)

This is a brief summary of how to bring a new partner into your business. CULTURE & COMPENSATION When bringing in the new partner, your primary risk is that the existing group and the new partner might not fit well together. For example, you and the new partner might differ on the group’s guiding principles or work ethic, or the new partner’s skills might not be a good fit. After you’re confident that the new guy will fit in, set a level of compensation for the new partner that is fair to him and to the existing partners. BUY-IN After culture & compensation, think ownership. Frequently a business asks a high-level employee to wait a period of time (e.g. one year) before they discuss the buy-in. This ensures that the new person fits-in before buying-in. It’s smart to be patient, because the unwinding of a bad partnership is painful and expensive. Employment agreements sometimes have clauses for the purchase of ownership in the business. Usually the clauses are vague and non-binding, and only express the parties’ expectations on the subject. If the buy-in is a material part of the deal, however, specify these deal terms: ** The ownership percentage that the employee will obtain ** The purchase price ** The period over which the employee will pay for and receive the ownership (i.e. vesting) ** The extent of the employee’s participation in control decisions for the business, e.g. is he or she on the board of directors? Ownership percentage is a matter of control. It’s dangerous to give control to a new person, and even a minority owner can get control if she aligns with other shareholders. Existing owners must think carefully about the effect of admitting the new owner on existing and future voting bloqs among the shareholders and on the board of directors. GROUP LIABILITIES If the existing owners are liable for business debts (most likely the office lease and bank loans), state clearly the liabilities for which the new partner will become responsible. Will the new partner guarantee existing loans or leases, and must he guaranty future ones? Will the new partner step into a capital call? EXIT STRATEGY Now that you’ve structured the entry of the new partner, structure the exit. The existing owners and the incoming owner all need an exit strategy. The most common exit is the termination of the partner’s employment plus the buy-back of his or her equity. This is where a buy/sell agreement comes in. A buy/sell agreement is essentially an agreement for exiting a business. A buy/sell agreement works like this – First, the agreement names certain trigger events for buy-back (e.g. termination of employment, death, disability, bankruptcy); Second, the agreement permits the buy-back of the partner’s equity on the occurrence of a trigger event; Third, the agreement sets a price for the buy-back. Termination of employment is the most important of the trigger events, because that’s how the existing owners get rid of the new (soon to be ex-) partner. The control group on the board of directors can fire the problem partner as an officer of the company; and the control group among the shareholders can remove the problem partner as a director. If the buy/sell agreement permits the buy-back of shares on termination of employment, the control group can take the final step to completely remove the partner from the business – repurchase of shares. BUY-BACK PRICE The buy-back price is all-important, clearly, because a low price may cause the ex-partner to sue the business, while a high price gives the ex-partner an undeserved windfall. Various methods exist for setting a buy-back price, including appraisal procedures and earnings-based formulas. The payment terms are important too, because payment up-front is a lot different than payment over 3, 4 or more years. NO-COMPETES The last item to keep in mind is whether the company will lock up the departing partner with a non-competition covenant. A company that buys back shares can prohibit the departing partner’s competition in a limited geographic area for a limited time.

How to Bring a New Partner into Your Business (Long Version)

