Why A Shareholder or Partnership Agreement is Necessary?

Transcript

Introduction

Good morning, everybody. Hello. I'll give everyone a couple of minutes to come in. It looks like they're still connecting. Let's see. Okay, I'll just give it a couple of minutes. It looks like there are still a couple more people coming in.

Okay, well, we'll go ahead and get started now. We're going to do something a little bit different today. I'm Regina Campbell from The Campbell Law Group, the managing attorney. Normally we have a little bit of a presentation format, and you can follow along as I talk. Today we're going to try something a little more conversational. You can see a little more and get an idea of how passionate I am about this particular subject, and maybe we'll get some more interaction from the group.

We are here today on a webinar sponsored by The Campbell Law Group: why a shareholder or partnership agreement is necessary. We're going to talk about a couple of reasons. In particular, we've divided them into five D's as to why it's necessary. There are other reasons too why a buy-sell agreement is potentially necessary.

Today we're going to use the term "partner" a little bit interchangeably. A lot of times "partner" refers to a partnership, "members" refers to LLCs, and "shareholders" refers to corporations. I'm going to use "partner" interchangeably just to talk about your business partner. With some exceptions for nuances in certain laws on partnerships and maybe some areas of corporations, most of the provisions we talk about today apply to all of them. The provisions in a buy-sell agreement are pretty much interchangeable between LLCs, corporations and partnerships. That's the overall concept behind buy-sell agreements.

In other words, a buy-sell agreement is, as I like to call it, sort of the exit strategy within a partnership, whereas the operating agreement is maybe more like a prenuptial or postnuptial agreement between the partners. Sometimes I'm going to point out the differences between provisions that might be in an operating agreement versus what is in these specific agreements, these buy-sell agreements or exit agreements. I'm particularly focusing on the exit agreement right now, but I'll give you some examples of what might be in an operating agreement that is also very important.

The five D's

So let's start off. Like we indicated, this webinar is going to focus on the five D's. What are the five D's? Dispute, divorce, debt, disability and death. It sounds horrible and ominous, I understand, but this is part of the reason why a buy-sell agreement is necessary. In the same manner that people often do probate documents, wills and trusts, it's the plan for if something should happen, basically to avoid any defaults that exist in the law, or to avoid some unintended consequences.

You want to avoid situations where you're defaulted to what the statute might say, or where you're having to deal with your partner's estate, your partner's spouse, children or creditor stepping into the shoes of your partner. These types of agreements are going to help avoid that unknown. Not everything can be controlled in life, but to some extent they lay out what happens in these circumstances, which I call the five D's.

But let me take a moment. I also want to give a shout-out to all of my Star Wars friends. I have brought a Darth Vader balloon in today. I want to make sure I say happy May the Fourth. May the Fourth be with you. Some people probably don't realize it, but I can be a little bit geeky. I love Star Wars. I'm also a Marvel fan. So this is a shout-out to all of my Star Wars fans out there who are also watching: may the Fourth be with you.

As you can probably tell, I brought Darth in particular because he is going to represent the nemesis in this confrontation today. Hopefully you'll find it enlightening and probably instructive as well.

Dispute

So basically, let's start off with dispute. How would a buy-sell agreement help you with a dispute? When you think of a dispute, you think, okay, you're not agreeing with your partner about something. It might be something small. The problem isn't the small day-to-day things. The problem comes with larger issues, where communication between the partners starts to break down, or you're taking opposite approaches to things.

In other words, maybe you're not happy with the way the business is going. Maybe there's poor business performance, in which case you think the business should go in another direction to improve its performance, and your partner may think differently: "No, leave it alone. It's perfectly fine." Management styles can be different, which leads to not being able to get along and the creation of a potentially toxic environment that you did not foresee during the honeymoon stage when you created the business.

Businesses are very much like marriages. They don't have the family aspects and the personal, romantic aspects, but they are very much about pooling resources together and making decisions between you and your partners, whether it's one or many partners. We're going to talk about how the dynamics can change depending on how many partners you have. But maybe you don't get along. Maybe you have different business styles. Or the partner might not be pulling his or her weight, or taking on the responsibilities that had originally been discussed.

