I have been working with a few small companies that are run by founders or the children of founders and they inevitably come to a point where they start thinking about how the business would run without them. Early on, this idea doesn't even cross their minds; they naturally spend their energy on how to run the business and are not thinking about how to leave the business. This often comes up in the context of retirement, particularly where one or more of the partners does not have an "heir" to take their place. Depending on who the current partners are, those willing to take the helm may or may not be seen as "worthy".
But all small businesses should also think about the dreaded unplanned exits: what if one member dies or is permanently disabled? Some planning now in the form of a Shareholder Agreement (sometimes known as a "Buy/Sell Agreement" or "Cross Purchase Agreement") can save the company and its partners stress and expense down the road.
So what should you consider when planning such an agreement? Like any contract, you can choose from a number of options, but I typically advise as a baseline to consider the following:
- Restriction on transfers of stock or membership interest. A small company will likely want to restrict who is coming and going as an owner because of the inherent close nature of the partners's relationship. The partners may want to prevent one partner from going out and selling his ownership interest to someone undesirable to the other partners. This is typically done with an outright restriction on transfer unless the interest is first offered to be sold to the company and/or the other partners first. This offers some stability to the company and the other partners to move forward. In the event they refuse, then the selling partner may transfer the interest with the inferred consent of the others.
- What are the "trigger" events for a purchase of a partner's interest? This agreement generally allows the partners or the company (or both) the right or obligation to purchase one partner's interest in the company in the form of stock or some other membership interest. Many companies will have a trigger on the event of the partners death so that the interest is purchased from the surviving spouse (this is both as a consideration to the spouse and because the other partners may not be interested in partnering with that spouse). But you should also consider whether there should be a trigger for a partner's permanent disability preventing them from continuing in the business. Or, under better circumstances, what if one partner just wants to retire? The last one is harder because of the lack of objective measures, but will certainly be of interest to the partners at some point.
- How do you define the trigger events? A partner's death is a pretty easy trigger to recognize, but when is someone considered disabled to the point that the company should repurchase her interest? Generally, the disability should be described in detail with objective standards (e.g. mental or physical illness that incapacitating a stockholder from performing normal duties as director, officer, or employee for a period of six consecutive months or any six months in a 12-month period). Obviously, these can change depending on the circumstances, but are an example. Often, that determination must be made by a licensed physician, or in some cases, more than one if a second opinion is required.
- How do you fund the cross purchase? (and yes, you should fund it). When the agreement is triggered and the repurchase of stock by the company or the cross purchase by the other partners is required, what if they don't have the money? There are insurance products that can help here. For example, when one of the partners dies, a life insurance policy taken out on her life can be used to pay for the stock repurchase. But if you have a trigger for disability, you might also want disability insurance to cover (in which case your trigger should match the insurance policy definition of "disability"). This gets a bit more complicated when you decide how to purchase the policies - whether the company is the insured or the individual partners take out personal policies on the lives of the other partners. The premium prices will be different depending on the age and health of the partners, and there are some different tax treatments depending on whether the company of the partners hold the policies. Finally, in the event of a partner's retirement, funding cannot be done through insurance so you may consider paying by financing the purchase price over a period of time. That of course will depend on the nature of the business (and the partner's view of the long-term success of the business).
There are many other considerations you may want to take into account in negotiating among the partners, but these should be considered as a baseline. Your attorney and accountant can also provide additional thoughts on how your agreement will impact your particular situation.