JP Fernandes, Small Business Lawyer

Generally start up companies are authorized for anywhere from five to ten million shares of common stock.  Let’s say the founders each take two million shares for themselves with a one million to two million share option pool, for a fully-diluted base of around six million shares.  The remaining authorized but unissued four million shares sit in reserve should the company need to issue stock in the future.  From a numbers point of view, it doesn’t matter if there are ten million or one hundred million fully-diluted shares, but for some reason new option holders/employees like receiving larger numbers of shares.  Then there is, of course, the Warren Buffet philosophy, which is to never plan on splitting or otherwise diluting your stock, (hopefully) making the stock price so high that it is out of reach of most Americans.

When starting a business the legal form you choose will have a significant impact on how your company will run, be taxed and protect you from liability.  The sole proprietorship is the most popular form for operating a business, with most small start-up ventures operating in that form.  The main problem with a sole proprietorship is the unlimited liability of the owner.  The sole proprietorship is usually unacceptable for operating a business since it subjects the owner to personal liability.

The next form is a “limited liability company.  An LLC is an entity separate from its owners, so ownership can involve one, two or more owners. As a separate entity, the LLC (not its owners) is responsible for the liabilities of the business.  If the business fails you may lose your investment, but your assets are not at risk. Corporations are the oldest form of business entity and as a result, people are generally at ease with a corporation.

Corporations provide the strongest protection against personal liability but may or may not have the same tax advantages of an LLC.   An “S-Corp.” is made for small business and can’t have more than 100 shareholders; however, it does feature pass-through tax treatment like an LLC.   A “C” corporation has a big disadvantage for start-ups; that is, that the income or loss of a C corporation only taxable to the corporation and does not pass through to shareholders.  Shareholders cannot use start-up or other losses to against income received by sources other than the corporation.  Neither an LLC nor a corporation is the best choice for all businesses.

The form of entity that is appropriate for your business will depend upon your situation.   One would be well advised to seek counsel before starting up a company because the tax and legal ramifications of the choice are significant.

When you are paying for advice listen to it! Recently I had a client who was working as a pharmacist for huge retail chain and just could not stand it any more so he wanted to buy a pharmacy. We came across what initially looked like a great deal—the seller had just been through a divorcee, was desperate to sell and was willing to finance the entire purchase price. The seller made numerous representations to that business was operating just fine and that it would be a turn key operation. Despite the rosy picture the Seller was painting after some digging we discovered that the store was almost 6 months behind in its rent, was in default to it main vendor who had initiated litigation and the ex-spouse would need to sign off on the deal since she was still part owner of the company. I don’t know what more could have been wrong with the deal.

Though my guy was anxious to leave his current employer, he did the right thing he listened to his team when we told him he would be crazy to move forward with this transaction. Too many times though a buyer gets a case of the “first time home owners syndrome.” The syndrome often afflicts first time home buyers who are so desperate to close on that first house that they will overlook any problems with the property—only to have buyers’ remorse down the road.

Just like buying a house, often buyers who are unhappy with their present situation and are longing to move on will catch the syndrome and overlook material problems with the deal just to close or leave or whatever. They always regret the day they decided to move forward instead of listening to the people they hired to look out for them. Buying a business is one of the most significant steps than a person can take. The transition from employee to owner is stressful enough without the added headaches of a company rife with problems from day one.

How do you know if you have the “first time home owners’ syndrome”? One test I use is to see if the client can get up and walk away from the table without looking back. If you can’t get up and walk away, then you’ve probably got the syndrome since and will probably do something you will regret down the line. What is the cure? Simple, listen to the people you’ve hired to guide you through the process—they have an objective perspective and can see more clearly than you.

I was talking with an acquaintance of mine who brought up a problem. His wife, who had a daughter from a previous marriage, was in quite a bit of financial trouble and refused to even consider the possibility of bankruptcy. She had fallen into some investment properties and was upside down in all of them to the tune of about $1 million. Her mother had literally cashed in everything she had and devoted a significant part of her wages to keeping her daughter afloat. My friend didn’t want his assets exposed or otherwise available as collateral because his wife was about to cosign part of a workout plan for her daughters loans. The couple is nearing retirement and the husband simply can not afford to put his good money after her bad money. Since he could not talk his wife out of her desire to be drawn further into this web of debt. He wanted to know what he could do to protect his assets.

I told him that a marital property agreement opting out of certain provisions of the marital property laws would limit (as much as possible) the ability of his Step-Daughter/Wife’s soon to be creditor’s ability to reach his assets or income in order to satisfy the debts incurred through the pending “loan workout.” Most importantly I said, any such agreement is not binding on the creditor unless the creditor has actual notice and a copy of the agreement before the credit was extended; otherwise any protection he might have had was now gone. He took my advice and we’ll have to see how things shake out for him.

Protecting your personal or business assets as much as possible is important in today’s world and should be explored a little planning now can save a lot of money later. Contact The Fernandes Law Firm with any questions you may have.

With an LLC you do have several options–First you can divide up the LLC pie (so to speak) into Units–which are the equivalent of shares of stock in a corporation. For instance, Martha Stewards company issued LLC units when it went public . . . well you could have your LLC issue any number of units (say 1,000) and divide them up and for what ever price/consideration you wish as long as it is reasonable. There is also the more traditional way of looking at LLC ownership which is based on a partnership model of allocating percentages to each individual. If you are going to be using the LLC as a vehicle to raise money from third parties, the partnership/percentage method can become a real pain and you are better off simply issuing units. Contact me if you have any additional questions or concerns on these types of matters.

Preferred stock is structured to attract angel investors, venture capitalists or other accredited investors. Separate classes and/or series are created to fit particular investor needs and/or to effect separate financings over time at different prices and is most often seen in the financing of private companies.

Preferred stock, like common stock, must be authorized before it can be issued and unless “blank check” preferred stock is used, the special rights and preferences of preferred stock must be stated in the articles when it is created.

“Blank check” preferred stock, permits the company to authorize a class of preferred stock via a stockholder resolution, but leaves the rights and preferences of the class to be fixed later by the board of directors. The advantage of blank check preferred stock is that once it has been authorized, a stockholder resolution is not needed at the time the company finishes negotiating the terms of the preferred stock and is ready to close a financing.

Rights and preferences of preferred stock include liquidation preference, voting rights, dividend and anti-dilution protection. “Full ratchet” typically provides that if the corporation issues any stock in the future at a price lower than that paid by the investors which will receive a change in the conversion price of their preferred stock so that they will be treated as having paid the same price as the new investors. “Weighted average” protection adjusts the conversion price of the investors’ preferred stock by a lesser amount, depending on the amount of lower-priced securities issued in the new financing.

Preferred stockholders often receive an enhanced right to receive dividends if dividends are declared, preferred stockholders must receive a stated amount of dividends before any dividends are paid to common stockholders.

These are only some of the examples that preferred stock is used to attract capital for new or existing companies.

Voting Rights Generally

One Share, One Vote Rule

Today one share one vote serves as a default rule for the rights, preferences, and privileges of capital stock. As such, all equity investment in a corporation is treated as stock and deemed to have the same voting rights and rights to the income and assets of the company, unless the company specifies otherwise in its articles of incorporation. Where the company seeks to make distinctions between the relative rights of equity investments, these distinctions must be described in the articles of incorporation. In addition to distinctions in rights to income and assets, the articles can specify differences in voting rights between different classes of shares. Typically these differences exist between common and preferred stock.

