Paper It Up: The Importance of Ownership Agreements and Buy/Sell Documents

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We have all heard the piece of advice, “Make sure you get that in writing.” The more time I spend in the valuation space, the more I realize just how justified this advice is. It is very easy in the moment to disregard due diligence when it comes to forming a business partnership or buying or selling a company. After all, it is just an added step and an added expense. However, this up-front cost of time and money is worth the investment for the pain it could help you avoid down the road.

Being involved in valuation lends itself to assisting the legal community through valuation and forensic techniques. A great number of cases that we work on are the result of disputes between family members and business owners. While Louisiana has statutes that govern how a small business is to be run, the best practice is to have a partnership or operating agreement in place.

The soundest business relationships among owners will typically have an executed operating agreement that addresses the common areas of dispute between partners and co-owners. We encounter many owners who assume that because they are dealing with a family member or a lifelong friend and confidant, that they will always see eye to eye and avoid conflict in the business relationship. Unfortunately, disputes are particularly prevalent among family members and close friends for this exact reason.

Proper governing documents will address the most burning questions during a dispute between owners:

  • Who makes management decisions for the company?
  • What if one of the owners threatens to sell their interest to a stranger?
  • Who decides when we pay distributions?
  • Who gets to vote on major decisions for the company?
  • How many votes do I get?

Ideally, an entity will have articles documenting the original formation of the entity, as well as an operating agreement or partnership agreement. Additionally, as questions arise during the course of business, the agreements can be amended to address these issues. We give extra credit to owners who have a buy/sell agreement in place. Buy/sell agreements are not executed as often as we would like to see, but they prevent a lot of owner disputes. A good buy/sell agreement will dictate the major terms of a change of hands in ownership, especially for buy outs of existing owners. It prevents disagreements as to price, structure, and logistics of the transaction affecting ownership.

To illustrate the importance of executing legal agreements, we will demonstrate a common issue we see in practice. Let’s say one owner owns 98% of an entity, and his two kids each own 1%. Logic might dictate that his 98% is the vast majority and controlling ownership; however, the kicker is that this is a family partnership, and the family never executed a partnership agreement. They didn’t see the need for the added legal cost, and they verbally agreed that the partnership would endure on the goodwill and amicable relationship of the family members. Louisiana statutes that govern partnerships dictate that in the absence of an executed agreement stating otherwise, each owner is entitled to receive one (1) vote in partnership matters, regardless of percentage. All of a sudden, in terms of voting on matters affecting the family partnership, this 98% ownership is effectively diluted to 33%. Likewise, the 1% ownership has effectively become a 33% ownership. This seems to go against the intent of the family members, but in the absence of an agreement in our line of work, this is the reality that we encounter, and we aren’t typically in a position to assume what the family intended to do, but rather what the letter of the law dictates. In court, perhaps an argument can be made that would preserve the function of the family partnership and how the family was running it, but for purposes of a valuation, especially when valuation discounts are at stake, we have to go by the documentation that was in place as of the effective date of the valuation (we will get into valuation discounts in our next article).

If you are currently a small business owner or involved in a partnership or any other type of entity ownership, let this article serve as your sign to verify that you have written, signed governing documents in place for your entity. Don’t assume that you have them, make sure that you have them and that they are signed and executed properly, even if you have been operating cordially for years with your current partners. If you don’t, you are placing your ownership interest at risk and opening yourself up to future business and legal headaches.