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Why and how to prepare for changes in ownership

San Diego business lawyer Sergei Tokmakov
858) 205-5665

What if your co-owner divorces and, since California is a community property state, his ex-wife gets part of his share in the company and puts their lazy son on the board? What if the co-owner tries to sell his or her share to somebody you just know you can't work with? What if the co-owner becomes disabled, bankrupt, decides to retire or starts taking money from the company behind your back? At the outset, people want to beat the statistics by hoping their business partnerships and marriages will last forever but, unfortunately, life does not always work out as planned. Therefore, whether your business is a partnership, a corporation or an LLC, it is always wise to foresee life-changing events and write up a buyout agreement, sometimes also called a buy-sell agreement or business prenup

Buyout agreement components

An effective buyout agreement would normally contain the following basic provisions:

- under what circumstances one owner can compel the other co-owners to buy a share;

- under what circumstances co-owners can compel another owner to sell a share;

- how to calculate the appropriate price, and what are the payment terms.

A buyout agreement can be incorporate into the company's bylaws and other paperwork, or it can be a separate document. An insured buy-sell agreement is funded with life insurance on owners' lives to guarantee payout in case of death.

The right of first refusal

The right of first refusal is popular vehicle to limit ownership transfers to outsiders. With this provision in place, you get to match the price a departing owner is offered for his share by an outsider or some other price you had incorporated into your buyout agreement previously. Depending on how you want to structure your buyout agreement, you can also prevent co-owners from gifting their shares, putting it in trust or transferring the shares in any way at all. The outright prohibition on all transfers is generally not recommended since it is too inflexible and may not stand in court. 

Forced buyouts

Forced buyouts are triggered by various unsettling events that all of the co-owners have agreed to outline in the buyout agreement. Forced buyouts come in two basic forms: forcing co-owners to buy, and forcing a co-owner to sell. For example, with a right to force a sale provision, a retiring owner or deceased owner's heirs can force other co-owners to buy his or her share at a certain price. With an option to purchase provision, co-owners can force a bankrupt or embezzling owner, or even owner's ex-spouse who got a share of business in a divorce settlement, to sell that share back to the company or its owners. 

The forced buyout provisions can be flexible and account for business's growth and stability. For example, the forced buyout provision may provide for a structured payout scheme, where anybody that tries to cash out before a certain time will only get a fraction of the value of the share. 

Methods of valuation

To prevent lengthy and foreseeable disputes over the appropriate value of the share, valuation method must be agreed upon. 

Independent appraisal

With this method, a third party neutral professional appraiser (preferably, a pre-selected one) determines the value of the company. The main advantage to this method is that it uses an objective and flexible standard which reflects the current value of the business, taking into account such difficult to value assets as company's goodwill, reputation and earnings potential. The main drawbacks are that it takes time and can get expensive.

Earnings capitalization

With this method, you take company's gross revenue, subtract costs, and multiply this figure by a certain agreed-upon number (capitalization rate). The advantage of this method is that it is quick and relatively easy to calculate the value. The main drawback is that the final number may not represent the true value of the company. For example, the company may not show much profit, and yet have great real value, if you reinvested nearly all profit back into the healthy, growing company. To account for this, you may decide to multiply company's gross revenue, rather than pure profit.

Book value

Book value is company's assets minus liabilities. The advantage of this method is its simplicity but the main drawback is that it does not account for earnings potential, especially if the company is new. To account for this drawback, you may decide to use a multiple of book value, where you multiply the book value by a certain agreed-upon number.

Other issues

An effective buy-sell agreement should address the following issues:

- Should the agreement be guaranteed by pledging corporate assets, personal guarantees, loans, etc.?

- How to allocate shareholder loans?

- Should there be a covenant not to compete?

- Should the spouses of the shareholders sign the buy-sell agreement? What if they will not?

This note by San Diego business lawyer Sergei Tokmakov is for general educational purposes only. It does not constitute legal advice because your specific case may be different. Readers should seek qualified counsel for assistance. This article may be reprinted, provided that all credit information and this paragraph remain intact.

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