[A] Alteration by Articles.

With few exceptions, the statutes provide that only a provision in the articles of incorporation can change the one share, one vote rule. The rule is strictly enforced; attempts to alter the rule by documents other than the articles of incorporation have been unsuccessful. Once the articles so permit, a corporation’s board of director may issue stock with such voting and other designations as described in the articles of incorporation.

[b] Class and Series Voting.

Voting rights may be varied by establishing several classes or series of shares, each with different voting rights. For example, common stock may be divided into various classes with each class receiving different voting rights and rights to income. Corporations with multiple classes of common stock are uncommon. Far more common is the issuance of common shares which are given full voting rights while denying voting rights to the preferred shares which usually have superior rights to dividends and payments upon liquidation. Or the preferred shares are given contingent voting rights exercisable upon the happening of a specified event.

All shares within the same class, and all shares within a series, must have the same voting rights. A company remains free to create one or more classes or series of stock with limited voting rights as long as the aggregate of some portion of the existing classes and series of stock together may assert unlimited voting rights.

[2] Fractional Shares

Nearly all the state corporation laws authorize the issuance of fractional shares. Fractional shares are usually issued in connection with stock splits or share dividends.

[3] Bondholders and Other Debt Security Holders

A number of state statutes allow corporations to give bondholders the right to vote. Usually the statute requires that the right be expressly granted in the articles of incorporation. Where debt holders are given voting rights and where the articles of incorporation so provide, such debt holders will be ‘‘deemed to be stock holders, and their bonds, debentures or other obligations shall be deemed to be shares of stock.’’ As with the voting rights of preferred stock, the voting rights of bondholders may be limited to certain matters or may be made contingent on the occurrence of certain events, for example a default in the payment of interest on the bond. In the absence of a statutory provision reserving to the corporation the right to confer voting and other rights on bond-holders, holders of debt are not entitled to vote.

[4] Voting Rights of Non-Voting Shareholders

Corporations may wish to issue non-voting shares for a variety of reasons. For instance, promoters may employ non-voting shares to raise large amounts of capital for the corporation. They retain control of the corporation by issuing voting shares to themselves and issuing non-voting shares to those financing the corporation, who may be more interested in securing a return on their investment than in controlling the management of the corporation.

WHAT EVERY BUSINESS OWNER SHOULD KNOW ABOUT BUY-SELL AGREEMENTS

A “buy-sell” agreement or “BSA” can mean many things to different people. It is perhaps the most important document in outlining the relative roles and rights of the parties, insuring smooth relations over a long period of time and attempting to maximize long term personal and business planning strategies. Like the foundation of a very expensive house, the agreement is frequently overlooked and unappreciated. However, it can provide the cornerstone to a successful business enterprise and personal relations and serve as a bedrock during turbulent times. Moreover, discussion of many of the thorny issues to be contained in a BSA will give each partner a sense of how their partners think about and react to certain situations and concepts.

1. Purposes of a Buy-Sell.

There are many well-intentioned goals which a well-drafted BSA achieves. Some factors will invariably be more important than others depending on the type of business situations.

Predictability and Continuity of Ownership. A well-crafted BSA provides a clear and precise roadmap regarding the ownership of the business and, in many cases, the management thereof. Absent a BSA, businesses would face ownership transition issues at the worst possible time– at the death or other departure of key executive personnel. A BSA cannot remove the issues of replacing departing executives or investors, but it can at least minimize the risk of the uncertainty over how and under what conditions the shares will be disposed of or retained.

Orderly Transfer of Ownership. Somewhat related to the benefit of predictability and continuity is the orderly transfer of ownership. Restrictions on transferability of shares can minimize the chances that a business could be disrupted or held hostage by the sale or threatened sale of a block of stock to an unwanted suitor or even a competitor or by a dissident block. Rights to buy employees’ shares upon certain circumstances also creates a sense of balance and order. As will be discussed in more detail below, a BSA should attempt to strike the delicate balance between a financial owner’s desire to monetize its investments in a reasonable period with key executives’ desire not to financially impair the business or sell out too soon. In family businesses, a BSA should also strive to provide a means for family members participating in the business and those not participating in the business to structure their relationship.

Create a Market for the Ownership Interests. Most BSAs involve privately- held businesses, where the ability to resell shares or other indicia of ownership interests may be legally restricted or impractical. BSA’s ameliorate the lack of liquidity by providing exit mechanisms for business owners in a variety of circumstances.

Establish a Fair Price for the Shares. Valuing closely-held businesses is more of an art than a science. BSAs can provide a known, objective and definable means of valuing the seller’s shares depending on the circumstance of departure.

Protect Minority Owners. Means of oppressing minority owners of businesses are beyond the scope of this article. BSAs assist in limiting some classic devices majorities utilize against minorities. For example, BSAs may require distributions be made to all owners in a minimum amount equal to their putative income tax liability based on the business’ net profits for the year. Absent such a provision, the minority owner in a pass-through entity would have phantom income but no cash to pay the taxes. BSAs could also give rights to minority owners to have supermajority and other voting rights to provide disproportionate input, to limit salaries 448 and other payments to the majority and to sell their shares at various intervals.

Protect Majority Owners. BSAs can also protect majority owners from the intransigence or hindrance of minority owners. These minority owners many either not be active in the business, have supermajority protection rights, ask many questions, or simply not share the same philosophies regarding the direction and goals of the business. BSAs may devise means by which majority owners may purchase the minority’s interests and limit the amount of involvement and information to which the minority is entitled.

Tax Considerations. Many tax considerations justify entering into BSAs. As noted above, tax items are generally beyond the scope of this article, and will only be discussed sketchily.

Preserve S Corporation Status. A corporation will lose its eligibility to remain an “S” corporation if transfers of its stock are made to disqualified shareholders. BSAs will prohibit such transfers.

Provide for Amount and Timing of Distributions. In pass-through entities, taxes on the net income will flow through to the individual owners. As discussed above in a different context, BSAs should provide a mechanism to assure that distributions are made to pay such taxes.

Assist in Setting Values for Estate Tax Purposes. The Internal Revenue Service (“IRS”) and applicable state counterparts will scrutinize values placed on the shares of closely held businesses in a decedent shareholder’s estate. A BSA will give some degree of credibility to the valuation methodology. The IRS will respect the values determined in accordance with the BSA in most cases if non-family members are also parties to the BSA, since their presence shows an arms’ length bona fide agreement.

Provide Liquidity to Pay Estate Taxes. Many times a business owner’s biggest asset is her shares in a closely-held business. While tax laws provide for estate tax deferrals or installment payment of taxes in certain circumstances as will be addressed below, BSAs provide a means to monetize this asset to generate funds to pay these taxes.

2. Typical Situations Necessitating a BSA.

BSAs are appropriate in virtually any business with multiple owners. Like Tolstoy’s observation about happy families being happy for the same reasons and unhappy families being unhappy for different reasons, it is never quite clear while drafting BSAs which provisions will be applicable or even necessary, as the relationships between or among the parties has yet to develop. BSAs will be appropriate in family owned businesses, businesses when two or more families are co-owners, when some family members are involved in the business and some are not, a business owned by an unrelated management team financed by an unrelated investor, and “strategic” ventures between corporate owners.