Now, some of these can be better handled in an operating agreement. By the way, buy-sell provisions can be put into an operating agreement, but this is for if you don't want these provisions in an operating agreement, or you don't have one and you just want an exit strategy. For instance, an operating agreement can help when a partner is not pulling his or her weight, by defining what they were supposed to do as part of your understanding with each other. Were you supposed to do the management and the accounting? Were you supposed to do the sales?

If you define those roles and responsibilities in an operating agreement, it's much easier to enforce the agreement, or to show that the other party is in breach of the operating agreement. You can say, "Hey, listen, you're responsible for accounting," or "You're responsible for sales." You defined those duties and responsibilities in the agreement, and it makes it a little easier to hold someone's feet to the fire.

When it's not defined, the partner can say, "That's not what I agreed to," or "I'm doing this here and there, on Monday and Thursday every other week." In that case, there's nothing indicating that part of that person's responsibility, and the understanding between the partners, was that they had to put in this effort and this work. That becomes particularly important for other reasons as well. If the partner is not pulling their weight, you may have to hire other employees to cover the work you anticipated each other doing.

So you might each be taking a salary, the person's not pulling their weight, and now you have to get another employee to do that work, which is going to reduce the profit. So, bottom line, coming down to practicality, that is surely not what was intended if you had talked about it from the beginning and made it clear that the presumption was that each of you would be putting in a certain amount of effort and work.

Now, sometimes there are silent partners, who basically just put in the money, and the other partner runs all the operations. It's much better if that is in an operating agreement, just so it is clear, and the passive investor is not running the risk of someone saying they're not pulling their weight or doing their job. The passive investor may also have another business or another career, and this is just an investment tool or instrument for them, not necessarily a day-to-day lifestyle in which they anticipated doing this type of work.

So in a dispute, though, in a buy-sell agreement: what if you want to leave? How can you leave? Depending on the type of company it is, the statutes don't easily just let you walk away. For instance, with LLCs, and particularly if you have an operating agreement that doesn't permit it as well, often you cannot just withdraw from the company. It must be permitted or agreed to by the other members, and if it's not, you run the risk of additional penalties and issues.

So you can put provisions into a buy-sell agreement that allow you to say, "Okay, in the event that I want to get out..." You can do a put: you can say, "I want you to buy my interest," potentially at this price. We're going to talk a little bit about fair market valuations and valuing your company for the purpose of the buyout. Basically, you could say, "I want to buy you out," or "You buy me out of this. We can't live together anymore, so to speak. We need a divorce. We can't work together. We're not getting along very well."

Or it could be that you decide to move on to something else and you just want out of the business. You can put provisions into these types of buy-sell agreements on how you do that, so it's not a question of going to litigation and requesting permission to get out lawfully, or to withdraw from an LLC, or to get out as a shareholder, which may not always be so easy.

The other thing is that sometimes this is where numbers matter. In other words, if you're a 50/50 partner with somebody, and, to use my analogy, your partner says, "We want to do black," and you say, "We want to do white," what do you do? You're diametrically opposed, and neither one of you wants to agree. If you're 50/50, you're in a deadlock position where neither one of you can technically act without the permission of the other.

That can often lead to shareholder litigation, which is very expensive and lengthy, destroys the business you may have created and its valuation, and sends a message to the market that the business is shaky and not on solid ground, which potentially makes it harder to sell. So you can have a deadlock provision: what happens if the parties cannot resolve their issues and their differences? That takes the sting out of the unknown, and it makes it clear: if this happens, this is how we're going to resolve the issue, so that we don't destroy the company or the value of everything we put together.

The difference is if you have three partners, each with, let's say, 33.33% of the shares of the company. Keep in mind it depends on the operating agreement, and if you don't have one, it's going to default to the statute: a majority interest, so to speak, assuming it's not a major issue, such as adding stock, valuations or selling the company, something that requires a higher percentage vote than a majority. You can be outvoted all the time if it's a majority. So you become a minority, and the other two partners could potentially take over the company, taking the direction that they want, including removing you as an employee.

These are things you want to keep in mind when you're setting things up, and that can also be in an operating agreement as well as a buy-sell agreement. It's a little bit scary, but it's much better to have these things in place than not to have them in place.

