A carefully thought out shareholders agreement can be a major asset to virtually any closely-held business. A complete shareholders agreement has two major goals:
-To provide a controlled mechanism for transferring one's interest in the business (buy/sell arrangements).
-To provide basic ground rules for decision making.
The very process of working out a framework within which ownership interests are handled and critical decision making takes place fixes the parties' reasonable expectations. This avoids conflicts down the road at a time when the resolution of such conflicts may be far more difficult because of their immediacy. Furthermore, the process of addressing the issues frequently leads to beneficial advance planning (such as the purchase of life insurance to fund a buy out).
In many practical ways a closely-held business is a "partnership" of the principals, notwithstanding that it is conducted in corporate legal form. As with any "partnership", the chemistry of the partners is critical to the success of the partnership. It is, therefore, usually essential that there be certain limitations on the transferability of interests in a closely-held business. Each of the "partners" wants (and should have) a certain amount of control over whom may become his "partner" by reason of a transfer. A "partner" may get along perfectly well with his "partner", but it does not follow that he will get along equally well with his "partner's" wife or son.
The four basic buy/sell scenarios
Buy outs generally arise out of four basic scenarios: (1) the death of a "partner", (2) the disability of a "partner", (3) desire by a "partner" to leave the business voluntarily (retirement would be a variation of this scenario) and (4) the forced sale of a "partner's" stock (such as might occur upon divorce, loss of a required license or personal bankruptcy)
Buy out pricing mechanisms
(1) Market-oriented mechanisms: Right of First Refusal and Right of First Offer; (2) Formula mechanisms: Book Value and Industry Rule of Thumb; (3) Appraisal and (4) Agreed Value
Funding the buy out
Generally, the selling "partner" is interested in receiving the payment for his interest as soon as possible (so as to provide maximum personal flexibility and a minimum of nonpayment risk). While there is some incentive for the purchasing "partners" to want to expedite payment of the selling "partner" (in order to minimize any continuing involvement of the selling "partner" through restrictive covenants or security interests), the remaining "partners" are concerned with meeting the obligation to buy the interest without unduly burdening the business (or themselves).
In a properly functioning business most decisions are made in the ordinary course and do not require a formal decision making process; these decisions are made by an easily reached consensus or are readily delegated to the individual in charge of that aspect of the business. Only the most sensitive issues require a formal decision making mechanism.
It is fairly common to provide for a gradation of mechanisms designed to accommodate varying degrees of importance. For example, admission of a new principal may be of great enough importance to warrant granting each principal a veto irrespective of that principal's actual percentage interest. Sale of the major business assets might warrant a super-majority vote--e.g., a 75% vote. Other issues which require special consideration vis-vis decision making include merger, major capital investment, major borrowing decisions, executive hiring decisions, expulsion of a principal and principal compensation.
At the same time that buy out and decision making issues are discussed and resolved, issues involving principal compensation ought to be resolved. In analyzing compensation issues, it is important to realize that a closely-held business owner frequently (but not always) wears two hats:
(1) Stockholder--the owner is a capitalist looking to reap a profit from his investment in the business. Such profits typically take the form of dividends or capital gains upon sale of the business.
(2) officer/employee--the owner is frequently an officer/employee of the business looking to receive compensation for his efforts on behalf of the business. Such compensation usually takes the form of salary and benefits.
It is particularly important to pay attention to the foregoing where a business has passive investors, where the principals commit significantly disparate amounts of time to the business, or where the principals bring skills of significantly disparate value to the business.