3. Restrictions on Transferability of Ownership Interests.

Restricting transferability of shares is a central feature of BSAs. While general legal principles descry alienation and restricting transferability of property, most courts and state laws have upheld restrictions in the context of BSAs for several reasons in addition to those set forth above. First, restricting transferability forces business owners to work together and stay in business with those that they initially chose. Transfer restrictions also serve to balance an owner’s desire for liquidity and reaping the fruits of the owner’s labors with the desire for stability, order and predictability. Finally, transfer restrictions are imposed under federal and state securities laws, and any sale of securities needs to be analyzed to assure compliance with securities laws.

a. Redemption vs. Cross-Purchase vs. Hybrid BSAs

Purchases of a selling owner’s shares is accomplished in one of three ways: the business redeems the shares, the other owners purchase the shares, or a hybrid combination or choice of both.

Redemptions

The redemption of the departing owner’s shares by the business is straightforward and easy. There is one buyer and one seller. In a cross-purchase agreement with multiple buyers, complexities arise with enforcing multiple buyers’ obligations to purchase the shares, and purchasing, as well as maintaining, multiple life insurance policies on the life of the departing shareholder.

Redemptions, however, have a number of countervailing shortfalls. First, installment purchases create balance sheet liabilities of the business and may even be prohibited under the business’ credit facilities. Second, redemptions do not provide shareholders with an increase in the basis of the purchased stock. Third, a C corporation’s receipt of life insurance proceeds to redeem a deceased shareholder’s shares may trigger an alternative minimum tax liability for the corporation. Fourth, state law restrictions on a corporation’s ability to redeem should be analyzed. Some states prohibit redemptions which would render the corporation insolvent; others prohibit redemptions in excess of stockholders’ equity. Finally, although a complete, or even a “substantially disproportionate” (i.e. a 20% or more reduction) redemption of a corporate owner’s interest should result in capital gain treatment to the selling owner. However, if the owner still somehow participates in the business (through consulting, employment, directorship or otherwise), and the owner’s family retains an ownership interest in the business, the family’s shares may be attributed to the selling shareholder. Depending on the relative sizes of shares owned by the family and the owner, the attribution of the family’s shares to the seller may result in dividend, not capital gain, treatment to the seller. For example, assume John Smith, Sr. owns 100 shares and John, Jr. owns 100 shares of X Corp. John Sr. retires and his shares are redeemed. If John, Sr. does not sign an election form furnished with his next tax return which avers that he will completely terminate his involvement with the company for the next 10 years, John Sr.’s gain on the sale will be taxed at ordinary income rates.

Cross-Purchases

These provisions require each owner to purchase the selling owner’s shares. The purchasing owners therefore receive a step-up in basis (assuming that the shares have appreciated in value) in the shares purchased, and their average basis in all of their shares is therefore proportionally higher. In partnerships and limited liability companies, the entity may also elect to step up the tax basis of its operating assets providing for tax advantaged cash flow from operations. Cross purchase agreements also circumvent the corporate family attribution rules and allow capital gain treatment for the corporate stock seller, even if she remains involved in the family business. Finally, cross purchase agreements are helpful if the business is precluded from redeeming the interests under applicable state law or a contractual restriction such as a bank loan forbids distributions. As mentioned above, cross-purchases may be cumbersome and difficult to enforce when an unwieldy number of multiple owners are involved.

Hybrid

Some BSAs take a hybrid approach. They will give the business the first option to purchase the seller’s shares and, if and to the extent that the option is not exercised, the other owners would, depending on the situation, have the option or requirement to purchase the seller’s shares. The hybrid approach provides maximum flexibility to address the variables set forth in the preceding sections on a case-by-case basis, and it is a wonder why more BSAs do not contain these clauses.

b. Voluntary Transfers of Ownership Interests.

BSAs assure that the management employee owners and family owners will not be able to freely sell their shares in the business. If the employee-owners are financially “joined at the hip” with the investor owners, most feel that the employees will stay more focused and motivated. Employee-owners may agree to these restrictions for a certain period of time (three to five years), but after that time elapses, be permitted to sell to any third party. Investors may not want any restrictions on their own ability to sell any shares at any time, but may have to agree not to sell their shares for the same reasons they wish to prevent the employees from selling their interests.

Rights of First Refusal, Offer and Negotiation

To achieve the goal of maintaining continuity of ownership and inter-employee relations, one party frequently gives the right of first refusal to the other party prior to the sale of their stock or the sale of the business. This right allows the non-selling party to match a bona fide arm’s length offer made by an independent party. Since this offer is from an unrelated third party, it is thought to be for a fair price. If the selling owner is offering an unreasonably low price to the third-party buyer due to the seller’s personal circumstances necessitating the sale, the other owners can reap this benefit. If the price the third party is willing to pay is very high, the non-selling owners can avail themselves of a tag along right, or, in some circumstances, cause the conversion of the selling owner’s interest to be non-voting. Many object to the concept of a right of first refusal on the grounds that it may have a chilling effect on would-be purchasers. The third party offeror’s enthusiasm is repressed by in effect not knowing whether its deal will be consummated. Third-party offerors also resist acting as the stalking horse to set the price that someone else can match.

To address the concerns that rights of first refusal may have the practical impact of reducing the universe and attractiveness of potential buyers of privately held stock, some BSAs provide for rights of first offer and first negotiation. A right of first offer essentially requires the selling owner to first make an offer to the non-selling owner at which price the selling owner would be willing to sell its shares or the entire business. If the non-selling 456 owner does not wish to pursue this opportunity on these terms, then the selling owner would have a finite period of time to market the shares or business. If the selling owner found a buyer within this time period for a price equal to or above the offered price, then the sale could go through. This approach enables the non-selling owner to assure that the price is fair and that it has had an opportunity to participate in the purchase. It also allows the selling owner to pursue the sale without the specter that the would-be buyer will be discouraged by the existence of the right of first refusal. The time period during which the shares or the business must be sold at or above the offered price should be kept relatively short (e.g., not more than six months). This minimizes the psychological and logistical impact of having the business or large block of stock being perpetually up for sale. The right of first offer should also adjust for the circumstance where the buyer’s price is ultimately reduced below the offer price (e.g., due to a purchase price adjustment between signing and closing caused by losses or declining levels of working capital). A modest, let’s say 5% reduction, below the offer price is generally accepted as reflecting the realities that the business can deteriorate by some amount without starting the entire right of first offer process over again from scratch.

Some investors believe that a right of first offer also has a chilling effect on would be purchasers due to the many timing and price caveats contained in first offer provisions. For example, the possibility that the value of the business may decline and thus reduce the sale price below the offer price, or the closing may be delayed due to financing or regulatory reasons and, therefore, the process must be re-commenced, may serve to dissuade many buyers from trying to buy the shares or business. Therefore, some agreements only require the parties to negotiate in good faith for a finite period. If the right of first negotiation does not result in a binding agreement within a finite period, then the selling party is free to sell for any price, even a price below the previous negotiated price. This approach provides the selling shareholder with the most certainty that the sales efforts will not be impeded by the other shareholders’ rights. Considerable subjectivity, however, regarding the standards of good faith negotiation abound and the threat of litigation over this issue could loom large. The ability to negotiate in good faith with parties with whom distrust or antagonism may be present is also difficult.

