Originally published in The Frederick News Post
For many entrepreneurs, the time and effort required to start a company on the right footing frequently leaves them with little opportunity to focus on noneconomic matters during the early stages of the business startup.
Failure to plan for the unexpected during these early stages may not only encumber a company’s growth, but also spell disaster for the company and its founders. The consequences of inadequate early planning may include gridlock in responding to the departure of a founder, disputes regarding the founders’ stake in the company, unresolved questions regarding the addition of new investors, and what happens to a founder’s interest in the event of death, incapacity, bankruptcy, or divorce.
In a recent article titled “The One Mistake Startup Entrepreneurs Always Make — A Legal Perspective,” published at www.jdsupra.com, one attorney observed that entrepreneurs, during the formative stages of their business, frequently failed to put in place a “pre-nuptial” agreement establishing, among other things: (a) the terms and conditions of ownership; (b) when and how new investors may be added; (c) what events and under what conditions may an owner sell his or her interest in the company; and (d) what restrictions are placed on an owner’s interest in the company.
The document within which many of these issues may be addressed (the “pre-nup”) is the operating agreement (where the Limited Liability Company form of entity is used) or the Shareholder Agreement (in the event that the Corporate Form is used). For purposes of simplicity, each of these agreements will be referred to hereafter as the ownership agreement.
When prepared properly, the ownership agreement will: (a) identify each owner’s share in the company and the rights associated with the interest received (voting, anti-dilution and rights of first refusal); (b) specify the restrictions associated with ownership of the interest received and the conditions under which the interest may be sold; and (c) state the conditions under which new investors may be permitted to acquire ownership in the company.
The ownership agreement will also provide for the sale or disposition of the owner’s interest in case of retirement, death, disability, or divorce, and may include noncompete and contain provisions addressing how, to whom, and under what conditions a founder or subsequent investor may sell his or her interest in the company.
The agreement’s purpose will be to ensure continuity of ownership and management in the business, and reduce the likelihood of dilution of the company’s liquidity because of the need to fund a significant and perhaps unanticipated buyout. Buy-sell provisions also reduce the risk to the remaining owners of having the departing owner’s successor imposed upon them.
A well-prepared buy-sell agreement will: (a) identify the events that will prompt a buyout and guarantee the purchase of an owner’s interest by the company, or the remaining owners, upon the occurrence of such a triggering event; (b) provide a mechanism by which the departing owner’s interest will be valued upon the occurrence of a triggering event, (c) provide a funding source for the purchase of the departing owner’s interest, so that the company’s (or the co-owners’) liquidity will not be adversely impacted; and (d) provide the terms, procedures, and conditions by which the departing owner’s shares may be sold to an outside party.
Negotiations on the valuation, purchase, and sale of a co-founder’s interest should be discussed objectively and with an understanding of the potential impact that future actions may have on the company and the remaining founders.
A well-drafted agreement can ensure that the company and its founders are prepared for unforeseen events and that the company’s assets and its ability to move forward, notwithstanding a change in owners or ownership, will not be impaired. Competent and experienced legal counsel should prepare the agreement and advise each owner regarding their individual interests and circumstances.
John C. Huggins practices law in Frederick and Carroll counties. He focuses on assisting founders and principals with their corporate and other legal needs.
SCORE is a nationwide volunteer network of 330 chapters dedicated to the formation, growth and success of small businesses. SCORE Frederick provides free and confidential business advice and mentoring to start-up businesses and to established small businesses. SCORE Frederick also offers workshops for both start-ups and established businesses.