You need to know how to bring in a new shareholder or partner to help run your business. If you’re the new partner, you need to know what’s at stake when you step into the business. [Note — this is a long article. For the short version, read How to Bring in a New Partner.] When I speak of a “partner,” I mean a partner in the non-legal sense, that is, the incoming doctor, dentist, chiropractor, software writer or other professional who will directly service clients on a full-time basis. I use the terms “company” and “group” interchangeably, and both could mean a corporation, professional corporation, LLC or partnership (depending on your profession). WHAT'S AT STAKE You bring in a new partner to expand your business and to build up revenues. The risk is that your existing group and the new partner might not fit well together. For example, you and the new partner might differ on the group’s guiding principles or work ethic, or the new partner’s skills might not be a good fit. The primary legal issues at stake in bringing in the new partner are: (i) setting a level of compensation that is fair to the new partner and the existing partners; (ii) deciding whether and how much equity the new partner will receive; (iii) setting a buy-in price and whether it will be paid in installments and/or through salary reduction; (iv) deciding whether the new partner will guaranty company liabilities; (v) thinking through exit strategies for the new partner (including termination of employment and other buy/sell events); (vi) setting the price to be paid to the departing partner; and (vii) determining whether to lock up the departing partner with a covenant not to compete. I will try to give you some guidance on each of these issues. COMPENSATING THE NEW PARTNER The hardest thing to get right and keep right is a group’s compensation structure. There are two guiding principles in compensating partners — you will need to (i) enhance the group’s ability to achieve its long term goals, and (ii) fairly distribute available cash to the partners. Compensation is usually salary + bonus. The bonus could be a percentage of collected receivables, gross income or even net income. You should avoid basing bonuses on net income, however, because it can be difficult to distinguish real company expenses from individual perquisites, e.g. what part of a professional conference in Hawaii is a prerequisite? EQUITY How important is equity to the existing partners and to the new partner? Some incoming partners take a hard economic view and discount the value of equity. Others want equity to be a real partner and to have some control over the business. Minority Stake — A minority equity stake in a small business has little economic value except for a payoff if ever the company is sold. There are few buyers for a minority holding. This is especially true for physicians, dentists, accountants and certain other licensed professions, because all purchasers of equity must be licensed in the profession. The primary benefit of a minority stake is psychological, because it makes the partner feel more like a real team member. BUYING INTO THE GROUP Coordinate the Buy-In with the Buy-Out People come and go, so the key is to coordinate buy-ins with later buy-outs. One disadvantage of equity is that the incoming partner must actually pay for it. Another disadvantage is that where there is a buy-in, there must be a buy-out. Liquidity will be needed to buy-out departing partners. For more on this topic, read Buy-in and Buy-out of Physicians to a Medical Group. Existing Partners Want a High Buy-In Price Existing partners want a high buy-in price for three reasons: (i) existing partners obviously would like as much cash as possible from the newcomer; (ii) a high buy-in price increases the company’s cash reserves available for the buy-out of the existing partners; and (iii) the buy-in price can be used to set a later buy-out price. Concerning this last point, the company can use a low buy-in price to argue that the value of the equity for buy-out purposes should also be low, and therefore pay less to the existing partners upon their buy-out. Purchase Price / Valuation Base the purchase price on a valuation of the company and on the required buy-out price for existing partners. Value = [hard assets + A/R + goodwill] X an appropriate multiple. For professional practices, I have sometimes seen a valuation of 60-90% of one year’s gross collections. Different industries weigh the factors in different ways, however. Payment Terms Consider how the new partner will pay for and receive the equity, including vesting and salary reduction. — Vesting The company can consider using options or restricted stock for the buy-in, to vest the partner’s ownership of equity and to permit payment for equity in installments. — Pay for Equity through Salary Reduction Along with vesting, consider having the incoming partner take a reduced salary in the first few years (3-8 years is common) as deferred payment for the equity. The company also would sell the equity to the partner at a reduced price (e.g. based solely on hard assets or A/R), so that the reduction in salary in part pays for the equity. In this way, the partner avoids a large up-front payment and essentially pays for the equity in installments with pre-tax dollars. At buy-out, the sale price for the equity could also be low, with the balance paid as severance pay. LIABILITIES If the existing partners are liable for company debts, then it is very important to be clear about the liabilities and obligations that the new partner will assume and become responsible for. For example, will the new partner guarantee existing loans or leases? Will the new partner step into a capital call? EXIT STRATEGIES The existing partners and the incoming partner all need to have an exit strategy in mind. The most common exit is the termination of the partner’s employment plus the buy-back of the partner’s equity. Termination of the Employment Relationship The employment agreement will set forth the conditions for the new partner leaving the company, including termination and retirement. Most of these conditions are negotiable. The partner’s leaving the company usually is a trigger event under the buy/sell agreement that permits the company to buy-back the partner’s equity. Buy / Sell Agreement A buy/sell agreement is essentially an agreement for exiting a company. The purpose of the buy/sell is to prevent persons who are not intimately involved with the company from owning equity in the company. A buy/sell agreement works like this – the agreement names certain trigger events for buy-back (e.g. termination of employment, death) then it either requires or permits the buy-back of the partner’s equity on the occurrence of that specific event. Then the agreement sets a price for the buy-back. Read also this article, Buy-Sell Agreements. SAMPLE TRIGGER EVENTS FOR BUY-BACK UNDER A BUY/SELL AGREEMENT Termination of Employment; Reduced Workload If a partner disassociates from the company or semi-retires, the company and/or the remaining partners may purchase all of the terminated partner’s equity at the buy-back price (or a discounted price). Note that the company has the option to buy-back but is not required to do so. Death or Disability If a partner dies or becomes disabled, the Company (and/or the remaining partners) must purchase (and the estate must sell) all of the partner’s equity, at the buy-back price. This provides liquidity to the partner or his or her estate. Insurance can fund the buy-back. Disputes Buy-out is a possible resolution to deadlock or disputes, using “shotgun” procedures (i.e. I cut, you choose). Professional Corporations For a professional practice, a partner’s loss of his or her license should be a trigger event for the buy-back of the partner’s equity. BUY-BACK PRICE Once you determine what triggers the buy-out, you next need to set a price. The price can be a combination of the purchase price for the equity plus severance pay. Various methods exist for setting a buy-back price, including appraisal procedures and earnings-based formulas. SEVERANCE PAY In addition to the buy-back price for equity, a departing partner might receive severance pay. Paying off a departing partner through severance pay can make sense for the company because the company can deduct the payments. There is no deduction for the buy-back of equity. Therefore the company might consider allocating more of the payoff amount to severance pay. NO-COMPETES During employment, a no-compete is enforceable. After termination, a no-compete usually is unenforceable, except that a partnership agreement may prohibit a withdrawing partner’s competition in a limited geographic area for a limited time. It is safest to have the no-compete only cut off deferred payment to the departing partner. That is, the company does not stop the partner from competing, but only stops paying the partner on future installments of severance pay or the buy-back price upon his or her competition. Also read Non-Competition Agreements at 100 mph. THE DOCUMENTS The two documents that handle most of the above issues are the employment agreement and the buy/sell agreement. The employment agreement sets forth the new partner’s compensation and the grounds for termination of the new partner, among other things. The buy/sell agreement (a.k.a. shareholders agreement, LLC operating agreement, partnership agreement etc.) is an agreement among partners that sets forth how they will control the company and the ownership of the company.

