Involuntary Transfers: I'm Doing Business with Whom??!!
- posted: Aug. 06, 2021
Death, divorce, and bankruptcy each trigger a legal process that can result in an involuntary transfer of ownership interests in an entity. If ownership interests are owned by multiple people, everyone is affected.
The death of a partner does not erase his or her ownership interest, but it does bring about immediate changes. For many LLCs, the members are not on salary. Members are allocated a percentage of profits, and hopefully, that percentage reflects their day-to-day contribution to the success of the entity – either in the investment of capital or in daily service. When a member dies, that allocation does not stop even though the day-to-day contribution of service ends. This can become very unfair to the surviving members who continue to keep the business going and who continue to build value in the business.
In time the decedent’s heirs will step into his or her ownership shoes but will probably not make any meaningful contribution to the daily operations of the business. They expect to (and can) reap benefits without sharing burdens. Moreover, as the value of the business grows, they share in the increase of that value without contributing to its growth.
Divorce can lead to a similar division, but with an ex-spouse added to the mix -- often not a very friendly (or comfortable) arrangement. Many property settlement agreements in a divorce prevent that outcome, but at what cost to the divorcing member?
Bankruptcy allows the highest bidder to acquire the bankrupt member’s interests. Much like the scenario following the death of a member discussed above, those purchasers are positioned to reap the benefits without sharing the burdens. Some years ago, I represented a small Houston-based company owned by a father and son. The son filed a Chapter 7 bankruptcy unrelated to the business, and his ownership interest in the business was sold at auction. Fortunately, we found out about the pending auction and the father purchased the interest, but not without first going through a bidding war with a man from Phoenix who made his living trolling bankruptcy filings looking for opportunities.
When I counsel clients starting a business, I ask them, “If your partner dies, do you want to be in business with his kids? Or his wife if he divorces? Or his creditors if he goes bankrupt?” People pick their business partners for a reason, so the answers are predictable.
The solution to these issues, and several others including long-term disability, is a shareholder agreement which identifies each of these as a triggering event, giving the business (or the remaining partners) a purchase option at fair market value in installments low enough to not strip the business of the cash flow it needs to survive. And that’s the goal, to survive.
The following table, taken is a table, from my model Shareholders’ Agreement form, summarizes the various triggering events, notices, and deadlines established by that Agreement:
As you can see, there are a variety of issues to consider – all of which are foreseeable -- and all of which can be planned for ahead of time in a manner that protects the survivability of the business and the interests of each owner.
Unfortunately, I am finding that more and more people are forming their entities using online discount services. Sure, they only spent $500, but at what cost? This an area where to call the maxim, “An ounce of prevention is worth a pound of cure” an understatement -- is itself an understatement.
I have seen successful companies, and, just as often, marginally successful companies perceived to be successful by an outsider, spend tens of thousands of dollars on legal fees dealing with the consequences of involuntary transfers, followed by several years of payments to buy someone out – usually someone they never sought to benefit from the business at hand.
All of this is avoidable with proper planning.
May you find joy in what you do and who you are with.