Drag Alongs/Tag Alongs

After the expiration of any holding period which prohibits an owner from transferring its shares, sales within an investor group, family group or employee group are typically offered to the other members of the group first and then offered to the other groups or the business itself. Employee-owners may claim that their ability to purchase the investor’s or other family’s shares is illusory since the employee-owners do not have a realistic access to capital to acquire the funds. The investors reply that this fact should not preclude their ability to sell and should not harm the employee-owners, since in substance one investor is merely being replaced by another. Whether this view is true depends in part on the degree the selling investor participates in or actually controls the business.

Since one family or group of investors may not own all of the business’ securities, their efforts to sell the business may be thwarted if the third- party buyer desires to purchase the entire business. Therefore, investors or one family group typically require the right to cause the other family group or employee-owners’ shares to be “dragged along” and sold to the buyer at the same price if either the buyer requests or the selling owner believes that the sale of all of the stock will enhance the prospects for sale of the business. Employee-owners or one family group, on the other hand, may desire to sell their shares to the buyer at the same time and price as the selling group. An employee-owner’s rights to “tag along” is generally acceptable to investors on two conditions. First, the tag along (or piggyback) right is not considered if the buyer genuinely would not buy the business unless the employees maintained their same ownership interest and the same motivation inherent in ownership of a business. This concern is only rarely voiced by a buyer and many avenues pave the way to address this concern, including selling some of the employee’s stock and rolling the balance over on a tax deferred basis into the buyer’s entity, giving options to founders to buy stock in buyer’s company, or selling them some stock in the buyer’s company. A second issue arises in poorly drafted “tag along” clauses. Frequently, these clauses simply allow the employee-owners to sell on the same basis as the investor. If the investor desires to sell all of its stock, which represents 80% of the business’ stock, does this tag-along right therefore mean that the investor can still sell all of its stock and the employees also have the right to sell all of their stock? Or does this mean that the investors may now only sell 80% of their shares (64% of the business total outstanding shares) and the employees may only sell 80% of their shares (16% of the total shares) to give the buyer the desired 80% of the total stock in the business? These clauses frequently do not address the ramifications of the buyer refusing to 459 proceed with the transaction if, in the first scenario, the buyer is forced to buy all of the business’ shares and aborts the transaction as a result.

Permitted Transfers to Affiliates

Notwithstanding any rights of first refusal and other rights set forth above, owners should be able to transfer their interests to affiliates such as family members, controlled entities and trusts, without interference form any of the other owners. This type of transferability is necessary to help the business owner plan his estate and otherwise organize his assets.

Certain caveats, however, should be placed on this type of transferability. First, if the business is an “S” corporation, no transfers should be made to unqualified shareholders (such as corporations, partnerships, limited liability companies and certain types of trusts) or which would exceed the 75 shareholder limitation. Second, if transfers are made to affiliates which are business entities, careful drafting should assure that the entity’s owners may not be from outside the transferee’s family. For example, if partner X transferred her partnership interest to a corporation solely owned by her, she should then be restricted from selling the stock in that corporation to an unrelated entity or person. Third, in many cases the transferee should not be able to vote the interests, as such voting power should remain with the transferor through some proxy or voting agreement. Finally, the transferee’s shares should have the same restrictions on sale as the transferor’s, as if the transferor still owned the shares. For example, if the transferor is an employee and her shares are subject to repurchase on her departure from employment, then the transferred shares should be subject to those same restrictions.

Pledges

While pledging shares in a closely-held business is problematic since they are so difficult to value, many BSAs will restrict or prohibit such pledges. If pledges are permitted, BSAs should assure that any foreclosure by the lender will not jeopardize the “S” election of the corporation, and will typically give rights to the business or other owners to repurchase the shares being foreclosed. Many BSAs prohibit any pledges to avoid this possibility and to keep the would-be pledgor out of potential harm’s way. Others feel strongly that ownership of a business interest is a personal asset which should be treated like any other asset.

c. Required Transfers of Ownership Interests.

The previous part dealt with situations where an owner had the option, but not obligation, to sell his securities and the rights of the business and other owners in those circumstances. This section addresses events where an owner may be required to sell her shares to the other owners or the business.

Employee-Owner Departures

An employee-owner will leave the business for one of several circumstances– retirement at a prescribed age, quitting, death, disability, termination by the company without cause, termination by the company with cause, or termination by the employee for good reason. This section will address each of the circumstances which gives rise to distinct rights in the parties and the next part will discuss the different valuation and payment obligations for each circumstance.

As a threshold matter, some employees desire not to be required to sell their stock upon their departure. They contend that they have earned the right to keep the investment, have great hopes in the future of the business, and do not want to be penalized if the fruits of their labor have not yet been fully appreciated. This last point is particularly applicable in a start-up or early stage business where the groundwork has been laid for future success but the business has not yet established earnings to justify a higher valuation. Other owners, on the other hand, may feel that those who participate in the business should be the owners (perhaps along with investors and non-participating family members thereof) and it is unfair and demoralizing to be working for and sharing profits with someone who is not contributing. Those other owners may also point out that the departing employee’s shares may be needed to attract a replacement for that role. BSAs will reconcile these conflicting general positions in one of several ways– an optional sale by the employee, an optional purchase by the company or other owners, a mandatory sale or purchase by either, or a right for the departing employee to retain the shares for a period of time, like three to five years, and thereafter with the right of the company to repurchase the shares.

Upon an employee’s departure for reasons that do not involve the his being terminated for cause (i.e. the employee’s death, disability, retirement at normal retirement age, quitting before the employment agreement terminates) or do involve the employee quitting for what is deemed to be “good reason” (e.g. the employee’s duties were severely curtailed or the office moved to an unreasonable location or distance) (“Non-Cause Events”), the employee will have much greater leverage to make the arguments presented in the previous paragraph that he should be entitled choose whether to sell or retain his shares. In those circumstances, BSAs will most always provide some right to the employee to sell within some time of departure, usually but not always furnish some right to the company to purchase, either upon departure or at some point in the future, and rarely allow a shareholder to hold the shares indefinitely.

In contrast, in situations involving an employee’s termination for cause or breach of a non-competition or confidentiality agreement (“Cause Events”), BSAs rarely permit employees to continue to hold their shares. At the same time, the company or other shareholders should have no compulsion to have to buy those shares. Therefore, most BSAs provide for the option, not obligation, by the company or other shareholders in these circumstances to purchase the departing employee’s shares at some point.

Mandatory buyback provisions in the event of the departing employee’s death could eliminate the decedent’s opportunity to defer estate taxes on favorable terms. Congress has attempted to make it easier for owners of small businesses to pay estate taxes and transfer wealth to junior generations to keep the businesses in the family. Payment of estate taxes on the estate of a decedent who owned an interest in a closely held business which value was at least thirty-five percent of her estate may be deferred and payable over a period of up to fifteen years. The decedent’s estate may make 465 payments of interest only at a 4% per annum rate on a portion of the deferred tax for the first five years after death and then at the applicable federal rate for the balance (since the first installment of the tax is actually due nine months after death, thereafter, principal and interest on the deferred obligation is payable annually). This estate tax deferral applies primarily to closely held businesses since the decedent must own at least twenty percent of the business to qualify for the deferral (unless the business has less than fifteen owners in which case there is no ownership percentage requirement). Consistent with the goal of keeping the business in the family, the deferred tax is accelerated in the event the business is sold or a controlling interest changes hands. Therefore, any sale of 50% or more of the decedent’s stock during this deferral period will eliminate the favorable deferral and trigger an immediate obligation to pay the remaining tax.

