Unexpected events happen. It is a common theme in virtually all facets of life. Planning for such events seems, at first, counterintuitive. If you could plan for them, then they wouldn’t be unexpected. However, Shareholder and Operating Agreements typically provide an exit strategy for active owners in the event of death, disability, divorce, creditor action, termination of employment and deadlock to minimize complications for all involved.
For purposes of simplicity, I have used the term shareholder or stock but the concept is equally applicable to members and units of a limited liability company. The documentation normally defines the stock value by formula, appraisal rights and/or annual agreement. Payment terms are frequently negotiated as part of this documentation so that the payment structure is realistic and does not require bank financing.
Often, the purchase of shares at death is funded with life insurance. Life insurance offers a great deal of liquidity to the family of the deceased shareholder and minimizes the impact to the company. The purchase price and payment terms under a shareholder agreement for disability frequently mirrors the provisions at death. Unfortunately a lump sum disability insurance policy that would provide liquidity to the disabled shareholder to purchase the shares is not cost-effective. The disabled shareholder will require payments to amortize the purchase price that the company may not be able to afford from its cash flow.
In a disability situation, purchase price does not necessarily have to be equal to the purchase price at death. Most often, the purchase price at death could be phrased as the stock value as agreed or the net insurance proceeds, whichever is greater. The company value should not be the optimum value that a strategic buyer would offer. The purchase price instead is a balance of the needs of the disabled or deceased shareholder’s family and the additional risks to the remaining shareholders. The shareholders are now faced with replacing a key officer of the company. They also have greater economic risk as the company value is a larger part of the remaining shareholders’ net worth. Still another risk may involve the loss of an exit strategy if only one surviving shareholder remains.
At a minimum, the disabled shareholder should have disability insurance that is privately purchased. The company may bonus additional compensation for the policy especially if the shareholders are rated differently. A private policy normally insures 60% of the earnings of a shareholder and if the premiums are paid with after-tax dollars, the insurance proceeds are income tax-free. Thus, the net insurance proceeds would approximate the net take-home pay of the shareholder to meet the family obligations.
By way of a stock purchase, the owners have two options:
Amortization. The purchase price may be paid over a longer period of time than in the case of death, which typically has life insurance to supplement the payments. If the company does not have sufficient earnings or it is experiencing growth pains in which all of the after-tax profits need to be reinvested for inventory and other company needs, an amortization over even a longer time period may prove unrealistic. Keep in mind that the remaining shareholder will need distributions equal to the income tax obligations imputed on the earnings of the company, provided that the corporation chooses to be taxed under subchapter S of the Internal Revenue Code or is a limited liability company.
Retention of Shares. If the company cannot afford to buy the shares, a second option is to have the disabled shareholder retain the ownership interest. This allows the disabled shareholder to participate in the future growth and earnings, but also risks of the ongoing operations.
Often the remaining active shareholder is not comfortable with this arrangement, especially if the company is aggressively growing. The shareholder may feel that all future growth is due to their efforts without the contribution of the disabled shareholder. This attitude however should be tempered with the realization that company risk is also shouldered by the disabled shareholder who no longer is actively participating in the decisions of the company.
The disabled shareholder should have some safeguards to protect his ownership interest such as:
I. The active shareholder should have greater compensation for the additional responsibilities, but have agreed to limits;
II. The Company will be required to make distributions to shareholders for a greater percentage than just the taxes;
III. Should the company profits not generate significant dividends, the disabled shareholder should have a right to force the purchase of his or her shares at an appraised value, less a discount for lack of marketability or control. The discount is designed to discourage an easy exit by the disabled shareholder. At the same time, however, the net purchase price with the discount should be paid in a lump sum which should effectively encourage the active shareholder to generate sufficient profits to avoid the lump sum payment.
If reasonable financing terms aren’t available then the discounted payments would bear interest at over the prime rate to reflect a higher risk of the loan, with a longer amortization period. In addition the agreement should consider collateral or guarantees for the installment payments.
The scenario and approaches described in this article are by no means comprehensive but should serve to give the shareholders a number of topics to consider in negotiating the terms of their agreement. At Kreis Enderle, we are frequently engaged to help clients plan and navigate these future decisions and reach agreements that are mutually beneficial whether the shareholder is buying or selling the shares. It is always prudent to expect the unexpected and prepare accordingly.