When two or more individuals start a new business venture, often the last thing they think about, or want to think about, is the day when they will no longer own the business together. The unfortunate reality is that business owners can never start exit planning too soon, despite the need to have difficult and sometimes uncomfortable discussions.
Wise owners will recognize that co-ownership, at least by the founding individuals, cannot last forever. They will address, come to an agreement on, and document their agreement on three important questions:
1) Under what circumstances will an owner have an option or obligation to sell his or her ownership interest?
2) If an ownership interest is to be sold, how will the purchase price be determined?
3)After the purchase price is determined, where will the money come from to pay it?
Events giving rise to an option or obligation to sell an ownership interest are often referred to as “trigger events.” The most common trigger events are death, disability, and termination of employment in the business, whether by retirement or otherwise.
If the termination of an owner’s employment in the business will be a trigger event, then the owners should discuss whether the circumstances of termination should affect the purchase price or terms of payment. For instance, should an embezzler who is fired be paid as much for his or her ownership interest, and as quickly, as an employee who retires at age 65 after giving a year’s notice? In cases in which an owner quits without cause, is fired with cause, or retires without adequate notice, the owners often agree that the departing owner will be paid a fraction of the purchase price that would otherwise be payable for his or her ownership interest.
Determination of the Purchase Price
At the outset, owners should determine the value of the business and an appropriate methodology for a periodic redetermination of value. In most cases, owners lack the objectivity or expertise to determine value in the way the marketplace would. Owners will sometimes apply a simple formula to calculate a value, such as a multiple of revenues or profits. Such formulas rarely reflect the marketplace. An objective determination of value is in almost all cases best left to a valuation professional.
A good shareholders’ agreement will establish a mechanism for the periodic revaluation of ownership interests. My preference is for owners to engage a valuation professional annually to redetermine the value. The redetermined value then becomes the purchase price for any transfers during the following year.
Owners are often unwilling to invest the time and money necessary for an annual redetermination of value. Therefore, a good shareholders’ agreement should require a current revaluation if a trigger event occurs more than a year after the date of the most recent valuation. This safety net will help prevent a selling shareholder from receiving inadequate value or a windfall on the sale of his or her ownership interest.
Funding the Purchase
Owners should recognize at the outset that the funds required to make a purchase will, under a shareholders’ agreement, almost certainly have to come from the business. Small business owners’ personal finances are generally too intertwined with the business’ finances to make self-funding realistic.
An ownership interest transfer triggered by death or disability can often be funded with insurance proceeds. To accomplish this, owners should purchase insurance as soon as possible after a shareholders’ agreement signed. If future revaluations determine increased value, the owners should consider whether to purchase additional insurance to keep pace. At some point additional insurance might become unavailable or unaffordable; therefore, the shareholders’ agreement should address how any uninsured portion of the purchase price will be paid.
The purchase price to be paid after an uninsurable trigger event (e.g., retirement) occurs is most often paid with a combination of an up-front payment and a promissory note. The shareholders’ agreement can provide for different payment periods, depending on the amount of principal to be paid. The owners should be realistic about the amount they will need to live on post-departure, as well as the business’ ability to pay that amount.
The law does not prescribe an orderly method for the acquisition of a business owner’s interest after his or her departure from day-to-day operations of his or her business, which can at times be rancorous. Wise owners will plan for the inevitable at the first opportunity. Although they will incur up-front expenses to do that, advance planning can spare owners great future expense and heartache.