All businesses are subject to unexpected issues and circumstances that simply cannot be anticipated. For this reason, it is critical for a business to have a clear and comprehensive ownership agreement to cover potential disputes over management and disagreements among owners, details on transfer restrictions and clear directions for possible purchase or sale events related to the business.

On any intake form when gathering information about a client's business, an important first question is whether or not there is an ownership agreement. The type of agreement depends on the type of entity. For a corporation, it would be a shareholders or stockholders agreement. For a limited liability company (LLC), an operating agreement or a limited liability company agreement. For a partnership (general or limited), a partnership agreement. This article uses the generic "ownership agreement."

Any business that has more than one owner must consider having an ownership agreement. While even many single member LLCs will have an ownership agreement, the focus of this article is on how an ownership agreement can facilitate issues among co-owners. Such an ownership agreement can cover a vast number of issues, but the most important broad categories are management and deadlock, transfer restrictions/permitted transfers and buy/sell provisions.

It is impossible for a single article such as this to touch on every issue that could be addressed in an ownership agreement, and each situation has its own unique aspects. This article is meant to highlight the types of issues that need to be considered, and the thought process to go through in developing an ownership agreement that fits the business and owners at issue.

Management and Deadlock

One use of an ownership agreement is to address how management functions will be allocated between the owners. Is there an active "inside" person and a more passive "outside" person? Are there two equal owners, or equal groups, or a majority block and a minority block? Are there multiple owners such that there are no clear blocks? Each situation could call for different management provisions.

Where there is a "sweat equity" owner and a financial "investor" owner, basic management will vest in the insider, subject to reporting, oversight and veto rights of the outsider for listed "major decisions" or transactions "not in the ordinary course of business." Where there are equal owners all active in the business, they will each likely have an equal say. In a majority/minority situation, especially in a case where perhaps a founder has given small pieces of equity to some key employees, the majority will generally control the business and the minority might even be specifically given non-voting equity to drive home the point.

Where there are equal owners or blocks, any disagreement could lead to a split vote causing a deadlock. Fortunately, the fear that a business will falter in the event of such a stalemate is based on a common misconception. Many people feel that a deadlock means that nobody wins, and that the company cannot act. In fact, it often actually means that the "no" side wins and that the company refrains from acting.

Take, for example, a proposal to bring in a new large client, but where the client is seeking a substantial discount. If one half of the owners vote in favor of the proposal and one half against, the proposal is rejected, and the new client is not brought in; but the company otherwise can go about its business. Where a deadlock becomes business critical is when not acting is not viable. For example, the company's lease is expiring and half of the owners want to renew with the current landlord and half of the owners want to move.

Being aware of the risk of deadlock and its implications does not mean the parties have to solve it. If they cannot pre-agree on a deadlock resolution method in their ownership agreement, the agreement can be silent. Should a business critical deadlock later occur, both sides' feet will be held to the fire to compromise at that time, or the company might face a voluntary or court ordered dissolution.

Where covered, methods to resolve deadlocks include (1) naming an independent decision maker in the ownership agreement or a mechanic to allow for the designation of an independent decision maker when the dispute arises, (2) providing spheres of influence to the owners so that, for example, Owner A makes the final decision on employment and compensation issues while Owner B makes the final decision on sales and marketing issues, and (3) forced sale provisions so that an owner aggrieved by the deadlock can require either that it is bought out or that the other owner(s) sell, as discussed below.

It is important to note that deadlock issues do not arise only in 50-50 splits. The same impact of disagreement comes up wherever there is supermajority voting or other special approval rights. As mentioned above, the ownership agreement for many majority-minority situations would typically include a list of limitations where the majority cannot act without the consent of the minority. Situations where the minority might be given approval rights include sale of the business, filing for bankruptcy or dissolution, transactions with affiliates of the majority owner, borrowing in excess of a certain threshold, expenditures in excess of a certain threshold, altering the purpose or nature of the business, and commencing or settling litigation in excess of a certain threshold.

Finally, the ownership agreement may set standards for certain actions in order to limit or take away discretion that might otherwise exist. For example, there might be a requirement that all or a specified minimum percentage of available cash flow must be distributed to the owners on a regular basis. Other matters that could be fixed in an ownership agreement include terms for the employment of the owners, required capital contributions or terms for loans from the owners, and requirements for owners to give personal guarantees if required to lease space or obtain financing.

Transfer Restrictions/Permitted Transfers

Typically, the owners of a closely held business want to maintain control over who may be an owner. For LLCs and partnerships, the default rule tends to be that interests cannot be transferred unless permitted by agreement or consent at the time. But, the default rule for corporations is that shares are freely transferable. Regardless, the ownership agreement should specifically state that no owner may transfer or encumber its ownership interest except as specifically permitted.

While this is usually not a controversial starting point, sometimes an investor owner will negotiate for conditions when it can sell its interest without consent of the inside owner.

