Posted: September 1, 2018 | Press
Robert Frost wrote, “Good fences make good neighbors.” At Ferruzzo we add: “Smart business partners build custom fences at the beginning of their business venture, and then tend and mend the fences throughout the relationship.” Why? Ranchers do not manage their herds without fence perimeters circumscribing their grazing valley. Similarly, savvy business owners should seek counseling to guide the birth of their enterprise and thereafter. Despite the almost ubiquitous and endlessly available supply of “form agreements” and a seemingly, and unfortunately misguided view that counseling should await conflict, a custom business agreement provides structure, delineates responsibilities, and accounts for the “what ifs.” The agreement should not be viewed merely as a “check-the-box” form to download, fill in, and forget. While not exhaustive, below are a few common issues that owners should consider in drafting such an agreement.
Who Owns the Widget?
One owner brings intellectual property, expensive equipment, or the “wonder widget.” Did the owner contribute the intellectual property to the company or license the property? Is the company’s use exclusive, or does it terminate when the contributor departs? Can the departing owner use the property to compete against the company? What happens when the contributor “wants to take her ball and go home?” Owners should consider including provisions that address the fate of non-cash investments or contributions into the business.
Just the Two of Us - For Now
For all business owners, the issue of equity dilution following additional capital infusion is critical to address. If the owners’ interest percentages are a function of initial or additional capital contributions, what happens if the money runs out while operational expenses need funding? If an owner adds additional cash, does his equity increase relative to the other owners? Instead, should the business seek financing from one or more of the owners or from a third party, and at what terms? How does the equity dilution affect management decisions? Wise owners address funding shortfalls before they almost certainly occur.
Why Are You the Only One Getting Paid? Don’t I Get a Vote?
“You make it, I sell it,” is a good script, but in and of itself, is not a practical management structure. Does an investor owner have any say in the operations of the business or hold a veto power for major decisions? Does the operations owner receive a paycheck when the business is losing money? What is the owners’ agreement regarding deferred compensation or accrual of other benefits? Owners should agree from the outset as to the rights and responsibilities of each owner.
Buy Me Out - You Can’t Go On Without Me - Let’s End It
Owners may exit an entity in a number of different ways with death, disability, retirement, voluntary withdrawal, and termination of employment being the most common. They may also agree to terminate the business altogether upon the occurrence of certain events. Some owners may be comfortable with a departing owner continuing to hold her equity interest after her departure, which is often the case with family-owned businesses where family members are willing to share distributions with “passive” owners. However, it is typical for the entity or the remaining owners to purchase (or have an option to purchase) the departing owner’s equity interest. One resonant surprise in counseling owners is having one owner hear the other say for the first time, “I may want to leave at some point and do my own thing.” Addressing the rights of each owner to exit the business, and the terms by which such exit will occur, mitigates potential adverse consequences in the event of a falling out.
How Much am I Worth to You?
While owners may agree on the, “I buy you out or you buy me out” concept, owners often disagree as to the value. A well-drafted agreement should spell out in detail either (i) the value of the equity interest, or (ii) a methodology to determine the value of the interest. Depending on the industry involved, it may be possible to value the entity (and thus the departing owner’s equity interest in the entity) by applying an agreed multiple of gross revenue. For other entities, it may make more sense to utilize an outside appraisal process in which each owner may have input. Some owners feel that a discount on the value is warranted upon the occurrence of certain events (i.e., upon voluntary termination or good cause expulsion). Further, the valuation mechanism in the agreement could address the special role that an owner plays on behalf of the business, such as a rainmaker or a chief inventor. By addressing this valuation in advance, owners can avoid the most common (and most costly) dispute that arises on a departing owner’s exit.
A Better Mouse Trap
Preventing a departing owner from competing against the business is only effective if the restriction is reasonably crafted in scope and application. Do not use boilerplate that will tarnish and crack the first time you try and enforce it. Consider provisions that identify and value customers or accounts so that misappropriation or solicitation claims are mitigated and costly litigation avoided.
Let’s Agree to Disagree and How
Owners are going to disagree, so their agreement should provide a structure for resolving conflict. For some, mandatory mediation followed by arbitration makes sense. Others agree that a deadlock between the owners should trigger court relief, the right to a buy-out, or an outright third-party sale. A well-drafted conflict resolution provision will help the owners resolve conflicts without destroying the value of the business.
Seek Professional Help Now
However tempting it may be to select an off-the-shelf agreement, it is the engagement and interactive process of the owners working together with their trusted counselor to develop the agreement where owners gain the greatest benefit and learn most about each owner’s values. This knowledge best positions long-term relational success. By discussing the issues identified above at the commencement of their business relationship, owners construct sturdy fences that provide certainty and predictability under otherwise tumultuous circumstances.