Purpose of the Owner Agreement

For a business facing a succession issue, the planning process must be conducted with considerations different from those used in the operational planning process. The core of the difference is that each owner must recognize and plan for the foreseeable and certain situation where that owner is no longer a part of the business.

The criteria are two: the plan must be strategic, and the plan must be the basis for an enforceable owner agreement. The foreseeable long-term events such as death, disability, divorce, bankruptcy, and withdrawal from the business must be part of the planning perspective. Once the succession plan is completed, the next issue is how it can be made enforceable. The enforceable owners’ agreement is commonly referred to as the buy-sell agreement, but the owner agreement will contain more than buy-sell provisions. The owners start wanting buy-sell provisions, but will in time recognize that the buy-sell provisions will be effective only if the owner agreement contains additional planning.

The owner agreement with buy-sell provisions creates a contract under which each owner agrees to offer that owner’s interest in the business to the business or to the other owners of the business on the occurrence of certain events, commonly referred to as triggers. The owner agreement should contain additional provisions concerning the management of the business and the funding of a buy-sell transaction.

From the perspective of an owner of a closely held business interest (an interest for which no public market exists), there are some readily identifiable factors relating to that ownership status. The owner may be an owner who remains with the business and is affected by the departure of a withdrawing owner, or the owner may be an owner, or an owner’s estate, who is withdrawing from the business. Typically, the owner has a substantial portion of the owner’s wealth invested in the business interest, and this interest is relatively illiquid, with the value of the interest unstated. Generally, the owner is involved with the management of the business with other associates, who may or may not be family members, and the chemistry of the business management is fragile.

For a withdrawing owner, buy-sell provisions can state a value for the owner’s interest and provide a method of paying for that interest upon the owner’s withdrawal from the business. The determination of the value of the interest may be done with respect to tax issues, and the method of payment may be designed to avoid adverse tax consequences to the withdrawing owner.

For a remaining owner, buy-sell provisions will establish a fair value, identified in advance, for the interest of the withdrawing owner. The right to purchase the shares of the withdrawing owner can be restricted to those within a certain group or to a certain individual or individuals by the buy-sell provisions. The owner agreement can be used to establish management control and prevent deadlock with respect to the withdrawal. The owner agreement may establish the funding, including the purchase of life insurance, for the purchase of the shares of the withdrawing owner. If the business entity is an S corporation, there may be provisions in the agreement that protect the status of the S corporation. Where there is a potential that the withdrawing shareholder might compete with the business, appropriate restraint against competition may be placed in the owner agreement.

The owner agreement is a contract and should be a written document executed by all the parties. Some states require an owner agreement to be written; however, some courts have enforced oral agreements. The primary functions of an owner agreement are met only when the agreement is in writing and is the subject of the planning and negotiation of the parties. The owner agreement will be subject to relatively frequent modification.

There are three basic structures of buy-sell provisions: cross-purchase, redemption, and hybrid. These terms describe the essential transaction that is the focus of the reaction to the trigger event. Where a cross-purchase is triggered, the remaining owners are the buyers of the withdrawing owner’s interest. Upon the triggering of a redemption agreement, the business is the purchaser of the withdrawing owner’s interest. The enforcement of purchasing or selling a business interest may be placed in an option setting or in an absolute requirement to buy. One group may have a first opportunity to purchase with another group having a subsequent opportunity to purchase. Often, it is through these purchase opportunities or requirements that a hybrid agreement is constructed, involving components of redemption and cross-purchase.

In the context of a private business, as opposed to a public business where the ownership shares are sold in a market environment, it may be difficult to establish a value between owners. A complicating factor is that in owner-managed businesses, the owners will be unwilling to pay one another for the intangible aspects of the business, such as goodwill, that might be included in the valuation of a business interest between non-owners.

The owners typically know what they want, the buy-sell provisions, but are puzzled about how to answer the questions asked so that the owner agreement may be drafted appropriately. The owners who get to the effective agreement are the ones who, using all the help necessary, are willing to create the complete succession plan, which will be the basis for the owner agreement.