Business contracts are inherently complex and legally challenging, particularly contracts governing the ownership and control of a business. In no area is this more poignant than provisions governing the purchase and sale (the transfer) of business ownership interest in partnership and limited liability company agreements. Contact an experienced Newburn Law attorney today to help you navigate this difficult area.
The Need for Transfer Restrictions
The vast majority of businesses start the same way. Two or more individuals have an idea, form a partnership or limited liability company, and dedicate themselves to bringing their vision to reality. It is rare that the founders of the business consider the “end game” at these beginning stages. What happens if one of the founders passes away, becomes incapacitated, loses control of their ownership interest through divorce or bankruptcy or wants, or needs, to sell their interests? Are the other founders financially able and willing to buy one founder out? Are they willing to take on new partners?
Transfer restrictions help business owners navigate these eventualities at the beginning of the Company's lifecycle. At Newburn Law, our attorneys have learned that helping business owners agree to these provisions at the outset can save thousands of dollars, hours of negotiations, and lots of emotional strife, when these issues arise unplanned.
LLC and partnership agreements can include a myriad of different constructs to govern how business owners buy and sell interests in their business. Broadly, these fall into two categories:
Provisions Dealing with the Involuntary Transfer of Ownership Interests
Involuntary transfers are typically caused by the death, disability, divorce or bankruptcy of a business owner. These transfers are typically handled by a forced sale, a removal of voting rights (but a retention of economic rights), or nothing at all (allowing the ownership interests to transfer via will, divorce decree, etc.).
Provisions Dealing with the Voluntary Transfer of Ownership Interests
Voluntary transfers can happen for a variety of reasons – an owner wanting to sell interests to finance a new business, home or school for children, an owner deciding they want to retire or pursue other interests, or a disagreement in the future direction of the company that cannot be resolved.
Common Transfer Restrictions in Operating Agreements
There are many common transfer restrictions in LLC and partnership agreements. In fact, in many operating agreements, members will be prohibited from selling or transferring their LLC interests unless that sale is approved in advance by a specific percentage of the members, or allowed under another provision like those listed below. Most LLC agreements and partnership agreements will permit transfers to immediate family members or family trusts; however, it is important to carefully examine all business agreements for possible transfer restrictions. Some of the most common transfer restrictions are listed below.
In the absence of any provision in the LLC or partnership agreement designating what happens upon an involuntary transfer, the transfer will be permitted to take place. The heirs of a deceased or disabled owner will receive such owner's interests in the company. The divorce or bankruptcy decree will determine ownership in those contexts. Below are a few of the strategies that companies may employ to avoid those circumstances.
Key Man Insurance
A company can put a life insurance policy on each of its owners. The company pays the premiums and is the beneficiary of the policy if the owner passes away (or, in some cases, becomes permanently disabled). While these type of policies – called “Key Person” policies – are typically used for the recruiting, hiring and training of the deceased's replacement, they can also be used to allow the company to buy the deceased ownership in the business. When an LLC or a partnership buys the ownership interests of one of its owners, that ownership interest is effectively “spread” to the other others pro rata according to their remaining ownership interests.
Conversion of Interests
While Key Man insurance allows a company access to funds to buy a deceased (or disabled) owner's interests in the company, the company may decide that paying the required premiums isn't a good use of corporate funds. However, the other owners may not want to deal with a new voice (the deceased's or disabled's heirs) in the management of the company. One answer could be to convert the deceased or disabled's owner's interest into the company into a purely economic interest without voting or management rights. This allows the heirs to receive the economic benefit of the ownership interest in the company without any participation in the day-to-day management. One important thing to keep in mind is the provision needs to be included in the LLC or partnership agreement before an owner passes away or becomes disabled. Following that point, it can only be done with the consent of their heirs and may have tax consequences.
In the absence of any provision in the LLC or partnership agreement placing restrictions on transfer, an owner is free to sell, bequeath, pledge, encumber or otherwise transfer their ownership interests in a company as they desire. There are no restrictions on who they sell to, how much they receive or whether or not they notify the other owners. Below are a few of the common provisions that companies employ to avoid unwanted transfers.
On some occasions, typically in the early stages of a company's life or while it is completing a particularly material project, company's may employ complete prohibitions on transfer which, as the name suggests, completely prohibit all transfers of interests in the Company. The sole exceptions are typically for involuntary transfers or transfers for estate planning purposes (i.e., to a trust).
Right of First Refusal
Right of First Refusal, or ROFR, is provision requiring members who receive an offer for their ownership interests in the LLC or partnership to first offer it to the other owners of the company on the same terms. If the other owners refuse to purchase the interest, the selling owner is typically permitted to then sell to a third-party, although on terms no better than those offered to the other owners.
Right of First Offer
Right of First Offer, or ROFR, is a similar provision to a Right of First Refusal, in that it requires members to offer their ownership interests in a company to the other owners before they make an offer to sell to a third party. However, whereas in ROFR provision, the selling owner brings an offer they have received from a third-party to the other owners and asks then to “match” it, in a ROFO, the selling owner first goes to other owners, tells them it wishes to sell, and they have the first right to offer to buy the ownership interests. The selling owner is then typically prohibited from selling its ownership interests on worse terms than what was offered by the other owners. It is very common for an LLC or partnership agreement to contain both a ROFR provision and a ROFO provision.
A drag-along provision allows a specified percentage of the ownership interests (typically a majority or higher) to force the remaining owners to sell their interests to a third party. For example, if owners A, B and C each owned 1/3 of the company and owners A and B negotiated a sale of the whole company to a third-party for $900,000, a drag-along provision requiring a majority of the ownership interests would allow owners A and B to force owner C to sell their ownership interests for $300,000.
Tag-along rights function as the opposite of drag-along rights. A Tag-along provision requires that, when any member sells their ownership in the company, each of the other members has the right to sell their ownership interests on the same terms. If the buyer does not want to purchase all of the ownership interests being offered, each selling owner's portion is reduced proportionately. For example, if owner A owned 50% of the company and sold its 50% to third-party X for $100,000, a tag along provision would allow owners B and C (which, for this example, each own 25% of the company) to sell their ownership interests to third-party X for $50,000 each. If third-party X only wanted to purchase $100,000 worth of the company in total, then owner A would sell 25% (and retain 25%) for $50,000 and each of owners B and C would sell 12.5% (and retain 12.5%) for $25,000.
When Agreements Fail
If business owners fail to provide transfer rules in an operating agreement, the prevailing applicable law (state codes, bankruptcy courts, divorce courts, etc.) will apply and, typically, not with a result that owners desire. For that reason, having well-drafted LLC or partnership agreement that plans for possibilities is critical for business owners.
Contact an Experienced Business Attorney at Newburn Law
If you are starting a business, or have an established business in which you may be desirous of adding transfer provisions, consider meeting with an experienced business attorney who can answer your questions and ensure all contingencies are planned for. Our experienced business attorneys can look at your situation and prepare you for the next steps. Contact Newburn Law, for your free consultation today.