In the event that the employee received the shares in connection with her employment, the receipt of those shares are generally taxable at ordinary income rates to the extent of the difference between the fair market value and the price (if any) that the employee paid for the shares. In other words, the receipt of the shares is treated as compensation for services. Transfer restrictions set forth in a BSA, however, will defer recognition of the income until those restrictions lapse. Further, if the employee bears a substantial risk of forfeiting those shares if she leaves the company, then any income recognition is also deferred until the time that the risk lapses.

Venture Capital and Other Investors

The venture capital or other outside investor’s attitude regarding the ultimate disposition of the investment varies based on the nature and risk tolerance of the investor. Most investors have a five to seven year time frame in which they expect their investment to remain outstanding before it is monetized. (Of course there are notable exceptions, such as the original investors in Intel and Compaq Computer who still own their shares.) This relatively short time horizon is dictated by several factors. Investors in venture capital funds and other institutions also demand a payback in a relatively short period of time and therefore the investor is merely expressing the needs and demands of its clientele. Further, given the discounting factor of dollars in the future, large sums of money realized many years out in the future are not worth as much as they seem. Finally, as time elapses, management and industries change to the point that the investment takes on a completely different character and form.

Many institutional investors may tolerate a longer holding period based on the nature and quality of the investment. Pension funds and insurance companies, whose obligations to beneficiaries extend for decades in the future, justify holding an asset like a stock that far in the future. Insurance companies, as taxpaying entities, have to be concerned with paying significant capital gains taxes on long term holdings. The implied tax liability to Berkshire Hathaway, for example, based on its current gains in Coca Cola, Gillette, Washington Post and Disney is in the billions of dollars.

Hedge funds, on the other hand, rarely hold investments for long periods. Disciplined hedge funds, while speculating on risky speculations, will cut their losses, or take their profits and run.

A blueprint to ultimately dispose of the investment, therefore, is a major priority of investors and is a prominent topic during the negotiations. This blueprint for the investor’s ultimate exit takes several forms.

Investors may seek rights to require the business to purchase their shares (a “put”) as an exit strategy. The put may be triggered upon the lapsing of time or the occurrence of deadlock or failure to meet targets. The put price could be either the liquidation value of the preferred equity of the investor and some sort of formula or appraised value for the common equity. While a formula value is sometimes used (e.g., eight times trailing net earnings), this method can be dangerous since fair and appropriate formulas vary over time and the then current risk profile of the business. The put is also of questionable value in a real practical sense. If the business is doing well, the investor has other means available to it to liquefy its position. If the business is doing poorly, the business may not have a means of financing the put, and therefore, the impact of the put is to convert the seller’s equity to the right of an unsecured creditor.

Some businesses extract a right to purchase (a “call”) from the investors as the logical mirror of a put. The pricing and terms of the call may be the same, except the call right is usually delayed for a year or two after the time that the investor is first able to exercise the put. The value of the put, moreover, may be discounted by a small percentage, say 5%, as the price the investor is willing to pay to gain cash. Conversely, the call may carry a 5% premium (or perhaps a premium which declines over time) to compensate the investor for having its interest redeemed involuntarily. Investors resist calls since they put a ceiling on price appreciation. The company responds that the call is a last resort after the investor has had the right to put the stock. The call treats the investor fairly, moreover, since the price of the preferred is fixed and the value of the common will be fair market value. In the case of convertible preferred held by the investor, the right to call the investor’s shares, further, gives the company the ability to require the investor to “put up or shut up” by causing the investor to decide to either convert its preferred to common or suffer a call. Puts and calls will not typically be viewed as second classes of stock which would terminate the status of an “S” corporation.

Family Owners Not Participating in the Business

Purchase Price Determination.

The determination of the purchase price for the owner’s interests will vary with the different circumstances of departure discussed above in Part 2(c). In cases of voluntary transfers subject to rights of first refusal, first offer, or negotiation, the price will be determined by either matching the price of the third party offeror, or the negotiated price if no third party offeror has yet materialized.

Fair Market Value

Most BSAs provide for a fair market price in buybacks in Non-Cause Events. This price is justified since the selling owner’s departure was beyond his control. Despite the commonly accepted view that minority interests in closely held businesses may be heavily discounted due to lack of marketability, illiquidity and lack of control, very few BSAs will ascribe a discount to fair market value in Non-Cause Events.

BSAs will attempt to define “fair market value” in one of several typical ways. First, a large percentage of owners may agree on a value at a certain time every year or so. This approach is obviously very simple and straightforward. However, it is fraught with peril for several reasons. The parties may not always agree, or may not always keep an updated agreed value. Further, their notion of value may be well intentioned but far afield of those values generally accepted for comparable businesses.

A related valuation technique is to buy life insurance on the owners and equate the value of the life insurance with that of the business. That very common approach is also risky for the same reasons as the “agreed value” approach and for the further reason that one or more owners may not be insurable or premiums may become prohibitive.

A third common valuation technique is to have an independent appraiser or appraisers, expert in the particular industry, determine fair market value. The BSA may provide for the parties to agree on one appraiser. Alternatively, the company and the departing owner may each select an appraiser and the two values will be averaged. To keep each appraiser objective, you will sometimes see one of two variations on this later approach. First, the “baseball” approach will call for a third appraiser, selected by the other two, to choose either of the two appraisals as the accepted appraisal. Alternatively, the two appraisals may be averaged if the lower is within some reasonable percentage, say 10 to 15%, of the higher appraisal. If not, then a third appraiser will be chosen. The three appraisals will be averaged if the lowest and highest are each within that same percentage of the middle. If not, then the appraisal or appraisals not within that reasonable zone of the middle appraisal will be discarded for purposes of determining the average. BSAs should further state that the appraisals are to be final and binding on the parties, and should appropriately allocate the costs thereof. The only real drawbacks of conducting appraisals are the time, cost and uncertainty involved.

A final common approach to valuation is to provide in the BSA for a particular formula. For example, the business may be valued on a multiple of trailing average net income or operating cash flow, or a multiple of net book value. While this method is easy to determine, provides a level of certainty and is well recognized approach in many agreements, its fairness is questionable. Determination of appropriate multiples varies with micro internal factors such as the financial health and stability of the company and macro external factors such as the level of interest rates and values ascribed to comparable businesses. The correct valuation formula will therefore vary over time and this will not likely properly reflect the real fair market value of the enterprise.

Some agreements will also engraft a vesting schedule in determining the percentage of fair market value which the seller will be entitled to keep. For example, a BSA may provide that an employee will receive an additional 20% of the difference between the fair market value and book value of her shares each year for five years. This vesting concept will serve as a “golden handcuff” to keep the employee retained, motivated and focused. A vesting concept is particularly appropriate in cases where the investor has provided most of the capital and the employee would receive a windfall if they departed soon after the investment.

In the event that an employee leaves a business for Non-Cause Events, the employee may also seek a right to revalue the put/call price if the company were sold for a higher price within a one to two-year period. This revaluation right keeps the company honest and prevents it from terminating the employee prior to a contemplated sale or refinancing.

The IRS will generally accept valuation methods in BSAs which are arm’s length and involve non-family members. In solely family owned businesses, special care needs to be given to assure that the methods are fair and supportable.