Business Joint Ventures

In this article, I explain business joint ventures. A joint venture exists when two or more businesses team up to engage in a limited activity, for example, one business has customer relationships in a particular market while the other has back-end personnel, so they team up to offer a vertically integrated service in that market. There are four basic concepts in structuring your joint venture: corporate structure, control, money, and exit: (1) Choose a structure for the JV, perhaps a corporation or a partnership. (2) Decide who will control the venture, including the votes needed to make decisions, and day-to-day operational control. (3) Decide how you will split the profits of the venture, and which partner will initially receive and hold the money from customers. (4) Create an exit – before you enter any business relationship, you need to prepare your exit. CORPORATE STRUCTURE You can form a new corporation or LLC to operate the joint venture. Usually I advise clients to form a JV corporation or LLC because it gives limited liability protections to the JV members. In the alternative, you can operate the JV without a legal entity, in which case you are partners in a general partnership. The primary drawback here is that partnerships don’t have limited liability, that is, all partners are liable for the partnership’s debts. In some cases, however, keeping it simple makes sense, for example if JV activities have little risk of liability. You should talk with your attorney about whether or not to form a corporation or LLC for the JV. Note: Irrespective of the JV’s corporate structure, all JVs need a Joint Venture Agreement. CONTROL Control means voting rights and veto rights. Voting is a positive form of control, in that you make decisions about projects and other matters based on the affirmative vote of members. Do not assume that a JV will have simple 50/50 voting for all matters, because there might be 3 or more members in the JV or one member might have a greater voting interest. Also identify the JV managers who will control day-to-day operations. Veto rights are a negative form of control. A veto right lets you stop certain JV actions. For example, you might require that a 75% vote approve the sale of the JV or the purchase or sale of JV property. Veto rights generally protect minority owners from the actions of the majority. MONEY Clearly state how the members will share in the profits. Consider such factors as money and other resources invested, and time and labor spent in operations. An ancillary requirement is to map out how money flows into the JV and into what account. For example, if money flows through one member’s website and into its account, the other member will need accounting rights and other protections. Keep your eyes on who employs the personnel that carry out JV activities – a member or the JV itself? The employing member must receive reimbursement for all related expenses and perhaps indemnity for employment law disputes. Be careful also if a member can use JV assets to its personal benefit, for example through the use of JV equipment or through related party contracts. EXIT All business partnerships end sometime, usually sooner than you think. You need a structure that permits an economic divorce among the members. The Joint Venture Agreement should provide this structure, which will consist of a trigger event followed by the separation. I write about this topic a lot, see for example, Buy-Sell Agreements. A common trigger event is irreconcilable dispute among the members. If the members can’t get along, then one or more of them can require the economic divorce. In the divorce, each member should receive a fair division of the JV’s assets. The easiest way to separate the members is for each member to take back the assets it brought to the JV. The division is harder for assets that the JV itself acquired, like the JV’s name, website, goodwill, customer relationships, and software developed for the JV. Consider also an allocation of JV obligations, such as taxes, lease rentals, guaranties and litigation related liabilities. You need special drafting in the Joint Venture Agreement to handle these more troublesome assets and liabilities. The goal is always the same, however: an efficient separation through the fair division of assets and liabilities.

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