The Importance of Pre-Negotiated Agreements in Closely-Held Business Entities
Before a client forms or invests in a business entity with any other
parties, it is critical that an agreement be negotiated which governs the
conduct of the parties in connection with that business. For a corporation, the
agreement is known as a Shareholder Agreement. For a limited liability company,
the relevant provisions will be found in the Operating Agreement. For a general
or limited partnership, the same provisions will be found in the Partnership
Agreement. Whatever the business entity, the concerns and potential problems
are the same. In addition, those concerns and potential problems are equally
applicable to a business venture with friends or relatives as with
The most important issues are those pertaining to restrictions upon the
transferability of shares of stock, interests in a limited liability company or
interests in a partnership. Most parties in a closely-held business want to
limit who may participate in that business with them. In order to ensure that
the other stakeholders have a voice in that process, an agreement should provide
that either the business entity or the remaining interest-holders may acquire
the departing party’s interest upon the occurrence of certain triggering
events. Those events are usually death, disability, termination of employment
or a desire of a party to sell his or her interests in the business. When one
of those events occurs, an agreement with buy-sell provisions will provide for
either a mandatory purchase or a discretionary purchase of the departing party’s
interest in the business entity. For a discretionary purchase, the agreement
will grant rights of first refusal to the business entity and/or remaining
A major advantage of pre-negotiated buy-sell provisions is that they are
agreed to when the entity is formed and when relations between the parties are
good. When a triggering event occurs, emotion will usually be involved
regardless of the nature of the triggering event. Under such an agreement, the
remaining shareholders of a corporation or interest-holders in an LLC or
partnership will know exactly what their rights are upon the occurrence of the
triggering event. A good agreement will specify methods of valuing the
departing member's interest in the business and paying the required amount for
While well-drafted buy-sell provisions will protect the remaining
shareholders or interest-holders of a business, they may also provide liquidity
and attempt to assure an exit strategy for the departing shareholder or
interest-holder. Whether the triggering event is death, disability, termination
of employment or merely a desire to leave the business, the advantage of good
buy-sell terms is that the departing party’s interest in the business can be
sold upon pre-negotiated terms. Those terms can be used to generate cash for
the departing party or his/her estate. In the event of death, life insurance is
often used to guarantee that the funds for the stock purchase are available to
the entity or the remaining interest-holders.
Minority shareholders or interest-holders may look to these agreements to
prevent the majority from "freezing them out" of a variety of situations. One
common example is the incorporation of “tag along” provisions which permit a
minority shareholder or interest-holder to participate in the sale of a majority
holder’s interest in the business.
Other common uses of these agreements are for the following purposes:
- To determine management of the business and other governance issues
- To plan for succession of management responsibilities or ownership
- To provide a system for resolving disputes within management
As an investor in a business entity, you cannot afford to be unprotected by
an agreement with the other investors on these issues.
Beginning of Year Review Time
The beginning of the year is not only the time to start thinking about taxes, it also the time to make sure your estate plan is in order. It is a great time to review your Wills, Powers of Attorney, Life Insurance and Retirement accounts, to name a few things.
If revisions are needed you should contact your professional advisors, including your attorney, accountant and financial planner.
Read Legal Ease every other Sunday in the Pottstown Mercury.
See Legal Talk, brought to you by OWM, on PCTV, Tuesdays at 8:30 on Channel
28, and Thursdays at 9:30 p.m. on Channel 98, and also on our website at http://www.owmlaw.com/legal_talk/legal_talk.php.
David A. Megay, Esq., and James
C. Kovaleski, Esq., speaking at SCORE business planning seminars on 11/8/10,
1/10/11, 4/25/11, 9/12/11, and 11/7/11 (contact SCORE at 610-327-2673).
David A. Megay, Esq., speaking at Owen J. Roberts Adult
Education 9/20/10 real estate transaction seminar and 10/4/10 business planning
seminar (contact Owen J. Roberts Adult Education at 610-469-5830).