Earnings Through Departure Date

In a pass-through entity, the earnings of the business will flow through to the owners. BSAs will frequently value an owner’s interest at a point in time prior to the owner’s date of departure, for example at the end of the calendar quarter immediately preceding the Cause or Non-Cause Event. The owner, however, is liable for taxes (or may benefit from the deductions) on the owner’s share of the net income for the fiscal year through the actual departure date.

BSAs address this issue in two ways. First, they will often provide that the owner will receive its share of the net income of the business for the period between the beginning of the fiscal year or valuation date and the ultimate purchase date multiplied by the owners’ federal and state income tax rate. While on the surface this seems fair, in reality the owner may be reaping a windfall by this approach. The windfall results from the fact that the owner will be deemed to have a capital loss on the sale of the interests for that short gap period. Therefore, the fair approach is to provide for a distribution equal to the net income for such period multiplied by the difference between the ordinary income and capital gains rate.

The proper cut-off of the pass-through entity’s year is another factor to consider in determining value of the interest. For example, if a shareholder of an “S” corporation departed on May 1 and the corporation earned no income through that date, but earned $1 million from May 2 through December 31, absent an election to treat the “S” corporation as having two separate tax years, the shareholder would owe taxes on her share of that $1 million divided by the proportion of the year that she was a shareholder, even though she enjoyed none of the benefits of the net income. All shareholders of an “S” corporation, therefore, should elect to bifurcate the year, so that the departing shareholder will owe no taxes for the post-May 1 portion of the year. This election is not available, however, for partnerships or limited liability companies.

e. Payment Terms.

The business or other owners, as the case may be, will always have the option to pay for the departing owner’s interest all in cash. For reasons of cash conservation and financing, the purchaser may desire a deferral of payment.

Installment Sale

In Non-Cause Events, the term of the installment sale is typically shorter than the term for Cause Events. Likewise, the interest rate for deferred payments in Non-Cause Events is usually higher than in Cause Events and security tends to be granted a pledge of the sold shares. Just as a payment period for repayment is usually shorter in Non-Cause Events than for Cause Events, it is also typically two to three years shorter with a call (since the company initiated the call) than with a put. The reasons for the distinction in payment terms are the same for valuing the shares differently depending on the different circumstances of departure. Some installment sale agreements in Non- Cause Events will also impose negative covenants on the business, particularly with respect to paying excessive salaries or dividends, and sometimes with increasing debt loads. On both Cause and Non-Cause Events, the installment obligation is accelerated upon the sale of the business.

While “S” corporations are prohibited from having two or more classes of stock, properly drafted installment notes will not be classified as a second class of stock. The interest rate on the notes, moreover, must be no lower than the minimum applicable federal rate to avoid interest being imputed under the original issue discount rules of the Code.

Offsets

Departing owners will often owe sums, whether employee loans or otherwise, to the business. Payment of the first installment of the price should be offset by these amounts. This point is frequently overlooked in many BSAs.

4. Management and Control of the Business.

Management of the day-to-day operations of the business as well as decisions on fundamental issues present a frequent source of tension between and among owners. As stated above, an important function of a BSA is to clearly set forth the roles and responsibilities of the owners in managing the business.

Control issues vary dramatically based on the size and stage of development of the business. In the simplest case, one owner will make all decisions, regardless of the magnitude or importance thereof. This is typically the case in family businesses where one owner owns a large percentage of the stock and the other investors are employees or family members from a junior generation.

On the other end of the spectrum, some BSAs will state that all decisions (except perhaps some day-to-day operational decisions delegated to certain key management personnel) require unanimous or supermajority approval. This approach is typically found in corporate joint ventures or businesses with two or more persons or families owning equal or close to equal blocks of stock.

The most difficult situation from the employee-owner’s standpoint is in an early-stage investment by an investor where the investor has the lion’s share of the common equity. Many investors, consistent with their voting position, demand full and untrammelled right to select the members of the Board of Directors (the “Board”) and authority over each and every decision, no matter how small or how significant. If the investor’s investment is held in a convertible debt instrument, however, the investor may be cautioned not to exert this amount of control. In a bankruptcy situation, other creditors may succeed in equitably subordinating the investor’s debt on the grounds that it exerted the control of an equity owner.

The employee-owners may try to negotiate some meaningful role in addition to their positions as employees of the business. A management role is necessary to impart their knowledge and experience in the business, as well as have some control over their destiny. This ability to have substantial control, at least over operations, is especially important in cases where management’s ownership stake may be reduced or “clawed back” if certain financial or other targets are not met. To suffer a clawback when the management team is hamstrung by budgets and financial conditions unilaterally imposed by others seems unjust.

Moving further down the continuum from total investor control, some Board decisions may require the assent of at least five of the seven directors and thereby afford the right of management to block an investor action. The items over which employees would expect to see this type of input are operational issues such as approval over budgets, giving raises and bonuses, and changing operating strategy. Structural issues such as sale, raising of capital and similar items however, would remain in the majority (i.e., investors) of the Board.

Super-majority consent may be further required for major structural decisions such as bank borrowings, major capital spending, raising of additional capital and ultimate sale of the business. A nuance of this approach provides a supermajority requirement in the first few years. After that time, or after the time that certain financial performance goals are not met, however, Board control may revert entirely to the investors.

Continuing down the control spectrum toward employee control is the situation where the budget is devised by the founders and ratified by the Board. Moreover, day-to-day decisions may be made by the founders, subject to the parameters set forth in the operating and capital budgets.

A final stop along the control continuum might be a neutral Board. The investors select three, the employees select three, and a distinguished member of the industry is selected by the six members as the seventh member of the Board. Further, the company’s charter may reduce the number of Board seats allocated to an investor as that investor’s ownership interest is diluted in subsequent financings. As this percentage is reduced, investors may ask for honorary, advisor or observer seats, which allow them to attend Board meetings and obtain materials circulated to Board members.

5. Deadlock and Unwinding.

A critical purpose of BSAs is to provide for means of preventing or breaking deadlocks over major decisions facing the business. BSAs are far preferable to resolving deadlocks than courts, which may, among other things, remove directors to eliminate a tie, appoint provisional directors to break a tie, appoint a custodian for the business or cause the corporation to be simply dissolved.

Triggering Events

One of three events typically trigger unwind or deadlock resolution provisions in a BSA. First, some BSAs state that after the passage of a certain period of time, any owner, or an owner exceeding a certain size, may elect to trigger the unwind mechanism. These provisions force owners to work together for some period of time, but recognize that one or more owners may desire an exit mechanism to monetize its ownership interest at some point.

A second initiating mechanism is at the election of an owner after the existence deadlock or series of deadlocks over major issues facing the business. While owners cannot be expected to agree on every issue, or even every major issue, the chronic and continual failure to agree on major issues impedes the progress of the business as well as the morale of its participants. Some provisions will allow one deadlock over a defined list of major issues to constitute grounds to trigger the unwind clause. Better reasoned provisions, however, will require three or more deadlocks within a defined period, such as twelve to eighteen months, to constitute a deadlock. This latter approach prevents an unscrupulous owner from using one issue as a pretext to cause a deadlock to trigger the clause. Obviously, that same owner could perpetrate the same shenanigans by causing three issues to be deadlocked, but the higher number of items reduces such owner’s ability to carry off such a scheme without tarnishing that owner’s credibility and litigation posture.

A final triggering event is similar to events discussed in the “Management” section which enable the investor to increase its Board representation. The right to trigger an unwind is the next logical step after increasing Board representation and perhaps taking control of the business.

