A couple of weeks ago we talked about the buy-sell agreement and how to prevent your partner from selling to the highest bidder. We talked about Voluntary Transfers and how to control them in your business. I also told you that the buy-sell agreement podcast episode would be live soon. Well, it went live this week. And it didn’t have the interview. It’s kind of a long story. If you want to know a bit more about buy-sell agreements, check out the episode (sans interview with the financial planner) here.
This week, let’s break down some of the involuntary language you may want to use in your buy-sell agreement.
Right of Redemption for Involuntary Transfers. The Company or the Members have the right to redeem a Member’s membership interest prior to any event that would cause another person to become a Member, have control of a Member’s interest or any event that would cause Members to have a divided interest in jointly held stock (e.g., death, incompetence, divorce or separation) or in the event any Member active in the business of the Company (that right, the “Right of Redemption”):
(i) is adjudicated bankrupt, voluntarily or involuntarily, or makes an assignment for the benefit of creditors;
(ii) becomes disabled and is no longer able to effectively contribute to the company for a period exceeding one year;
(iii) any other event should occur which, were it not for the provisions of this agreement, would cause a Member’s membership interest, or any part thereof, to be transferred, assigned, canceled, or sold to any person, voluntarily or involuntarily, under circumstances which would not bring such transfer within section 8 of this agreement, then such event shall be deemed to constitute an offer to sell the membership interest so being transferred, assigned or sold and shall give rise to the same rights and terms of purchase as set forth in section 9 of this agreement.
Notice, first off, this paragraph is more involved than the paragraph we broke down a couple of weeks ago. This paragraph has to cover more ground because there are more events you need to reference in this.
Also notice that this right is not a “Right of First Refusal” like we discussed a couple of weeks ago. This is a “Right of Redemption”. The difference is, in the voluntary transfers you are dealing with a member who has an offer to purchase his shares or some other way he is trying to exit the company. The Right of First Refusal gives the members the ability to keep someone else from buying themselves into the company. The Right of Redemption allows the members to keep someone else from inheriting or gaining an interest by way of some other mechanism (e.g. divorce, incompetence, bankruptcy).
Let’s look at the different types of transfers we are preventing:
Death – This one is pretty clear. If a member of a company dies, you have one of two choices: (1) it passes through the estate and the estate or an heir becomes an owner, or (2) you, through the buy-sell agreement, liquidate the interest of the member and make sure his estate receives value for his ownership in the company, but you avoid any accidental partners.
Incompetence – This is an issue where someone else begins to make decisions for another person. You do not want another person (a guardian) to be making decisions for your partner. So, take the questions out of it by creating a mechanism to liquidate their membership interest in the event of incompetence.
Divorce – You do not want the ownership interest in your company held jointly by Husband and Wife to become part of their divorce. Stop that from happening by planning for it. Avoid the questions that can come up in a divorce and keep your business records out of the divorce by creating a liquidation event that happens during a divorce.
Bankruptcy – The same goes for bankruptcy, except instead of a spouse, you are fighting against creditors. Keep your business out of a member’s bankruptcy by liquidating their interest at the time of bankruptcy. That way, your business cannot be dragged into the bankruptcy proceedings because there was a liquidation of the equity that is at issue in the bankruptcy.
Disability – This is a provision you need to consider more when all of the members are actively working in the business. Disability of an active member matters because it affects production. You may need to liquidate their interests, so you have equity to offer someone else to come in and serve their role. This provision keeps your business from being hindered by a member’s disability. They will likely need the liquidated asset and they can no longer participate in the business, so it helps both parties.
Catch-All – There may be other events that occur (collections law suits etc.) that could bring a member’s shares into issue and possibly cause a member to lose their financial interest in their shares or lose them altogether. This last section covers any of those events.
The important part of all of this is that you must plan ahead. If you wait until your partner is going through a divorce or bankruptcy, it will be too late to keep your business out of it. If, however, you do plan ahead, these unplanned events that cause problems and stress in the life of your partners will not create the same level of problems and stress in your business.
Don’t forget, if you haven’t come up with a way to fund these events, the buy-sell agreement can cause more harm than good. If you have a liquidation event for a member’s equity in a divorce, but you can’t pay it, you have not solved your problem. You have created a new one. Now, your business owes money that is being divided in litigation between two separate parties in litigation that you are not a part of. This is not good.
So, make sure you discuss these issues with a life insurance agent or financial planner to make sure you are legally and financially covered.
I will talk to you next week, unless you talk to me first 😉
P.S. I hope the content I provide here every week in this conversation, on the podcast, and the blog help you out. I hope you have seen that I really want you to understand the legal that affects your business everyday.
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