Permitted transfers for individuals are usually for estate planning purposes. That is, to immediate family members, to trusts for the original owner or family members or to entities owned and controlled by the original owner, family members or family trusts. These transfers can occur during lifetime or on death.

Permitted transfers for entities are within its controlled group or, perhaps, to its individual owners (who could then make further transfers for estate planning purposes). When the business at issue is not the sole significant asset of an entity owner, a difficult issue is whether to allow the entity owner to transfer its interest upon a sale of all or a substantial part of its overall business.

Often overlooked is whether or not to include transfers between owners as permissible. This does not matter for a two owner business, but it should be considered where there are three or more owners. On the one hand, it can facilitate exit strategies if owners can negotiate directly with one another. On the other hand, it can allow one owner to assemble a control block to the potential detriment of other owners.

Finally, of course, any buy/sell provisions included in the ownership agreement are by definition permissible transfers.

Buy/Sell Provisions

Broadly speaking, a buy/sell provision is any term of the ownership agreement that allows or requires one owner to purchase the interest of another owner. Issues that come up for each buy/sell include the trigger event or mechanism, how to determine who will be the buyer and who the seller, how to determine the purchase price, and payment terms. And, the answer to the first question will influence the answer to the second, and so on.

As already expressed above, one trigger may be because the parties are deadlocked. In that case, consider allowing the non-initiating party to avoid the buy/sell if it can instead change its vote or otherwise resolve the deadlock. Other triggers include a working owner ceases or wants to cease working for the business, any owner dies or is dissolved, or an owner wants to sell.

Note that there may not be a buy/sell following death or dissolution if there are permitted transfer provisions. However, you do have to consider that the proposed transferee might not be a permitted transferee. Further, an ownership agreement could allow an option following death, with inheritance by a permitted transferee only occurring if the option is not exercised. Clearly, if there is a buy/sell following death or dissolution, the deceased or dissolved owner will be the seller and the company or another owner will be the purchaser. This means that the parties are on opposite sides in fixing the price and may well be unable to agree. In that event, an outside mechanic is required. This will either be a formula derived from the company financials, including book value, a multiple of net earnings or a multiple of gross revenue, or a neutral appraisal.

Where one owner wants to sell without consent, and the ownership agreement seeks to facilitate that (which it need not), there will typically be a right of first offer (ROFO) or a right of first refusal (ROFR). In a ROFO, the proposed seller sets forth the terms on which it would sell and allows the company or other owner(s) an opportunity to buy on those terms. If the offer is not accepted, the offeror can seek to sell its interest on substantially the same terms for some period of time.

In a ROFR, the proposed seller must first obtain an offer from a third party and, before selling to that party, must offer its interest to the company or other owner(s) on the same terms. If the offer is not accepted, the offeror has a set period of time to close the proposed sale on the terms and to the third party proposed.

Of course, neither a ROFO nor a ROFR assure an owner of an out. That is where a buy/sell comes in. When one member invokes a buy/sell right (whether upon a deadlock, some other trigger event or because the ownership agreement simply allows the exercise in a party's discretion), there will be an exit by one owner unless the parties can negotiate otherwise.

In the most typical buy/sell, the invoking party sets forth a dollar amount as the deemed sales price for the entire company. That dollar amount will be used to determine how much any owner would receive for its interest. In the simplest example, assume a corporation with one class of stock owned 60% by Shareholder A and 40% by Shareholder B. If the set amount were $1,000,000 (net of all costs and liabilities), then Shareholder A would receive $600,000 if it were the seller and Shareholder B would receive $400,000 if it were the seller.

The party receiving such a buy/sell notice then has the option to choose whether to be a buyer or a seller at that price. Failure to respond within the set option period is deemed to be an election to sell.

Once you know who is the buyer, who is the seller and how much is being paid, you must address payment terms. For the price to be paid in full at closing often means that third party financing has to be obtained. Otherwise, it will be seller financed, with the buyer paying some amount down and delivering a promissory note for the balance.

Anytime there are deferred payments, consideration must be given to how they can be secured. Is someone available to give a guaranty? Are there free and clear assets in which the seller can take a security interest, or enough equity value that a second position lien is meaningful? Finally, consider including covenants designed to ensure that the obligor remains capable of paying. For example, if one owner's interest is being redeemed by the company while the other owner takes over the business, the company should agree not to pay excessive compensation or make distributions and the remaining owner could agree not to compete with the company and to allow the selling member to enforce the non-compete.

Conclusion

As this brief overview has shown, there are a number of issues and sub-issues to consider in negotiating and drafting ownership agreements. Further, while I have discussed issues somewhat discreetly, it is easy to see how they all interrelate. Considerations are like branches on a tree, with each selection taking you on a course to the next set of questions.

Mark Silverstein is a partner at Schwartz Sladkus Reich Greenberg Atlas.