Keeping the Keys to the Kingdom: Agreements a Business Should Not Be Without

• Publication year: 2015
• Author: Charles L. Crouch, III

Keeping the Keys to the Kingdom: Agreements a Business Should Not Be Without

Charles L. Crouch, III

Chuck's focus is on general business, transactional, and insurance regulatory matters. His business and transactional practice includes formation and financing of business entities, mergers and acquisitions, and counseling on issues including corporate governance, securities, strategic relations, sales and distribution, intellectual property protection, and real estate. His insurance regulatory practice includes counseling insurance companies, producers, and administrators on insurance regulatory compliance, operations and distribution, and representation before regulatory agencies. Chuck has served as General Counsel to a national property and casualty insurance group and was a managing partner of the Los Angeles offices of two international law firms. He is a past Chair of the California State Bar Business Law Section and a past Chair of that Section's Insurance Law Committee.

Consider the founder of a startup enterprise or the owner of a mature, closely held business. The business may operate as a corporation, limited liability company, partnership, or joint venture. It may be a developer of groundbreaking technology or operate in the brick and mortar sector. But if the business has more than one equity owner or has a key employee with access to proprietary business information, then the departure of an owner, or that employee, can have a catastrophic impact on the value, competitive position, and even survival of the business unless certain simple safeguards are in place.

This article addresses three types of agreements often overlooked by business owners that, if put into place prior to the departure of an owner or employee, can significantly mitigate potentially catastrophic consequences. War stories abound regarding the aftermath of such events when the rush to market, the demands of running the business, or the desire to avoid legal fees took precedence over the preparation of these agreements. The irony is that each of these agreements may be tailored to meet the needs of a business at any stage of development, can be fashioned to meet any budget, and can be later enhanced as needs require and budgets permit. These agreements are the buy-sell agreement, the noncompetition agreement, and the nondisclosure agreement. ¹

The Buy-Sell Agreement

Envision the consequence of a fellow equity owner of your business either dying, experiencing a divorce, or (in the throes of a management dispute) selling stock in your business to a competitor. Consider the impact on the business of having someone else's inexperienced and disinterested heir, a disgruntled ex-spouse, or an ill-motivated competitor as the surviving shareholder's new business partner. Such nightmare scenarios occur all too frequently as a result of not having signed a "buy-sell agreement" addressing the disposition of an equity owner's shares upon the occurrence of specified events.

The buy-sell agreement is a written contract among the corporation and its shareholders. The primary purpose of the agreement is the purchase of a departing or selling shareholder's shares by the corporation and/or the remaining or surviving shareholders upon the occurrence of any number of triggering events.² Those events may include the death, divorce, termination of employment, or bankruptcy of, or the prospective voluntary or involuntary transfer of the shares held by, the departing shareholder.

The buy-sell agreement serves several functions. It assures that the shares of a departing shareholder do not wind up in the hands of an unwanted third party, permitting that party access to the corporation's proprietary and confidential information and also possibly a position on its governing board. Restricting transfers to third parties is also of particular concern to shareholders of Subchapter S corporations, who need to assure that the shares are not transferred to persons or entities who will make the corporation ineligible for S corporation tax treatment.³The buy-sell agreement also provides a "market" for the shares upon the death, disability, or retirement of the departing shareholder (and establishes an arguable value of a deceased shareholder's shares for estate tax purposes).⁴ It specifies a means for determining the purchase price of the shares and the manner of payment, thus avoiding controversy at a time when the parties can least afford it.⁵

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Side Note:
A buy-sell agreement will be easier to implement and administer where there is a limited number of shareholders. Limiting the number of shareholders simplifies nearly every other aspect of the formation and operation of a closely held corporation. With the exception of institutional or other sophisticated investors that lend material financial and management value to the enterprise, increased numbers of shareholders causes increased burdens on the corporation, ranging from the need to address shareholder suitability and disclosure and notice requirements to garnering the requisite votes to undertake material corporate transactions.

Who Purchases the Shares?

Buy-sell agreements may provide for the right or the obligation of the corporation to purchase the shares of the departing shareholder upon the occurrence of a triggering event. The corporation and its shareholders agree that the corporation may or will purchase the shares of a departing shareholder with corporate funds (commonly referred to as a "redemption").⁶

Another form of a buy-sell agreement is an agreement among the shareholders of the corporation that the remaining shareholders may or will purchase the shares of the departing shareholder. Commonly referred to as a cross-purchase, it prescribes a mechanism for the purchase of the shares by the remaining shareholders on a pro rata basis with the use of their personal funds.

Finally, the buy-sell agreement may combine the features of a redemption and a cross-purchase, giving, for example, the corporation the first option to purchase the shares of a departing shareholder, with the remaining shareholders being given the opportunity to purchase those shares not purchased by the corporation.

Side Note:
There are myriad factors bearing on which form of buy-sell agreement best suits the interests of the corporation and its shareholders at any given time, including tax and non-tax considerations. For example, the particular sequence of exercise rights under the combination approach described above can have differing tax ramifications.⁷ In addition, state corporate laws will likely restrict the funds from which a redemption may be funded to the corporation's "surplus" or retained earnings.⁸ Similarly, any loan agreement to which the corporation may be a party will likely prohibit a redemption without the lender's consent. Typically, a redemption is easier to administer than a cross-purchase, as it is self-executing by the corporation without the need for multiple shareholder actions and will better preserve the remaining shareholders' existing percentage equity interests in the corporation. In contrast, executing cross-sell rights requires actions by all of the remaining shareholders, and less financially able shareholders who do not fully exploit their cross-sell rights will suffer a reduction in their pro-rata equity interests. For all of the above reasons, it is important that business counsel advise the corporation and its shareholders both at the formation stage when the buy-sell agreement is executed and when a triggering event occurs.

Right of First Refusal and Put and Call Rights

The terms of the buy-sell agreement will specify those events that trigger either the option or the obligation to purchase or sell shares. Examples of triggering events and the rights they might enable include the following:

1. The prospective voluntary sale of shares to a third party, in which event the corporation and/ or the remaining shareholders will be granted a right of first refusal to purchase the shares on the same terms as those offered to the third party.
2. The prospective involuntary transfer of shares through a bankruptcy, divorce, or execution on a judgment, in which event the corporation and/ or the remaining shareholders may be given a "call" right, requiring the departing shareholder to sell the shares prior to the transfer.
3. The entry of the departing shareholder into competition with the corporation, in which event the corporation and/or remaining shareholders may be given a call.
4. The termination of the departing shareholder's employment, through retirement or otherwise, in which event the departing shareholder may be given a "put" right, requiring the corporation and/or remaining shareholders to purchase the shares, or the corporation and/or remaining shareholders may be given a call, depending on the circumstances.
5. The death or permanent disability of the departing shareholder, in which event the departing shareholder or his estate may be given a put, or the corporation and/or remaining shareholders may be given a call, depending on the circumstances.

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Side Note:
It must be anticipated that upon the occurrence of any number of triggering events, the corporation and remaining shareholders will not be able to count on the cooperation of the departing shareholder or his prospective transferee. Accordingly, it is essential that all stock certificates representing shares subject to the buy-sell agreement bear a legend characterizing the shares as restricted and subject to the terms and conditions of the buy-sell agreement. To further secure the obligations of each of the shareholders to perform pursuant to the buy-sell agreement, the parties might also consider placing all certificates representing outstanding shares into escrow, to be released as appropriate under the terms of the buy-sell and escrow agreements. Should it be determined that a shareholder's shares are or could be community property, additional

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