I. When creating a business/entities, partnerships, corporations, limited partnerships, limited liability companies.
- (a) What about the creation of an exit strategy?
(Not really an issue at the time of creating the business as there is no real value)
- (b) Different forms of entities where buyouts are appropriate, Corporations, Limited Liability Companies, Limited Partnerships and General Partnerships.
II. Anecdotal sharing facts
Husband, wife and friend buy into a mechanical engineering company approximately ten years ago for the sum of $1,000,000. At the time everyone is happy, no difference of opinion, and they all sign up and pay collectively $1million together. Someone comes up with the idea of being a woman owned, disadvantaged business qualified under the Department of Transportation/CALTRANS in order to qualify for better breaks on contracting bids under state and federal contracts.
Optimal fact; this company was going to be doing a lot of public contracting. The purchase structure was 52% by husband and wife and 48% by other friend. Husband and wife agree that for business operation purposes and for biding on disadvantaged woman owned business transactions, that she would be the reflected 51% business owner and he in turn would own 1% (truly they owned 26% a piece) and the other shareholder would own 48%.
So the business continues to push ahead and do better and better and for one reason or another, a schism develops between the husband and wife somewhere about halfway into the agreement, four or five years into the purchase.
Wife files for divorce, takes off with younger boyfriend 10 years younger, the couple have two kids and she continues to work in the business; she also has a separate job in the medical field. Divorce is filed, the parties represent each other, they go to mediation without representation, they sign a bunch of documents and are entered into court in or around 2013 and they agree she will continue on as “51% owner”, but to the outside world they will be 26% owners each. This is filed with the court and endorsed through mediation, but not represented by counsel mediation. Approximately three years later, issues arise between the ex-spouses, the ex-husband and the other owner begin to formulate a game plan to eradicate the company of the wife’s presence.
In or around April 2016 they tell her she is basically doing nothing, adding nothing and that they are going to fire her; therefore, she would be losing her benefits, her job, and she would have to go look for work somewhere else.
It is at this juncture that we are hired and we are able to confirm a status quo negotiated buy out, where she gets paid for 120days at the same rate, same perks, same benefits, and the parties agree to negotiate for a good faith buy out of her interest in the business. However, importantly they will not agree that if there can be no agreement that there will be a binding valuation to be determined by an agreed upon valuator, they would not agree to that.
So now time is running by, they CPA on our side and myself start trying to extrapolate values from the past tax returns and we start out trying to negotiate about a $700,00 buy out. We were continually rebuffed by the other side and ultimately we get to the end of the 120-time period and they are not willing to pay more than a reduced book value; and on top of all that they want to break it into payments overtime.
During the discussions, there was a concept of inter spousal transfer of stock [26USC Section 1041(a)] and the ability for her to have the transaction be considered tax free. That was agreed to, withdrawn, and then ultimately finalized which was a huge deal as it allows for her part of the transaction to happen tax free. Eventually we were able to get them up a little bit, but not much and this brings us back full circle as to why there should have been a buy-out.
A buy-out should have been entered into in this case, and should be entered into in almost every cases where there is more than one owner; and the buy-out should focus on what happens when someone terminates, is terminated and/or retires; someone is disabled; or someone dies.
The funding for the buy-out can be partly paid for by the company and/or insurance policies when it pertains to disability and death situations. Lifetime buy-outs are more difficult and usually call for a down payment on the buy-out of anywhere from 25% to 33% of valuation and the balance over three to five years with interest and security and so forth. Also, there are usually formulations in there to ascertain fair market value.
What is the difference in what happened in the Anecdote and if you had a buy-out?
Simple answer is that the buy-out agreement would have allowed our woman to compel that a valuation be done on the company which would have supported a buy-out figure of somewhere between 1 and ¾’s to as much as three times what she ended up getting.
Otherwise, without such a buy-out agreement and a minority position (1) you cannot commence a dissolution action; (2) you cannot remain an employee of the company; (3) you are not entitled to have perks of the company. So you are simply a stalemate, in a position where you will be entitled to some financial information, but everything you do will cost you money in the form of legal fees and or accounting fees.
In sum, when you are beginning a business or any of your friends are beginning a business, if there is more than one party involved absolutely, every time, have a buy-out agreement prepared by the attorney who is helping them set up the entities.