Consequences Upon Occurrence of a Triggering Event

Upon the occurrence of a triggering event discussed above, one of several consequences could follow. On one extreme, many BSAs simply provide no mechanism for solving impasses. The rationale underlying this approach is that the parties should be required to work out their differences to the best of their ability and not have an easy roadmap for unwinding their relationship. Further, one owner should not be confronted with a perpetual “sword of Damocles” hovering overhead and threatening the maintenance of the existing business in the event of a disagreement.

Moving down the continuum of remedies in the event of a deadlock, some BSAs offer arbitration or mediation provisions to solve a deadlock. On the same lines, some will provide for the appointment of a provisional director. These approaches, however, are stopgap in nature since they only address one problem at a time, and not the fundamental cause of the deteriorating relationship between the owners. Further, arbitrators do not always know the business as well as the owners, are sometimes expensive, and many times take an expedient compromise approach instead of favoring one side over another.

A common approach for resolving deadlocks is the “dynamite” or “candy bar” method. A deadlock will give one party the right for some period of time to offer to buy the other party for a price named by the offering party. The party receiving the offer then has two choices– it can either accept the offer and sell at that offered price or buy the offeror’s shares at the same offered price per share. Theoretically, the offeree’s right to buy out the offeror at the same price offered by the offeror will incite the offeror to quote a fair price, for fear that if the price is too low, the offeror will be bought out at that price. In reality, however, the offeror and offeree do not always have the same financial resources, and the offeree’s rights to match a low offer by the offeror may be illusory.

BSAs occasionally provide an exit strategy to large owners or management by giving either the right at some point to cause the business to be sold or merged. Investors typically demand this right which they can exercise at any time. The parties may agree that some time should elapse before this right could be triggered in order to give the management team a chance to implement the business plan. In lieu of tying the right to cause a sale to a specific time period, some agreements require the occurrence of some event such as a deadlock on major issues, failure to achieve targeted financial goals, or the departure of a key employee. Sometimes, the parties agree to give either party the right to sell the business at any time, or after a certain time, for a price not less than an appraised or agreed to minimum value. The other party would then have the right to match that price prior to the time the business is marketed for sale, even though this right may be illusory in the case of a management team with few financial resources. While investors desire the flexibility to be able to cause a sale of the stock or assets of the business at any time, the management team will want to limit the periods during which the business is being shopped. This reduces the negative impact on employee and customer morale and uncertaintythat naturally occurs during the sale period.

A final method set forth in BSAs to address the possibility of a deadlock gives one or more parties the right to sell their shares (a “put”) and/or the company the right to purchase the shares (a “call”) upon the occurrence of a time based or event based triggering event. The put price could be either the liquidation value of the preferred equity of the investor or some sort of formula or appraised value for the common equity. While a formula value is sometimes used (e.g., eight times trailing net earnings), this method can be dangerous since fair and appropriate formulas vary over time and the current risk profile of the business. The put is also of questionable value on a real practical sense. If the business is doing well, the investor has other means available to it to liquefy its position. If the business is doing poorly, the business may not have a means of financing the put, and therefore, the impact of the put is to convert the seller’s equity to the right of an unsecured creditor. The call right is the logical mirror of a put. The pricing and terms of the call may be the same, except the call right is usually delayed for a year or two after the time that the investor is first able to exercise the put. The value of the put, moreover, may be discounted by a small percentage, say 5%, as the price the investor should be willing to pay to gain cash. Conversely, the call may carry a 5% premium (or perhaps a premium which declines over time) to compensate the investor for having its interest redeemed involuntarily. Investors resist calls since they put a ceiling on price appreciation. The company responds that the call is a last resort after the investor has had the right to put the stock. The call treats the investor fairly, moreover, since the price of the preferred is fixed and the value of the common will be fair market value. In the case of convertible preferred held by the investor, the right to call the investor’s shares, further, gives the company the ability to require the investor to “put up or shut up” by causing the investor to decide to either convert its preferred to common or suffer a call.

6. Capitalization.

BSAs frequently address capitalization and financial issues of the business.

Preservation of Subchapter S Status

Subchapter S imposes a number of specific technical requirements to elect and retain “S” status. Such requirements include, among other things, limiting the number of shareholders to no more than 75 and the types of shareholders to U.S. citizens and certain types of trusts. A BSA will specify that any transfer which negates or revokes “S” status will be null and void and of no force and effect. Likewise, the transfer of a 50% or more interest in a partnership or limited liability company will result in a technical termination for federal income tax purposes of that entity. While the consequences of a technical tax termination will generally be innocuous as a result of recent U.S. Treasury Department regulations, some partnership or operating agreements (particularly where the entity generated tax credits) prohibit such transfers which may cause a technical termination.

Pre-Emptive Rights

Owners invariably ask for, and usually receive, the right to purchase the number of shares necessary to maintain their percentage interests in the business. While the right may be nice to have in theory, in actuality the owner’s appetite or capacity for additional investments may very well be sated by the time additional equity is being raised. Pre-emptive rights may also be illusory with impecunious owners. These rights typically terminate upon an initial public offering.

Mandatory Distributions

The net income of an “S” corporation, partnership or limited liability company or similar entity will flow through to and be the responsibility of the shareholder, partner or member, respectively. Each owner’s responsibility for the payment of the tax, without a requirement that the company make a cash distribution in the amount of the tax, could cause a hardship to those owners who are cash-strapped. The absence of a mandatory tax distribution may also be abused by controlling owners desiring to “oppress” minority owners. BSAs will attempt to prevent this potential for abuse by requiring a pro rata distribution to owners equal to the product of the net income and the highest marginal federal and applicable state income tax rates. Ideally, the distribution should be made quarterly prior to the quarterly estimates, but at least once per year once the prior year’s tax liability is known.

Additional Capital

Most businesses, whether they grow or lose money, continually need to raise new capital to exist. A growing business needs new capital for expansion and to finance working capital. A business suffering losses 490 needs to fund those losses. Very few businesses are fortunate enough to internally generate sufficient free cash flow to cover all operating and capital needs.

Owners frequently tangle over the degree of investor and other protection in the event that additional rounds of financing may be needed. While many BSAs afford pre-emptive rights to owners to subscribe for more shares, very few agreements will require owners to provide additional capital. Some BSAs necessitate unanimous or super-majority approval before the business seeks new capital. This super-majority protection can place the business in a precarious position, however, if it needs capital for purposes of survival. Therefore, many BSAs will provide flexibility to enable one owner to unilaterally cause the infusion of new capital, after offering the right to all other owners on a pro rata basis, without the consent of the other owners in limited circumstances. Those circumstances will be narrowly prescribed as necessary for the business to continue to operate and would typically include items such as capital necessary to cure bank defaults and operating deficits.

In the event that additional capital contributions are made by the existing owners, they typically take one of three forms. First, the additional capital may be a loan made by the owners. The loan is to be repaid before any equity capital is distributed and will typically bear a high interest rate commensurate with the greater risk involved.

A second approach is for the new capital to take the form of preferred equity, except in “S” corporations where this would be a prohibited second class of stock. The preferred equity, like the new debt, would also be paid before any common equity and reap a high coupon due to the heightened risk. Sometimes, the debt or preferred will have convertibility features.