And by the way, with the dispute, I forgot to mention at the beginning: imagine the worst-case scenario, that your partner is Darth Vader. Unreasonable, not very kind or compassionate. I would say it's much better to have these types of provisions in place than to go to court with Darth Vader. Trust me, it's not fun. Or a Darth Vader type, shall I say.

Divorce

So divorce is the other D. Unfortunately, most of us can relate to it one way or another. Even if we haven't been divorced, we've seen family members and friends go through a divorce, and it's never pretty. There are a couple of scenarios you want to think about. A lot of times you're going through a divorce yourself. Well, if you own the company with your spouse, an agreement as to what happens to the company itself during a divorce would be very handy. It would eliminate the guessing game, and the court potentially being called upon to decide what's going to happen with the company.

Particularly in Florida, with Thompson v. Thompson, the courts are unfair to the party that does not keep the company. Now, this is assuming that both parties are owners of the company on record, not that the other party has a right in the company due to the marriage without actually being a stockholder or shareholder on record. But if you are shareholders together in a company, and you're married and go through a divorce, it would help for valuation purposes, because you might avoid the court applying Thompson v. Thompson, which is actually not fair in determining valuations for the party that does not keep the company. It has a tendency to be lower than what you might normally get under a market value analysis. So it's probably better to have one of these agreements in place if you own a company together as a married couple.

If you're not married to your partner, and you're going through a divorce, part of the problem is that without a buy-sell agreement, depending on the circumstances, you could potentially have a court... Normally courts try to have the party that owns the business keep the business. But there are circumstances in which you may have fraud or other issues going on, where assets have been dissipated, and the courts in certain circumstances may have to divide up the company, or your particular interest. If you have a partner and you don't have an operating agreement or buy-sell agreement that limits third parties' rights, you can potentially have the issue where your partner's shares are being given to the spouse. Not a very pretty situation.

You want to have a limitation so that, in the event a creditor by operation of law (we'll talk a little bit about debt) or a spouse were to inherit the shares of one of the partners, they're limited to economic benefit only. They can't step into the shoes of their prior spouse. They can't vote. They can't run the business, basically. More ideally, you would have a right of first refusal to buy out that person's shares in the event this occurs, you map out what those prices will be, and you potentially give yourself funding methods.

In other words, in the event you have to buy out the shares of the person who inherited them, so to speak, whether by death, divorce, or by operation of law in a creditor issue, you're given the right to buy their shares back on certain terms, which might even include a promissory note for paying part of the valuation of those shares. That makes it more affordable, so you can make sure you actually can buy them out. These are little tools we can use to help in these types of circumstances, and they should be used, but they have to be put into an operating agreement, or in particular a buy-sell provision or agreement.

Another example: your company might be brought into divorce proceedings. You hear some of these nightmares where the other spouse is basically saying, "I'm going to destroy you and your partner. I know you're hiding money there, and you have a girlfriend at the business. I'm going to rip it apart. I'm going to bring the company in as a third party. I'm going to be Darth Vader. I'm going to make your life and your partner's life miserable until you give me what I want."

Well, if you have a provision in an operating agreement or a buy-sell agreement that limits the partner's spouse's remedies against their spouse's interest, you avoid those types of issues, and you can limit them. It doesn't mean they're not permitted discovery as to the financials of the company. But it does mean that they can't come in and say, "This company may belong to me in the future in a divorce, therefore I can come in here and wreak havoc," and throw into turmoil decisions that have to be made on a day-to-day basis. So this is just something to keep in mind.

Debt and bankruptcy

Also, with debt: unfortunately, you could have creditor issues, or you might file for bankruptcy. That's another circumstance. A bankruptcy court has to do something with your shares, depending on the type of bankruptcy chapter you file, and you're basically going to be subjecting your shares to the bankruptcy court and the trustee to do what they believe is necessary in the proceedings.

So this is another example, bankruptcy, in which you would want a buy-sell provision in place, so that you can say there's a right of first refusal in the event of a bankruptcy as well: the other partner, or the company, has the right to immediately purchase the shares of the other party for fair market value. You might determine in the agreement the methodology that's going to be used for fair market value. And if you have put in place a promissory note that could be used to purchase the interest, or the terms on which you can do so, you can try to keep that out of the bankruptcy court's purview. Not because you're denying the bankruptcy court any of the person's shares or rights to their assets to restructure them. You're basically creating a preemption: this is what's going to happen in these circumstances.

