In my previous post, I talked about what is arguably the most important, but often most overlooked, component of a shareholder agreement – the buy/sell clause. This mechanism establishes the ground rules for the orderly transfer of an ownership interest.
I’ve seen a lot of unfortunate situations in my work—shareholders who pass away, become ill, succumb to substance abuse, endure personal crises that derail their business focus, or simply fail to fulfill their obligations to their business partners. Without a well-written buy/sell clause, any of these scenarios can cause undue hardship and financial loss for all of a business’s stakeholders.
Take Howard, for example. He is the successful owner of a manufacturing company that makes products using composite technology. He owns 40 percent of the shares in the company. Three other shareholders each hold 20 percent.
Howard and his wife have three children. His wife doesn’t work, and depends on the income generated from Howard’s ownership interest in the company.
Then Howard dies, without a buy/sell clause in the shareholder agreement. This leaves his wife with his 40 percent ownership interest in the company, but she has no intention of actively participating in the operations of the company. She needs the proceeds from the sale of Howard’s 40 percent interest to provide for herself and her children.
The other shareholders don’t want some unknown party acquiring Howard’s shares, but they do not have the funds available to buy Howard’s interest. They also have the added challenge of finding someone with Howard’s expertise to take over his role with the company.
Fifty percent of the company’s revenue comes from a single customer. Seeing how uncertain the future of the company has become, this customer is considering taking its business elsewhere.
Without this customer, the company’s value could plummet. Employees could be out on the street. The potential loss of value may result in Howard’s wife having to sell her shares for a fraction of what they were worth when Howard was alive.
How much value will Howard’s wife lose? How will this impact her ability to provide for herself and her children?
Now, if there had been a proper buy/sell agreement, it would have:
- Provided a mechanism for how and when the remaining shareholders could purchase Howard’s shares.
- Defined how the other shareholders could have funded a purchase of Howard’s shares to ensure liquidity for his wife. Funding is often accomplished through a life insurance policy.
- Ensured the shareholders would have agreed on the method that would be used to determine the purchase price of the shares.
In my next post, I’ll recount the outcome of a more positive scenario, in which the shareholders did it right from the outset, to their mutual benefit.