The Risks of Not Implementing an Owner Agreement

Owners of small to medium sized businesses want to realize the maximum value for their business interests. There are many risks preventing realizing maximum value for a business interest – most can be avoided by the implementation of an owner agreement.

Where an owner does not hold a controlling interest, there is the risk that the owner will not have control over the outcome of certain business transactions that may diminish or terminate the owner’s interest.

There is an increased risk of misunderstandings and conflicts. Where there is no written owner agreement, there are no defined rules for how the business should be run, how decisions are made, how profits are distributed, or how disputes are resolved.

The risk of failing to secure a loan or investment is increased. Banks and investors often want to see a comprehensive owner agreement.

What happens if one owner wants to leave, retires, becomes disabled, or passes away? The termination of an owner’s interest can happen through involuntary circumstances, such as death or disability, or through voluntary withdrawal for personal, family, or other reasons. Without an owner agreement containing buy-sell provisions, the risk of the remaining owners being forced into business with an uninterested or inexperienced third party (such as a spouse or child) is increased. Also, the risk of the business being forced into a costly and time-consuming dissolution process is increased.

Most businesses do not have an owner agreement among the owners because it is difficult to negotiate and implement an owner agreement among the owners of a closely-held business. Often the subject matter is difficult to discuss, and the pressures of operating an owner-managed business make it difficult to find the time needed to accomplish this task. The benefit of implementing an owner agreement for the owners of a small to medium-sized business is that for each owner the risk of not realizing the maximum value for the owner’s business interest is greatly reduced. This makes implementing an owner agreement worthwhile.

As with most complex and difficult tasks, it is best to use a segmented approach and address the various issues one at a time.

The issues that must be discussed and decided upon can be generally described. The business entity type of the business should be understood and described in terms of liability and tax consequences for each owner. The group of individuals or entities that own the business should be defined and appropriate restrictions should be put in place. The governance of the business, including who will make policy and who will be the chief executive, should be clearly specified. The events (triggers) that will cause one or more owners to transfer interests in the business should be defined. The procedure of the transaction occurring after each type of trigger, including funding and payment, should be provided for in detail. For each transaction, the determination process of the price of the transferred interest should be clear. If the business will act as a buyer in certain procedures, then the means of the business accumulating the funds for the transaction should be provided for in detail. A dispute resolution process should be described. The final task is the consolidation of the decisions into one coherent written document.

There should be a meeting of the owners and appropriate stakeholders to discuss each one of these general issues. For each issue there should be a separate meeting. The meetings should be held at regular intervals. The decisions resulting from the meeting discussions must be documented in writing. Where issues are technical or outside resources would be helpful, they should be utilized. The documented decisions resulting from these discussions, consolidated into one coherent document, will constitute a succession plan for the business.

The succession plan is the basis for the drafting of the owner agreement, a written document. Even though this is a written plan to which the owners have agreed, each owner must have separate counsel to review and advise each owner concerning the written owner agreement.

With an owner agreement in place there will be an agreed-upon rulebook for operating the business. This will prevent disagreements and help keep focus on business success. Moreover, the business will be protected from unexpected events ensuing a smooth transition if an owner leaves the business.

The owner agreement is a way to document the strategy of the owners to realize maximum value from their business interests. This is the Prior Diligence Strategy accomplished through Dynamic Planning. These concepts are explained in detail at the Owning a Business Substack at rickriebesell.substack.com.