The final form that an investment of new capital may take is as common equity. Sometimes the common equity is valued on the same basis as initial contributions, sometimes at perceived fair market value, and sometimes at a penalty rate. In cases where the infusion of additional capital is purely optional, it is difficult to rationalize a penalty rate for the additional capital. For example, assume owners A and B each contributed $1000. New capital of $500 was needed and only A agreed to invest this capital as common equity. That new equity would then give A $1500 of the $2500 total common equity capital. The straight valuation method would give A a 60% equity interest. The penalty approach may value each new dollar as if it were $1.20 and therefore A would be deemed to have contributed $600, not $500, and would therefore have a 62% interest.

Finally, BSAs may protect outside investors from future “dilutive” financings. If additional shares are issued at a price less than the price at which the investor purchased its shares, investors often receive an adjustment of their share price, or conversion price for preferred shares, in the event of the dilutive financing. The adjustment is typically based on a weighted average formula, but an aggressive investor will sometimes insist that the investor’s conversion price ratchets down to the new lower price per share.

7. Non-Competition and Other Agreements.

Non-Competition Agreements

BSAs frequently require the employee or consultant owners to refrain from competing with the business or soliciting its employees and customers during the term of engagement and for a specified period thereafter, as well as refrain from using or disclosing any confidential or proprietary information during the term and for a perpetual period thereafter. In Non-Cause Events such as the company’s termination of the employee without cause, the departing shareholder’s non-compete provision is often terminated, while the non- solicitation and non-disclosure obligations remain. Rescission of the non- compete provision is justified on the grounds that the corporation made the conscious decision to terminate the employee and therefore cannot stand in the way of letting him earn a living. The corporation sometimes argues that it is appropriate for some portion of the non-competition covenant to remain even in such circumstances. The corporation will argue that while it did not claim the employee was terminated for cause, it only refrained from doing so out of a distaste from pursuing a lengthy and costly battle. Further, in the event that the employee is entitled to post-termination severance payments, the non- compete provision should remain in effect for the period where substantial payments are being made, since the employee is in effect being paid not to compete.

New Opportunities

A more complex issue that, surprisingly, only a few BSAs address, deals with the right or responsibility of the employees to bring new opportunities to the business in lieu of exploiting those opportunities themselves. In many closely-held businesses, the investors try to insure through proper documentation that the founders and/or management team is “lashed to the mast”. Slavish full-time devotion to the business by management and pure focus on the business at hand are critical to give the investment the opportunity to pay off and prevent the founders and management team from bailing out and pursuing more lucrative opportunities at the first sign of trouble. A failed investment will not impact on the management team financially as it will inflict economic loss on the investors. The experience of running even a failed business may actually help build the management team’s credibility and resume as it seeks to form new ventures.

The management team, on the other hand, desires more flexibility to pursue other ventures either in the same industry or in unrelated fields. Management employees reason that as long as they are devoting sufficient time to the business, they should be free to pursue other opportunities in related or unrelated fields. For example, in a computer software business formed to develop banking transaction software for electronic funds transfer, the founders may desire to start another business developing software for analyzing credit card debts as long as they oversee the business’ programmers who create the software, and are standing by ready to market and further develop the software once it is commercially available. In a paging business located in one state, the founders may desire to start or acquire another business in another state once the original business is operational and meeting or exceeding projections. The founders often feel their obligations on behalf of the original venture are satisfied if they have instilled that entrepreneurial vision and assembled all of the necessary financial, operational and research pieces to make that business work. Their creative energies, they argue, should not be stifled while they wait for others to execute their vision.

Investors react in several ways to management’s desire to have more flexibility and freedom to pursue other opportunities. These reactions also span a wide continuum. At one extreme, the investors will require the management team to spend all of its business time and energy on the business, at least for the duration of the employment agreement and vesting periods. This position is probably the most common.

The investors may agree to commit additional funds for investments in the same industry to build the business and give it substance. In the example of the paging business, the founders may have agreed to accept capital from the investors to acquire the Minnesota business for $10 million, only on the grounds that the investors shared the founder’s concept and vision to grow the business through acquisitions of add-on businesses in contiguous markets and to geographically diversify the business through acquisitions in other areas. Therefore, the investors may agree to commit an additional $20 million for these types of acquisitions, provided that the new transactions meet their financial and operational requirements. This commitment for future capital therefore quenches the founder’s thirst for pursuing these opportunities yet, at the same time, justifies the investor’s insistence that management focus solely on the particular investment.

A second condition to releasing the management employees from the investor’s typical requirement that such employees devote all their time and effort to running their business is that the employees spend at least the amount of time necessary and proper to assure that the business model is being implemented. While these concepts are not capable of being objectively quantified by specific time or financial performance thresholds, these terms convey the sense that the business at issue should initially command the founders’ substantial focus and priorities.

Investors will also seek the right, not the obligation, to participate in the new opportunities. If the investors do choose to participate, the battleground is whether they will invest all required capital or just a portion of the required investment. If the investors desire to invest just a portion of the new investment, a minimum portion is typically expected just to show the seriousness of the initial investor. A further complication 496 arises regarding whether the new opportunity should be melded, legally, or operationally with the initial business. This, in reality, requires all investors, new and initial, to agree on a valuation of the existing business to give proper credit for any appreciation in the initial investor’s investment, and to agree on a governance structure which shares the investor authority between the initial and new investors. A final nuance involves the allocation of the right to participate in the future between the initial and new investors. Is it on a basis proportionate to the initial investments, on the value of the initial investment at the time of the new investment, or is there a first priority given to the investor in the industry or geographic area which is closest in kind to that investor’s investment? For example, if the initial investors invested $10 million in the business in the paging business located in Minnesota, the new investor group invested $5 million with the management team in a paging business in Oregon (in which the initial investors chose not to participate and not to blend in with the Minnesota business), and the Minnesota business was worth $15 million at the time of the Oregon investment, how should a new opportunity in a paging business located in California (which is considered to be contiguous to Oregon) be offered to the initial and new investors? Should it be offered at all? Should the Oregon investor group have the entire right to participate since the new opportunity is contiguous? Or should the Oregon investor group get the first right to participate? Should the Minnesota and Oregon investors split the right to participate on a basis of 10/15 to the Minnesota group and 5/15 to the Minnesota group (the ratio of the original investments) or should it be based on 15/20 to 5/20 (the ratio of the original investments marked up to market value)?

8. Enforceability.

Notwithstanding our cultural antipathy toward alienation of property, modern state corporation statutes generally conclude that BSAs with extensive transfer restriction provisions are enforceable. For example, the Revised Model Business Corporation Act authorizes transfer restrictions of an indefinite term for any “reasonable purpose”. Many states laws specifically authorize the enforceability of such agreements, while state law frequently limits the term of voting proxies or trusts to a certain number of years. Most states authorize BSAs designed to restrict transferability to preserve the corporation’s Subchapter “S” status.

Restrictions must be reasonable, however. While courts uphold most BSAs on the grounds of freedom of contract, provisions which are too vague or outrageous will not pass muster. For example, one court refused to enforce a BSA which placed a permanent ban on all transfers of shares and required each shareholder to sell their shares back to the corporation on death for their original purchase price. The court reasoned that this restriction made the stock worthless and was an unreasonable alienation of property.

Some courts have suggested that BSAs may not be binding on a shareholder’s heirs, unless the transfer restrictions were set forth in the corporation’s charter. Better reasoned decisions, however, would not impose such a requirement, especially if the shares contained a restrictive legend.