Problems that can occur if Multiple Owners start a Corporation or LLC without a Buy-Sell Agreement, Operating Agreement or similar

Over the years, I’ve represented many companies with multiple founders.  In some cases, I have helped form the company, and in other cases, I’ve been brought in later on, either for a matter unrelated to ownership, or to help deal with a situation that involves issues that could have been addressed in a Buy-Sell Agreement (also often called a Shareholders’ Agreement or Cross-Purchase Agreement) or an LLC Operating Agreement (this could be a subject for an entirely different posting, but an LLC Operating Agreement typically covers the types of issues that are included in a corporation’s charter, bylaws and Buy-Sell Agreement).  Following is a list of the types of problems that occur where there is no buy-sell, or equivalent, agreement:

  • An owner who leaves active involvement with the company, either through voluntary termination, death or disability, gets to keep all his or her shares.  If the remaining owners want to replace the departed owner with someone new who brings the same areas of working expertise to the company, they may have to issue shares to that new person as part of the compensation package.  The issuance of new shares to the new active employee will dilute all owners’ interests in the company.
  • An owner who leaves active involvement with the company maintains all rights to be a director or officer, obtain company information and share in profits, even if that owner moves to a competing company.  Would you really want one of your co-owners to be able to obtain competitive information from your company while they are working for a competitor?
  • An owner leaves the company and wants to sell shares back, but there is no agreement on the proper valuation or the purchase terms.  This is a ripe area for disputes, often leading to litigation, as the interests of the two sides are typically at complete odds.
  • The company has no process to get back shares even from an owner who is terminated for cause.  If you don’t have an agreement in place that gives the company the right to purchase the shares of a non-contributing shareholder, there is no way to force the sale.
  • An owner can sell shares to an outsider without any input from co-owners.  Shares in a private company are freely transferable, subject to federal and state securities laws.  Now it’s not easy to sell shares in a private company to a complete stranger, but do you want to risk the possibility of having a complete stranger as a partner in your business?
  • An owner can transfers shares to family members without any input from co-owners.  Would you enjoy having your ex-partner’s spouse as your new business partner?
  • An owner dies or becomes disabled and then the owner’s spouse or other heirs become a owner.  The shares could be transferred to all the children!
  • An owner’s shares can be awarded to the owner’s spouse in a divorce proceeding.  So it’s not just termination of employment, death or disability that should be covered.
  • An owner can sell shares to another owner, disrupting a balance of power.  It would be better to have an agreement that provides a right of first refusal among all other shareholders, so that the remaining shareholders can maintain their proportionate interests.
  • One or more owners holding a majority of the shares can direct all company actions without input from any other owners.  In the absence of any provisions requiring consents from other shareholders, the holder or holders of a bare majority (more than 50%) can control almost all company actions.
  • A minority owner can be squeezed out from any participation as an officer or director.  Again, the majority holds absolute power without an agreement to the contrary.
  • An owner in difficult circumstances sells shares back to company at a discount, then the remaining owners promptly sell the company to a third party for a premium.  The company can take advantage of a low valuation or the poor leverage of the selling shareholder, when there are third parties waiting in the wings to purchase the entire company at a much higher valuation.
  • Owners in an S corp or LLC do not receive distributions to pay taxes on their share of the company profits.  S corporation shareholders and LLC members (for LLCs taxed as a partnership or S corp) must pay tax on their share or company profits, whether or not they receive any distributions – the profits flow through to their personal tax returns.  A shareholder without extra cash to pay those taxes could be forced to sell shares back to the company or to other shareholders, both to raise cash to pay the tax liability, and also to reduce the amount of that liability in future years.
  • An owner could transfer shares to an ineligible S corporation owner, terminating the corporation’s S election.  S corporations have strict rules on who can be a shareholder.  A transfer to an ineligible shareholder will terminate the S corporation election, subjecting the corporation to double tax, without recourse to the selling shareholder.
  • The owners reach an impasse – a deadlock – and can’t even agree on how to attempt to resolve the deadlock.  This will typically happen in businesses with 2 owners, but can also happen with any even number of owners, and sometimes with odd numbers of owners where there are 2/3rds or other super-majority voting requirements for certain actions.
  • The majority owners want to sell the company in a stock sale, but minority owners do not agree, eliminating the ability to sell.  Buyers of companies typically want to buy 100% ownership.  If the company is to sell by means of a stock sale, one minority shareholder could object to the sale.  This can be cured by means of a merger, but it would be simpler to avoid that path with provisions in the buy-sell agreement
  • Owners can divert legitimate company business opportunities for their own benefit.  Fiduciary obligations may not always require that corporate opportunities be directed to the company.  A buy-sell agreement can address this.
  • Owners can use company confidential information for their own benefit.  A buy-sell agreement is a good place to include confidentiality and non-use provisions, especially if some of the owners are not employees subject to an employment agreement with similar provisions.
  • Owners can compete against the company and take company employees and customers for their competing business.  Again, these are useful restrictions to put in a buy-sell if the owners are not subject to these provisions under a non-compete or proprietary rights agreement.

I hope this list of horribles is sufficiently scary to cause you to put a buy-sell agreement or equivalent in place as soon as possible, if you don’t already have one.