One of the business law areas on which I work quite often is a change of ownership in a business. It may be an existing LLC or corporation that wishes to provide an equity interest to a long-time employee or it could be a third party brought in to provide investment or expertise.  There is also the situation where an existing owner wishes to part ways or sell out their portion of the ownership.  In this article, I discuss the legal issues and business considerations of these changes, which can be major business opportunities or disruptions. Owners of an LLC are called “members” and owners of a corporation are called “shareholders.” For purposes of this article, I will refer to them all as shareholders.

Why Buy or Sell Part of a Business?

There are numerous circumstances in which an owner might come on board a business or existing co-owners wants to sell out.  Shareholders in a corporation whose shares as publicly-traded just sell their shares on the open market. This is not the case for a small business or closed corporation where there is no ready market.  There may be few interested buyers, except for the existing shareholders and those who might be enticed to invest to earn a profit.

Who owns the Business?

If your business is an LLC or a corporation, you are supposed to know who owns it.  That is easy if there is one owner. If there are two or more owners sometimes things are muddled as to who owns what percentage.  Good accounting practices would provide the answer since members/shareholders of a small corporation, often a S-Corp.  should generally receive a year-end statement showing the amount of profits,  if any, on which taxes are due.

However, it is a good idea to have an operating agreement for an LLC and a shareholder control Agreement for a corporation that will state who owns what, how one’s ownership interest can be transferred or sale restricted, and perhaps even an agreed-upon value for shares.

Adding a new owner

Assuming you know who owns the business, you may wish to bring in new money or talent and provide a new person with an equity stake in the business. Perhaps you will also pay them a salary.  If your business needs money, you may consider adding a “passive” owner to provide capital but give no governance rights or management rights.  That can be done.  Many investors just want a share of the profits in exchange for their investment.  If that is the case, you should have contractual provisions in a subscription agreement and operating agreement.

If you are seeking multiple investors, the same scenario applies. Some of my clients are the main shareholder or member in the business and have the management authority on a day-to-day business.  They seek multiple investors to provide the capital to create and fund the business. Naturally, all parties need to know what they are buying (or selling) and it is vital to negotiate and agree on a multitude of points and get those in a set of signed agreements.

A subscription agreement is a contract for the purchase of an ownership stake.  Generally, it includes provisions about who much is being invested, when the money is to be paid, when shares are issued, and the like. It should also make reference to whether the investment is subject or exempt from state and federal security exchange laws.  Unless you can point to such an exemption, there may be required up-front filings with the state or federal Security and Exchange Commission and ongoing reports as well.  This can really be a high hurdle and runs into big money.  Most small investments in a business can be found exempt, but the analysis must be made up-front to assure compliance.

Shedding an Owner

A well-written operating agreement will detail how an owner can sell out some or all of their part of the business.  Sometimes, a co-owner dies, in which case their shares would ordinarily go to their next of kin.  Both financial and governance rights would vest in their spouse, for example.  This would mean the spouse is now your new partner. This is seldom a desirable result. A hallmark of business law is that you get to “pick your own’ partners.”  This flies in the face of that since the spouse may have little business experience or might not like them. That is why it is essential that an operating agreement deal with this issue. Generally, the deceased co-owner is compelled to sell their shares to existing shareholders or to the business itself.  In that case, the two main issues are what is the buy-out price and how will the business or other shareholders pay it. The best answers entail advanced planning.

Paying for the Buy-out

In operating agreements that I draft, there is either a stated share price that can go up with time or a method to determine an exact number at any point in time. This hopefully does away with appraisals which are expensive and often inconclusive in my view.

If existing shareholders for the business have the cash to buy the deceased co-owners shares there is no problem. However, if not where does the money come from?  It is best for the operating agreement to state that the business may buy life insurance on all co-owners for this purpose. Premiums can be tax-deductible to the business. With the insurance proceeds paying for the shares, they return to the business and the potential spouse partner is paid off and stays out of the picture.  As well, there can be a time-payment component to this type of forced buyback where the payment for shares is spread over a multi-year period with interest.  Once bought back, the shares can be later resold, if that is the desired result or split among other existing co-owners in accordance with the operating agreement.

Conclusion

In a multiple-owner business of a kind, it is vital to have a good operating agreement or shareholder control agreement in place before the business is up and running.  A single owner-business certainly needs one when new owners or investors are added.

I can assist you in creating customized agreements that meet your goals and I can help with negotiations with the other parties so that everyone’s needs, and those of the business itself, are met.  A sound agreement generally reduces unnecessary risk, limits disputes, lowers costs, and lets you use your time to get down to the business at hand.

I look forward to discussing adding or subtracting owners, operating your business, buying and selling, and much more.

Please feel free to contact me. I look forward to talking with you.

Thank you!

Glen R. McCluskey
Attorney At Law

THIS DOCUMENT IS NOT LEGAL ADVICE AND MAY NOT BE DEEMED TO BE LEGAL ADVICE.  IT DEALS ONLY WITH THE MATERIAL SPECIFICALLY DISCUSSED HERE.  YOUR SITUATION WILL BE BASED ON YOUR OWN FACTS AND CIRCUMSTANCES.  YOU ARE ENCOURAGED TO SEEK THE ASSISTANCE OF YOUR OWN LEGAL COUNSEL AND TAX ADVISOR.