“In times of unprecedented disruption, business owners should ensure that they have carefully documented agreements that govern their business and what happens next.”
Starting your own business is exciting. Finding the right partner to share the same vision is vital for the company’s future success. However, people don’t always see eye to eye when it comes to important details like finances, marketing, and a strategic business plan. Throw in a global pandemic to turn the economy upside down, and things become even more complicated.
Rise to the Challenge
Lately, business partners have had to face unusually significant challenges due to the effects of the COVID-19 pandemic on business operations and revenue. With uncertainty continuing to loom over our economy’s future, those challenges are likely here to stay for a while.
Fortunately, some companies have been able to find relief during this stressful time through government stimulus checks, insurance claims and other types of aid. On the other hand, many have faced roadblocks, causing disagreements between partners and their visions for the future. The added disruption brought on by COVI9-19 has led some to a business divorce, which is more easily managed when there are clear contractual agreements in place. Without such comprehensive agreements between owners, businesses are in danger of failing.
Luckily, a business agreement between owners can help by providing a structure for writing a legal contract itself that outlines how shares of the company can be transferred in ownership and lay out a “prenuptial” agreement on succession, information rights, governance and other critical operational matters. These pointers are especially important for entrepreneurs and small inventors, who may not otherwise have the proper legal representation to ensure such safety-net provisions are in place.
Buy-sell provisions and transfer restrictions. If two business owners cannot remain at the helm of a business, a “buy-sell” provision can set forth how one party can buy out the other, and if so, when, and at what price. If the majority owner has no right to force the minority investor to exit the business, the majority owner’s options are limited. If an owner dies, shares will pass to heirs. If a member divorces, the court could award shares in the business to the ex-spouse. If a co-owner wants to sell shares, a dispute over proper value could result if an agreement is not in place. And in the event of a disagreement, an owner could sell shares to a competitor or another unapproved individual or entity.
These days, business agreements are integral to maintaining the company’s future in its owners’ hands. Without a business agreement, an exiting business owner could attempt to trigger some legal action that might render the business insolvent or require it to be put up for auction in a fire sale. An agreement can be set up so that one partner can be bought out at a price agreed upon by both parties. If the partners cannot work together, one may use the buyout option without requiring legal intervention.
Importantly, it is crucial to determine triggers when establishing an agreement. Mutually beneficial agreements provide both sides with the right to trigger a buyout or redemption. For majority partners who may not want to stay in business with a minority owner, there should be a redemption right to repurchase the minority owner’s interest. On the other hand, for the minority owner seeking options if it comes time to leave, there should be a right that provides for a buyout from the majority stakeholder. Companies creating a business agreement during COVID-19 should consider looking into a delayed trigger to a buy-sell provision such that neither side will have the right to trigger a buyout for a certain period of time.
In addition, parties negotiating buy-sell agreements should be mindful of when they are triggered. Minority investors can seek provisions for a look-back period as part of the agreement, to ensure that they receive additional payment to compensate for the value of any sale that takes place after the majority owner redeemed their ownership interest. Both parties should explore provisions that require a notice period, which provides the other partner with time to prepare.
Additionally, agreeing on the method of valuation can prevent disputes between partners. Valuation methods vary and may use a defined formula or allow the party who triggers the buy-sell to retain a business valuation expert. All partners should decide whether minority discounts will apply, including those that account for unmarketable interest and a minority owner’s lack of control over business decisions.
Other issues to consider include structured payments, ownership limitations and conditions for sale. Buy-sell provisions can call for a minority owner to be paid in a structured buyout over a pre-determined time period. If companies are going through challenging financial times during COVID-19, negotiating a longer period may help. In addition, agreements can outline what needs to paid upfront, whether interest is paid, the interest rate, and the time majority owners have to pay interest. And lastly, partners can create rules for the conditions of sale of an ownership stake in the business. Overall, buy-sell agreements can be custom-tailored to include specific terms and conditions.
Dispute Resolution. Resolving disputes with an out-of-court process is something to consider well in advance. The business may have a board of directors, yet a quorum can’t be met because one owner does not want to attend. Or the parties may fail to agree on a major item. If that happens, the matter should be isolated, escalated and resolved as part of a mediation process that lasts for a limited duration. The parties could require that they each negotiate in a commercially reasonable fashion and in good faith. If – and only if – these efforts fail, then the buy-sell could be triggered, or a termination or some more formal mediation or arbitration could be required.
Termination. At the outset of a business venture, each of the founders should be eyes wide open about the trajectory. If they intend to run the enterprise for cash flow as a lifestyle business, when is one party allowed to retire and cash in the chips? If the business is destined to raise venture capital, then both parties need incentives to stick around for an exit. If one party leaves before a year, they should lose their equity. After one year, equity should begin to vest over time. If one party’s contribution to capital or sweat equity is greater than the others, this should be reflected in their relative ownership percentages and capital accounts.
Management. Who gets to run the business and its finance and marketing functions? Who sets the compensation and hires and fires? While management will report to the board of directors or board of managers, who determines which appointments should be well understood. Once third-party capital is contributed, that investor will also want input on these decisions.
Additional contributions. Are the owners required to put in capital, add capital, or provide guarantees for leases, equipment or other matters? If they do so, should they be rewarded with equity or some form of secured debt? A good business agreement will foresee these eventualities and plan ahead.
Dividends and distributions. If the business is expected to generate cash flow or income, how and when will it be distributed? For LLCs, this should be at least in an amount sufficient to pay taxes on deemed income reported on the K-1.
Restrictive covenants. During the time that the owners are working together in the business, the business agreement should specify whether restrictions will apply as to their other activities. For example, there should be non-competition, employee and client non-solicitation provisions and stipulations regarding the duties of care and loyalty that will apply to each owner. If an owner leaves the business, should there be a post-separation continuation of these restrictions?
Information rights. A good business agreement should stipulate which accounting, financial, and tax reports will be prepared and shared with the owners, as well as a schedule for doing so
Taxes. Taxes are inevitable, and someone should be made responsible for their payment. Depending on the type of entity that your business has selected, one of the owners may need to be designated as the person responsible for preparing tax returns and making decisions that affect how this is done.
Financial performance is unstable during the pandemic, whether companies are launching new businesses or simply navigating the challenging times. Business agreements should be prepared in light of the specific risks that the business currently faces. In the difficult times we are experiencing, the time is right to evaluate existing or draft new and clearly defined business agreements.
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