Founders of start-ups quickly discover there are not enough hours in the day. Their energy, time and efforts are consumed by getting the business off the ground, developing its products and services, and marketing and selling to customers. Any time spent on administrative or organizational matters is viewed as an unnecessary distraction to be avoided. However, there is much truth in the old adage– an ounce of prevention is worth a pound of cure. In other words, a relatively small investment of time spent on the fundamentals can yield significant dividends in the future – and help to avoid much distress. And, the first fundamental, particularly for founders who do not anticipate seeking venture capital, is to put in place a shareholder buy-sell agreement.
The benefits of a buy-sell agreement include controlling ownership of equity so that corporation’s stock is held only by those actively involved in the business, providing liquidity for the founders (and/or for the founders’ heirs) in the event of permanent disability or death, and addressing any potential disruptive governance issues which may occur when a founder or any other employee-shareholder leaves the business. Those disruptive events typically involve a departing founder or key employee-shareholder who:
- Wants to remain on the Board of Directors to influence decision making in a manner that may not be in the long-term best interest of the corporation or may cause a deadlock on the Board.
- Asserts shareholder rights in a manner that takes management time away from growing the business to respond to various information or inspection requests from such person.
- Communicates with management and/or other shareholders in a manner that unfairly or improperly questions the decision making of management or attempts to provoke dissention among the corporation’s shareholders.
In each of the examples described above, the potential problems that may arise can be avoided or minimized by having a buy-sell agreement in place. One of the purposes of a buy-sell agreement is to trigger a right of the corporation and the other shareholders to buy the shares held by such exiting shareholder. A termination of services triggers the option in favor of the corporation to purchase any or all of the shares held by the former founder or other key-employee at a either a predetermined, formula-based or appraised purchase price. The purchase price also may be discounted depending on whether the founder or other key-employee exits voluntarily or is terminated with or without good cause.
Death or permanent disability also commonly triggers the optional or mandatory purchase of shares, primarily to provide liquidity for the co-founder or other employee-shareholder who meets with an untimely death or suffers a long-term or permanent disability. Assuming the start-up doesn’t have excess cash available to provide the needed liquidity for the deceased or disabled founder (and/or for the founder’s heirs), insurance can be obtained by the company to provide the funding oftentimes at favorable rates, or if no insurance is obtained, the liquidity can be structured to be funded in installments over time to reduce the burden on the corporation to a manageable level.
The buy-sell agreement also will establish other terms and conditions to make the buy-out process go smoothly, including the timing of the consummation of the purchase and sale of the shares, the period of payment of the purchase price and interest rate on any deferred portion of the purchase price and, in some cases, the imposition of a non-compete provision so that the former founder or other key employee will not be free to compete with the company upon leaving the company.
A buy-sell can also contain provisions that (i) prevent the shares from being held by a former spouse of a former founder or other key employee, (ii) require a shareholder to sell her or his shares if the other shareholders decide to sell their shares as part of the sale of the business (so-called drag-along rights), or (iii) allow the other shareholders to share a pro-rata portion of their shares if the ROFR is not exercise (so-called co-sale rights).
Buy-sell agreements come in all shapes, sizes, colors and levels of complexity and can be tailored to the start-up company’s situation and the needs of its founders and other key employee-shareholders. And, as the company grows, the buy-sell agreement can be modified and enhanced to provide more benefits and protections for the parties to the agreement. The most important thing is to put one in place from the beginning, even if it is not designed to cover every likely scenario, so that the basics are covered initially. Then as the company grows and developments occur, appropriate modifications can be made as desired.
Terrence P. Conner, Business Group