By Michael J. “Mick” McGirr, Esq. | Phocus Law
My clients know that one of my favorite sayings relating to business formation is that “an ounce of precaution is worth a pound of cure.” There are few scenarios where that quip is more true than when it comes to planning out and documenting the life plan of a business partnership. In my career, I’ve drafted hundreds of operating agreements and shareholder agreements for LLCs and corporations, ranging from single-member entities to entities with dozens of shareholders. What I consider to be perhaps the most important element of an entity’s governing documents is what is referred to as ‘buy/sell’ terms.
Buy/sell terms are the roadmap for how a buyout of a member of an entity is to be handled. Typically the buy/sell terms include, among other things, descriptions of how valuations are to happen (and how frequently) and payment terms for the purchase of membership interest. The buy/sell terms will also often include ‘triggers’ for when the buy/sell provisions come into play, including disputes among members, the disability of a member, and the death of a member.
First, we can talk a bit about those triggering events. The importance of including dispute triggers for a buy/sell lies, at least partially, in the concept that the operating business will be more valuable complete than if the members were to strip it down and sell it for parts. So, to maximize the benefit to all members in an irreconcilable dispute, you can draft into your buy/sell terms a mechanism to allow members to buy out others, on fair, pre-determined terms. In the event of the disability of a member, it is valuable to establish, in advance, what a disabled member’s rights are in the disabled state, as well as what the definition of ‘disability’ is, as agreed upon by the members. Finally, the triggering event of death is important to consider you build your business not only to provide immediate income but also to establish security for your loved ones even after you are gone. Building in mandatory buy-out provisions, which can even be funded by life insurance policies paid for by the business, can ensure that your loved ones will receive the fruits of your labor in your absence.
Second, let’s discuss briefly why including valuation provisions in your buy/sell terms is important. In the occurrence of one of the triggering events discussed above, one member will be having their membership interests in the business acquired, often without any choice in the matter. Thus, it’s important that, in advance of a triggering event, the members have agreed on a mechanism for how the business is to be valued upon a triggering event occurring. Sometimes, that mechanism can be as simple as, “each year, we will sit down and agree, in writing, on the value of the business for the coming year.” At other times, valuation is much more complicated, often involving calculations of ‘EBITDA’ and determining the proper factor by which the EBITDA will be multiplied. Regardless of how simple or complex your valuation mechanism is, having the mechanism pre-determined and in writing will prevent a great deal of heartache and legal fees at the time of a triggering event when emotions are high and the last thing the parties want to be fighting over is money.
Finally, it’s important to outline in your buy/sell terms how payment for the purchase price will be made. Sometimes, the parties have funded the buyout by buying life insurance policies, so payment of the purchase price can occur immediately upon the policy(ies) paying out. In other instances, parties agree that the purchase price will be paid over time, secured by a promissory note by the business or the members to the departing member.
At the outset of a business relationship, parties often are enjoying a bliss akin to newlyweds, and they don’t consider that every business relationship, in one way or another, comes to an end. By sitting down and having a few conversations, then reducing those conversations to writing, while still in that early joyous state, a great deal of headaches, and, equally (if not more) painful, legal fees can be avoided.
The Phocus Law team assists business owners daily with sorting through the ins and outs of business ownership. Because of this experience, we are able to offer insight on what works best, and can often cater that advice based upon the personalities of the partners, the industry of the business, and many other factors. If we can assist you in structuring your business, please don’t hesitate to reach out. I can be reached by email at Mick@PhocusCompanies.com or by phone at 602-457-2191.