Same thing with a creditor. If your partner has a creditor, they don't necessarily have to go through bankruptcy, but they can put a lien on that partner's interest. They're going to look to actually foreclose on that interest and either become the owner of the company or potentially try to force the sale of the company, because they want to get the asset out. They want to get the money back. So by putting together a buy-sell provision, you avoid that. You set the terms of what happens in the event a creditor attempts to do this, so you limit the havoc that could be created: the litigation, the fighting, the protecting of someone's interest and of the other partner's potential interest.

So that is debt: debt, bankruptcy and creditors. Hopefully you're starting to see now the benefit these types of agreements can have, and the added element of stability that's very hard to find, often, in life and in business. At least you know what's going to occur under these circumstances, which are often life-changing.

Disability

One of the other examples is disability, whether it's short-term or long-term disability. You can define these things in the contract, because of course someone may become disabled for a short period of time. If one of the partners becomes disabled, you basically want to say what happens in that event. If it's a short-term disability, maybe you and your partner talked about buying a disability insurance policy that would help you during this time, maybe supplement your salary, or potentially supplement the company for its loss as a result of the partner not being able to work during that time. You might say, "Okay, short-term, no problem. We're not going to force the sale of anybody's shares."

But for long-term or permanent disabilities, which might even include being found to be mentally incompetent, you can define the terms. Let's say you've been disabled for more than 12 months, or have been found to be mentally incompetent: this is what occurs. In that case, the company may want to force a buyout of that person's shares, particularly in professional associations, where that partner's skills are needed. It's not as if you can just go get another manager to fill that partner's spot, and there's an additional cost as well.

So it might be particularly important to bring in another partner to help with that responsibility, in which case the company cannot afford to continue to pay out distributions or salary to a partner who's not able to contribute in the same manner. In some cases it may also not be fair, right? The person and the person's family would continue to receive distributions and salary without doing the work, and the other partner would have to shoulder additional costs and work.

But there are times, of course, when partners will say, "I want to help take care of you for a little while. I'm going to do this for a certain amount of time." The disability provision at least defines what occurs in those circumstances, and what the parties' understanding with each other is if this occurs.

Death

The same thing with death, our fifth D for the day: the death of a partner. It's very difficult on everybody, of course, and particularly on the partner's family. But what occurs if you don't have a buy-sell agreement in the event of the death of a partner? The interest is going to become a probate asset, which can be a mess to go through in probate court, and even more difficult if it turns out your partner died intestate, without a will that directs what happens with his or her interest in the company in the event of death.

It also becomes an asset of the estate, so technically the court could order its sale, or the estate or the beneficiaries could become new partners. Well, you may not want to be partners with them. With all due respect to your partner's wife or husband, you didn't choose to go into business with them. They may not have the ability to conduct or run the business with you.

A buy-sell agreement can help avoid that. Once again, you put provisions in place that the company or the other shareholder has the right to buy that partner's interest from the estate first. You set out the terms, and potentially the use of a promissory note. Here's where the use of life insurance would also be helpful. If the company owns life insurance taken out on each of the partners, in the event of a death, the life insurance can help purchase that partner's share from their estate and buy them out under a buy-sell provision. That's very helpful, and it's actually usually very tax-efficient as well, which is something you should talk to your accountant about a little bit more.

So hopefully you're seeing right now some of the benefits of a buy-sell agreement. Maybe you're starting to think about circumstances where it could be very important to have one. You're probably even thinking about other circumstances where it could apply. There are many different circumstances. I've given you a couple within the five D's, just to get you thinking about these things and understanding their importance, and what can be done to help mitigate some of the risks and issues that can come up within a partnership.

Questions from the audience

So, I don't know if anyone has any questions. Hopefully that's been helpful. Does anyone have any questions I might be able to answer? Okay, thank you. This is Ricardo. He's bringing me questions. Okay, all right.

First question: what if you sign a shareholder agreement and the shareholder still defaults? Remember, we talked about how a shareholder agreement is usually what's found in a corporation, and it can be similar to an operating agreement or a partnership agreement. Often there are similar provisions in both types of agreements: management obligations, capital calls, potentially buy-sell provisions. So if a shareholder does breach, it just depends on what remedies the agreement actually provides for.

