Congratulations! You have decided to start a business with some friends. It is an exciting time, full of the promise of what the business might do and the rewards that it might bring. For most people, the last thing on their minds would be to discuss what could go wrong between them and the other owners. However, now, when everyone is getting along, is the ideal time to lay out rules or agreements for how such potential disagreements and break ups might be handled.
Too often, people starting a business simply assume that everything will keep going well forever. Further, sometimes the mindset is that once you are committed you are committed forever; perhaps because there is a concern about the business’ viability were one of the owners to leave. Finally, starting a business is expensive and time consuming – it’s easy to skip the money and effort it would take to lay out solutions for problems that only might happen in the future. The reality, unfortunately, is that in many cases something will go wrong and at some point, at least one party will want out. For example:
- An owner might move away and not want to remain tied into a business they cannot actively supervise.
- An owner may find they have an irreconcilable difference of opinion on a business matter.
- An owner might have a sudden need for cash like an illness, new baby, or a divorce.
- An owner might die.
- A personal conflict outside of the business could lead an owner to want out.
When these situations come up, it is a stressful and upsetting situation. Too often this leads to parties airing long held resentments, acting to, “get even” or to get revenge, and ultimately to prolonged and expensive lawsuits. Further, for the remaining owners, if one owner is demanding to be bought out or trying to sell their share, it can be hugely problematic. Most businesses do not have the cash on hand to buy out even a small percentage of a company. The points of contention in this situation include:
- How is the owner’s interest valued?
- Can an owner sell their share to a third party?
- How long do remaining owners have to raise money to buy back an interest?
- How are monetary and non-monetary contributions to the business valued at the time of sale?
- How long do remaining owners have to review each stage of the negotiations? To obtain financing? To pay out a lump sum?
Clearly, the last thing anyone really wants is a lawsuit or other legal battle over ownership which can quickly grow to into prolonged conflict eating up time and money. So, viewing things in that light, what are some steps that might be worthwhile to undergo at the time a business is being set up to help avoid a legal battle down the road.
Allow owners a relatively easy way to cash out their interest in the business if they want to leave.
The bottom-line question here is, why would you really want to force someone to stay in a business if they want to leave? Now, an owner may still be on the hook for specific financial or non-monetary contributions but it is usually in everyone’s best interest to let owners out if they want out.
Give the business the right to buy the interest of a departing owner.
Most owners would not want a third party to suddenly own part of their business – which may or may not give them ownership rights or control of the business. But also, would you want Owner A to be able to buy Owner B’s interest in the company leaving Owners C with a significantly smaller piece of the pie where previously all owners had an equal share of ownership? The business will want to have the right of first refusal to purchase the interest up for sale.
Clearly define how the interest will be valued.
This is often the most contentious point! Other owners may agree to buy back a departing owner’s share but naturally they are going to be motivated to buy at the lowest possible price while the seller will push for more money. A clear and predicable formula will help this process be fair and transparent.
Give all parties a realistic timeline for how fast (or slow) this process might move.
Often agreements that address these things give totally unrealistic deadlines as to when, for example, financing must be obtained. Too often there may be a perfunctory recitation that a business can buy back an owners interest but that it must pay in 60 days. Could you go and get a loan and close in 30 days? 60 days? Even six months? It is important to think through what a process of buying out like this would look like. Remember, the business has to go on at the same time.
These goals can be accomplished through specific legal agreements such as rights or first refusal, buy/sell agreements, valuation formulas, and other specialized tools. In the end, the time and money spent ensuring that you have a good system to approach these issues when they arise will provide great value to business owners. And remember, the time to do that planning is now, when everyone is cooperating and on the same page, not when the fight starts.
Redding Law, PLLC intends this educational article to be an overview of a legal document, idea, or theory. The reader should note that this overview is specific to Texas and Texas laws and is not intended to be legal advice for any person or situation. To receive additional copies of this newsletter or permission to reprint any portion please contact Redding Law, PLLC.