Sell Agreement Structure – Oh, no you didn’t!

Ron Burgundy: “That is without a doubt the dumbest thing I’ve ever heard.” From Anchorman 2

When I deal with a new privately held client, I always ask if there is a “buy/sell” agreement amongst shareholders.  I get the usual range of answers from “a what?” to “sure – the lawyers made us do one.”  I can’t emphasize the importance of having one especially in the case of death or disability.  The insurance brokers out there will usually press this issue since funding this potential eventuality with insurance is one of many solutions – but please work through that and get to the need for an agreement.

I have blogged before about not getting into a deal without knowing how you get out and the related issue of providing liquidity for shareholders if for any reason one leaves.  My advice has always been to address all the shareholder issues early in the corporation’s life when everyone still likes each other and is talking. I don’t want to dwell again on shareholder liquidity here, but I just ran across a case that reminded me in a very stark manner what not to do when setting up a buy sell.  Let me explain.

Four family members had a very successful business which they sold.  Each became, what you might call, independently wealthy.  All were involved as owners in starting another business which is now doing very well.  I was brought in to review some equity/shareholder/key employee issues.  In the course of completing my work, I asked my standard question regarding a buy/sell agreement.  The reply was one of the standards: “Yep, and it is funded by insurance, so no problem.”  As you know, I am still, at times, an auditor at heart so I asked to see the agreement.  I read it and my only comment (from my Italian heritage) was “madonne.”  It was structured such that surviving family members were personally fully liable for buying out the shares of a departed or disabled shareholder to the extent the buyback was not covered by insurance.  A quick calculation showed that, net of life insurance in place (and there was no disability insurance) this could mean a multi-million dollar non- recourse personal liability for 10 years.

I approached the shareholders and asked them to confirm, with legal counsel, my layman’s interpretation.  The lawyer (who had not prepared this agreement) used the above quote from Ron Burgundy – with a few deleted expletives.  Once the shareholders found out… the “you know what” hit the fan.  It was Apocalypse Now live!  Every possible emotion came out – anger, frustration, disbelief, etc.  There were no happy campers.  Fortunately, working with other advisors, we were able to structure an alternative that mitigated most of the risk. But this was a time bomb just waiting to go off.

So, my message is simple, boys and girls.  Please make a periodic review of all shareholder agreements part of a normal annual review process – perhaps tied to your review of corporate tax returns or insurance coverage.  You don’t need someone using this quote to describe your situation.

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Ownership Rewards – You Can’t Always Give What You Want

“You can’t always get what you want” – lyrics by The Rolling Stones

Today’s blog comes fresh from two recent experiences with problematic ownership issues.  My not-so-clever play on words from one of my favorite groups really captures the essence of an all-too-frequent discussion with owners regarding sharing equity. This blog will, once again, point out the issue impacts new as well as established businesses.  The first case is an early stage company and the second, a 15-year-old established service business.  Both have the same issue – looking for ways to get equity to employees.

The starting points seemed simple enough.  The early stage company had just raised a small round of financing and wanted to issue equity and the service business just wanted to get some ownership to key employees as part of a retention and succession plan.  I have blogged in the past about the need to always have ownership sharing as part of a periodic review of current state – where are you now and where are you going?  So, as Mona Lisa Vito would say, “So, what’s your problem?”

Well it seems both had what some might call “old baggage.”  The early stage company had made some informal commitments to employees regarding the price per share they could “get in at” but, had failed to execute documents and the recent round had set an indication of value far in excess of that informal promise. You really can’t get equity to someone at $0.10 a share when you just raised a round at $2 a share without some adverse tax consequences.

As part of the succession/retention planning process, the service business had come to an agreement with both current and future shareholders that the business was now worth $6mm.  While that’s a good start, (by the way, no valuation was done to support this) the current owners had already recently given 8% of the business to one of the key employees for no consideration.  Once again, giving an employee or advisor something of value for minimal or no consideration creates the potential for significant tax issues.  As you might imagine, a stock certificate accompanied by a notice of taxable income with no cash does not quite fit into the definition of an incentive benefit.

So, what started as a well-intentioned gesture by two thoughtful organizations became an exercise in futility as time and fees were wasted trying to both fix what had been done and reconfiguring what they wanted to do.  Not only did it show that you can’t always give what you want, but it focused again on a constant theme related to equity – that owners must stay vigilant regarding timing and good advice when considering any equity sharing.  With those two “friends” in your corner, as The Stones would say, “but, if you try sometimes, you just might find, you get what you need.”