Stein Sperling: Will Your Business Agreement Work When Needed?

Is your Corporation Shareholder/Buy-Sell or Limited Liability Company Operating/Partnership Agreement up to date? Does it still reflect what you would want to have happen upon a certain event?

Successful business owners know firsthand that their businesses today rarely resemble the businesses they originally started. Often this is as a result of years of hard work and significant investment. Similarly, agreements that business owners originally executed upon the formation of their company likely have become outdated, and do not adequately deal with the business owners’ or the company’s growing needs because of changes in ownership or other transition events.

In many cases business owners sign their agreements when their companies are first organized and then put those agreements in a drawer until the day they are needed. Here at Stein Sperling, we have seen this on many occasions while working with various businesses throughout the years. Unfortunately, business owners frequently only realize that their agreements do not reflect what they would have wanted at ill-timed, “triggering” events (e.g., a business dispute among owners; the death, disability or departure of an owner; the transition of ownership interests to family members; or the sale of ownership interests to third parties). When those events occur, the agreements may not account for the passage of time and changes in the business.

There are important provisions in agreements of which every business owner must be aware. These provisions may need to be revised from time to time to ensure their effectiveness when a triggering event occurs. They are the following:

The methods or formulas for the valuation of an ownership interest. Such methods may include a stated dollar amount, “book value,” a multiple of profits, a percentage of compensation, projected earnings, appraisal procedures or a combination of methods. The valuation method provided in the agreement at the time of formation may no longer reflect a reasonable method for valuing the business now or in the future given the current status of the company.

Dispute resolution procedures. When people go into business together they hope it will be forever. However, like some marriages, some business owners may find their business relationships strained or deadlocked on certain important business decisions. Further, similar to marriages where children are involved and may depend on their parents for survival, companies have employees that depend on the survival of the company. When there are business disputes, such disputes affect more than just the business owners. It is important to have effective dispute resolution procedures to help resolve disagreements or deadlocks among business owners. They can provide the framework for a “business divorce” that will keep the company intact and viable.

Purchasing a former stockholder’s or member’s interest in the company as a result of a triggering event. Agreements should provide for reasonable payment terms over a certain period of time. This will help ensure that the company has sufficient cash flow and the purchase of an owner’s interests will not prevent the company from being able to conduct business.

Changes in tax laws. Tax laws are constantly changing and reviewing agreements frequently can help avoid unintended, and potentially devastating, tax consequences. For example, in 2007 the Internal Revenue Service issued new regulations under Internal Revenue Code Section 409A; these regulations took effect in 2009. The 409A regulations dramatically alter the rules governing nonqualified deferred compensation plans, particularly with respect to plan funding and payment date elections. Failure to comply with the new regulations can have severe consequences, including immediate taxation of amounts deferred (even though such amounts may not be received until a later year), a penalty of 20 percent and an interest charge.

Changes in circumstances. The growth of a company is a dynamic process and the needs, expectations and circumstances of the owners, as well as the company itself, change over time. Growth and reinvention of a business is often the result of contributions made by nonowners of the company who have become an invaluable asset of the company. Considering adding new owners may allow the company to keep and incentivize vital key employees who have made themselves essential to the future and success of the company. Likewise, issues arise over time that were not contemplated when the company was organized, such as: the involvement of owners’ children in the business; owners’ wishes to “cut back” or change their roles within the company; or the company’s core business becomes static or in decline.

Regular review of the ownership agreement provides a catalyst for strategic planning, which helps the company be proactive in addressing upcoming issues as circumstances change.

Due to the passage of time and as a result of certain triggering events affecting business owners and their companies, agreements must be reviewed and appropriately revised on an ongoing basis so that when the need arises, the agreements will adequately address the business owners’ intentions.

Millard Bennett is one of the founding principals for Stein Sperling Bennett De Jong Driscoll PC, a law firm based in Rockville, Maryland. Millard’s practice is concentrated in the areas of business organization, business ownership conflicts, conflict resolution, transition of ownership interests and civil litigation. His background in business, as well as his experience in running a successful law firm, gives him particular insight into the legal and financial needs of the business clients he serves. Millard frequently speaks on business transitions, disputes and controversy topics to various business and civic groups throughout the Washington, D.C., area.