Not Having a Shareholder & Buy-Sell Agreement

BARRY: Number 8. It’s bold, by the way. Which is exciting. So not having a shareholder agreement, buy-sell agreement, and I know we’ve talked about the funding component of the buy-sell agreement, but let’s put that aside for the moment. What is the significance of having or not having a shareholders’ agreement in a business?

CHAD: Well, not having it exposes you to a lot of potential litigation amongst former spouses, it could be litigation amongst the partners if it’s about who will take over shares if someone passes away, how are shares divvied up, how do you buy them back? So, one, I think you open yourself up to a lot of legal issues. Because there’s nothing dictating who has what rights. So I think that is a big issue. There could be tax issues, too, if the agreement is not structured correctly.

BARRY: All right, let me jump in. Bottom line, here, and you mentioned some really great points, if you don’t have a shareholders’ agreement — if you don’t have your own body of law for governing your company, you’re deferring to the statute to fill in the gap. And if it’s 608 for LLCs or 607 for corporations, there’s a lot of bedtime reading to put you to bed on all the gap-filler. You’re not going to like the gap-filler. There’s a couple things there that are nice, but for the most part it’s not very good. And so that’s why you wanna have the agreement memorialized in writing, understood by the partners. That’s like the bigger pictures.

CHAD: But the rules that dictate. What procedures are there if you need to vote a partner out? Or to bring a partner in? How do they buy in to equity? How do they do it? Installments? Cash up front? There’s all sorts of things on the front and back end that need to be addressed.

BARRY: You raise a good point. That if you don’t have an agreement, there’s an issue of ownership. And it’s less of an issue, I think, for a C corp or an S corp because you’re got your tax returns to back up ownership. You can’t say ownership is different than what you filed on your federal tax returns. That’s a whole other bag of chips. But LLCs can be changed every year. You can change your ownership, allocations, profits and losses, distributions. So that’s up to interpretation. But when it comes to ownership, control, management, meetings, allocations, who’s working in the business and who’s not, who has the right to tell people they can’t work. Those are issues.

I would say we have what I would call Very Important Issues, and I think you’re going to touch on them as well. In the event of disability and death, what happens if you have a partnership or business and your partner becomes disabled? Well, hopefully you have a disability policy to kick in so that this person who is disabled can have money to help them live.

CHAD: And add to that, “Do you have the right disability policy in place?” Because I’ve seen times where the wrong contract language is in that policy, and that’s what people don’t understand. It’s nothing more than an employment contract in the scenario that you can’t work. And the language in those policies will dictate what you’re income is going forward. And I’ve seen what happens when you have the wrong language. I’ve had a family member who got bought out of a business and his benefits stopped after two years because it was the wrong language in the policy. And so it’s really important to make sure you’re consulting with a professional who understands the contractual nuances of these vehicles that we’ve mentioned about. The legal entities we’ve mentioned. Because there are nuance to all of them.

BARRY: I would add on to that, and I think it’s an important one, when people shop for insurance, they usually shop on price, and they usually get exactly what they paid for. And they have no idea what they’re getting. They don’t read the policies. Find me someone who’s read their policy and I’ll take them to lunch. That doesn’t happen. Frankly, I haven’t read half my policies. People don’t do it. They buy it on price, they don’t even know what they’re covered for, and when push comes to shove and there’s a claim, you’re rolling the dice on whether or not that claim is going to be covered. Your agent, if you’re not working with a professional, they sold you what they sold you — they don’t know what you need. So that’s a concept we should explore together.

But going back to disability and the death of a business owner, we’re talking about providing for the departing member to make sure they can survive in a meaningful way and with honor. But also not dragging the business down because you’re down a person. And if you have to keep paying that person, you’re not gonna fill that role–

CHAD: Also, if that person is a partner, they’re also probably a key person in the business. All of a sudden, you have to replace that person. So how do you do that without also running the business dry? There’s ways, different key man type stuff where to provide the funds for the business to be able to go out and find the replacement for that partner. For another expert in that area.

BARRY: Say, for example, you have three partners and one goes down, that person still owns their 33%. There’s nothing you can do about that without an agreement. They’re going to be disabled at home and working on their life, but they’re still a partner, and while you’re busting your ass in your business, when you make distributions to partners, they’re getting a third and there’s no way around that. The only way around that is to give salaries to people, and that means more taxes, and that gets complicated and gets into quasi-ethical situations.

Take, for example, the person passes away. There’s now an estate that has to be involved with respect to that person. That’s where I come in next time, talking about estate planning and probate. You don’t want an estate involved in your business. But say some person passed away, you’re going to have beneficiaries that become your new partners. “Hello, I’m John and I’m your partner. I know nothing about your business, but I’m really excited to get to know how things work.”

CHAD: One other partner you don’t want, just like Uncle Sam.

BARRY: There’s three. There’s four! Uncle Sam, their spouse, there’s heirs, and there’s creditors in bankruptcy. Which is the next thing I was gonna get at. So, partner files for bankruptcy, creditors come in, they horse-trade. Eventually you’re partners with a creditor who wants nothing to do with your business except to sell it to get their money back. Now you have a series of creditors that are your owners. You have no protection or control over this issue without a proper agreement. Whether it’s divorce, death, bankruptcy, disability — these are issues that will blow up your business and really distract you from your focus of what you’re trying to do with your business. And the cost-benefit of planning around it from the beginning versus addressing it later when it’s an issue is night and day.

CHAD: A lot more expensive to address on the backend, that’s for sure.

BARRY: And we’re happy to do it. We’ll make a ton more money, we’ll help you through the process, we’ll give you the support you need. But you’re going to pay us exponentially more to deal with this problem later then you would upfront. But this is what goes into the agreements, and that’s why it’s so important, among many other things.

CHAD: A lot of time we’ll go into business with a friend or a family member and they don’t think they need one of these agreements in place because they trust the person unquestionably. Trust is a weird thing when the business goes from being worth nothing to worth $20M and there’s money behind people’s motivations. You need to have these agreements in place, because things do go wrong.

BARRY: I have business interests. I’m very entrepreneurial. Business-minded. I have a lot of businesses I’m involved in as general counsel and advisor, and I’ve experienced that issue personally where a very close friend of mine, trusted. We went in 50-50 and we had an agreement but it wasn’t enough for the issues that we came up with. Sometimes they’re not enough. But I’ve experienced it and it’s a problem, and if you don’t have an agreement, it’s going to be even worse.

I can share more about those experiences that I have had with my businesses and how I can give that insight to my clients that I work with to help save them the trouble. Anything else to share about not having a shareholders agreement?

CHAD: Yeah, don’t make that mistake.

BARRY: I guess I would say that it’s not just about death, disability, bankruptcy–

CHAD: Someone wants to retire from the business.

BARRY: I should add that. Retirement. What if a partner wants to sell to the neighbor for $1M? Or $1? There needs to be a mechanism in place to keep it in the family, so to speak. That’s called a right of first refusal. You’ll see that in a lot of agreements. There’s also management and who’s gonna be in control, who’s not. There’s liquidation, there’s allocation of profits and losses. These agreements are fairly long, but they’re comprehensive. You do it in the beginning when everybody’s excited they’re going to make a bazillion dollars, be the next Google. You put it on paper and you put it in a drawer and you hopefully never have to look at it again.