However, often within buy-sell provisions, assuming we're asking the question about buy-sell provisions, the buy-sell provision will indicate a forced buyout. So say the person, the estate or the spouse does not actually go through with it. For instance, you're trying to buy your partner's shares, maybe their spouse inherited them in the event of a death, and they do not want to abide by the buy-sell provision. A lot of times the buy-sell provision actually indicates that in the event the party does not go through with the procedures set out in that provision, the company automatically becomes attorney-in-fact, basically holding a power of attorney on behalf of that third party, and can sign all these agreements. Those types of provisions should be there so that it can be enforced.

And of course, often there are attorney's fees provisions in these agreements, so in the event someone does not cooperate, including third parties, and you're required to enforce the agreement and go to court, often the prevailing party will be entitled to attorney's fees. That's something that should also be in these agreements as well.

Now, another question we had: what are my legal options, and approximately how much would litigation cost? This is from the same person who asked about the default on the shareholder agreement. So presumably you're trying to enforce one of these provisions in a creditor situation or a death situation. Hopefully you're not litigating a lot of other issues, assuming you're only litigating that one issue. And if it's in probate, it could be anywhere from $5,000 to $7,000, to $20,000, $30,000, $40,000, $50,000. It's really hard to tell. It depends on the type of company, the number of partners, and the number of things that might be disputed. But it can be very costly, and particularly very time-consuming, and it can take some time to actually get a ruling.

Often litigation in these kinds of situations can take years. More often than not, I find it takes anywhere from 12 months to 18 months, but that's still a very long period of time to be left in limbo. Often the partner who has suffered a disability, or the estate where there's been a death, needs the money fairly quickly. They need certainty. If it's them actually defaulting, that's another situation. But the company also doesn't need to be tied up with this potential liability. So it's just better to have an agreement that clearly sets out each party's rights.

Resolving a deadlock

Here's another question: in drafting a provision addressing deadlock situations, what would be the most effective, efficient and cost-effective way to resolve a deadlock? Well, there are probably 100 different ways you could write a deadlock provision. However, I think one of the most cost-efficient and effective ways is that you determine the valuation of the company: fair market value, how an independent appraiser is going to find it, or what methodologies are going to be used to find the fair market value of the company in the event of any of these circumstances. And of course, fair market value is as of the time the circumstances occur, not 10 years before, when you signed the agreement.

Then it's very straightforward. We have a dispute. We cannot get along anymore. We have tried to mediate; maybe you have a mediation provision there to try to mediate the dispute you have with each other. If the mediation fails, you could basically do a put: you give the other person an offer and they buy you out right then and there, or you're automatically given the right to buy them out if they do not exercise their right to buy you out. And of course it will be at the fair market value you have determined.

And of course, if neither party can actually buy the other out, because they don't have the actual money, maybe there's another provision. This is where a promissory note actually comes in handy, because if you indicated that a promissory note can be used in the buyout of another party, that can potentially help one of the parties afford to buy out the other. But they may not want that. They may want cash. So they might agree to a provision that would basically sell the company. That's one of the ways: if the put or the call doesn't work out, then you're forced to sell the company.

One of the other questions is: what do you do where the business is worth more than its liquid assets, so buying out a partner would not be feasible? Sorry, I was actually partially answering that question in the previous one. If they can't buy out the other party's interest, or there was no agreement to use a promissory note to purchase the other party's interest, then the provision should indicate that the company should be sold immediately. My suggestion, if it's sold immediately, is that it not be sold under duress or in a fire sale, because you're going to get a lot less for the company.

There should also be a confidentiality provision in place that basically tries to keep everyone quiet, so that the market doesn't learn there's turmoil, because the company will become devalued as well, unfortunately, or you'll get some low offers because they know you're in a bad situation.

So that's all for the questions. Hopefully this information has been helpful. If we can ever be of assistance to you, or you need help with a buy-sell agreement or anything related to corporate law, please do not hesitate to reach out to us. Hopefully this has been informative. Thank you very much, and once again, may the Force be with you, and hopefully you never end up with a partner like Darth Vader. Okay, everyone, take care, and we'll see you soon.