Partnership: Agreements Should Precede Commitments

Once the parties are at a standoff or embroiled in litigation, the opportunity to clarify terms has likely passed them by.

Partnerships can certainly provide a great deal of opportunity through the pooling of talents and resources. However, significant risk can also be introduced for people who tie up their capital in an arrangement with other individuals.

When there is joint ownership of an asset, it is important that this arrangement is governed by a written agreement. If the entity through which the venture is carried out is a corporation, then the agreement used is a shareholders’ agreement. It is preferable that this agreement is entered into prior to entering into a business arrangement. If there are differences in understanding of how an arrangement will operate, it is best these differences be addressed at the onset. It is certainly easier to have these discussions while the shareholders have a good relationship. Once the parties are at a standoff or embroiled in litigation, the opportunity to clarify terms has likely passed them by.

Before engaging a lawyer to draft an agreement it is often beneficial to discuss some key terms and come to some level of agreement. An advisor who has both an understanding of these kinds of agreements, the partners’ circumstances, and the business/asset in question, can be of great assistance. An advisor can help the parties give attention to the issues that could be a problem in the future and develop terms for resolving any disputes. Using a boilerplate or off-the-shelf shareholders’ agreements can be problematic, as they may not address the parties unique circumstances or preferences, and shareholders may not even understand the terms of the agreement. This is not an ideal situation, but is something that occurs all too often.

Some Key Terms to Discuss:

What is the remuneration for shareholders who are employees or managers of the business?

• It is often preferable that compensation for employment or management roles be distinct from the dividends received as a shareholder.
• What is the policy for how much dividends are to be paid, when, and for how much capital is to be retained in the company?
• What decisions would require unanimous agreement by shareholders or a certain percentage of the votes? Examples include:

Examples include:

• Expenditures above a certain dollar amount
• Taking on debt
• Hiring or firing of key employees
• Entering into various types of contracts or agreements

What happens if one of the shareholders dies or becomes disabled?

• Normally there would be a buy-out provision where the other shareholders are obligated to buy out the disabled or deceased shareholder; normally funded either by life insurance or business profits over time.
• In some cases, a buy-out might only be required if a shareholder becomes mentally incapacitated versus physically.

What options are provided to a shareholder who wishes to leave the business altogether?

• In some cases, the other shareholders will have the option to match any third-party offer to buy shares. This is referred to as a right of first refusal.
• In other cases, the other shareholders are required to buy the shares of a departing shareholder at a previously agreed value over an agreed period of time.
• If the other shareholders are unwilling buy the shares, then terms of the agreement may require the company or its assets be sold with the proceeds being distributed to the shareholders proportionately.

Are shareholders required to be active in the business?

• If so, then if a shareholder chooses not to be active in the business, that shareholder would be forced to sell his/her shares to the other shareholders.

What happens if the business runs out of cash?

• Shareholders may be required to loan funds to the company.
• Shareholders may also be required to provide personal guarantees to creditors.

Should shareholders be prohibited from having outside business interests that could be seen as competing with the company?

Should the shareholders’ agreement include a non-compete clause for a period of time for shareholders who are bought out?

What is the method for determining share value when a shareholder is being bought out?

• A predetermined formula can be used.
• A Certified Business Valuator can be used.
• A fair market value is preferable for avoiding negative tax consequences.

What options should be included to allow flexibility for share buy-sell transactions to be done in a tax effective manner?

The shareholders’ agreement won’t make a business successful or ensure that shareholders will not end up in disputes. However, having a shareholders’ agreement developed and understood by the shareholders themselves, should reduce the potential for dispute arising and will help changes in ownership to happen in a much smoother fashion. A well designed shareholders’ agreement will even make being a shareholder of the business more attractive. Minority shareholders, in particular, can gain great peace of mind from knowing the terms that all shareholders are bound to.