Co-Owner Transfer Scenario
What is a Co-Owner Buyout?
A Co-Owner Buy-Out is a Transfer Scenario where one owner of a business, or the business itself, is purchasing or “buying out” the ownership interests of another owner. Usually this transaction occurs when one owner is ready to retire, is leaving for personal or financial reasons or there is unresolved conflict in the business.
Who Does This Transfer Scenario Apply To?
These types of internal transfers occur in each of the business entities (corporations, limited liability companies, partnerships and business associations), and relate to the shareholders, members or owners of the business. The outcomes of these Transfer Scenarios are typically dependent on the terms and conditions agreed to by the co-owners in the “buy-sell” section of the existing shareholder, operating or partnership agreement.
How Does a Co-Owner Buy Out Work?
If the owners have detailed and legally sound “buy-sell” provisions in their shareholder or operating agreements, the co-owners will use those provisions as a road map for valuing the company, determining the purchase price for each owner’s interests and the “buy-out” process. The provisions will address:
- The purchase price and payment process
- The conditions or requirements to be satisfied before the owner can sell their interests
- The timeline for the sale and payment of the purchase price
- What the departing owner transition obligations will be after they sell their interests
- What to do in the event there is a break down in the process.
In the event these provisions don’t exist, or they become obsolete given the changing needs of the involved parties, the parties must consult an experienced business attorney or transition advisor to help work through each concern before continuing with the co-owner buy-out.
The co-owner buy-out process normally begins with the parties responding to a set of key considerations and questions to address these issues. They work to get everyone’s perspective and to better understand all goals and objectives of the owners and the business. The advisor uses that information to facilitate consensus on the key issues and the outcome is a set of written agreements customized to meet the needs of the co-owners which enables the company, or other owners, to buy-out the interests of the exiting owners on mutual terms.
Actual transaction terms for the buy-out will vary based on the price, financing terms and value of the business. Most co-owner transactions consist of some cash up front and seller financing over a period of 2-5 years.
What Happens after the Co-Owner Buy-Out?
At the end of every co-owner buy-out, the parties will amend the company records and all other internal documents to reflect that the seller owner is no longer empowered to conduct business on behalf of the company and that the successor owners are now in charge.
There will also be a series of legal provisions to protect the successors from liability incurred prior to the effective date of the transition. They also protect the seller owner from any liabilities incurred after the transition date.
What Can Go Wrong with Co-Owner Buy-Outs?
As with any type of business transition, there are serious concerns to be aware of and pitfalls to avoid.
First, it’s critical that buy-sell terms are established early on in the business, ideally when it’s created. Experience tells us that co-owners will have close to equal value and leverage before the business generates income or builds value, however their value in the business may vary greatly after the business builds value.
Once operations begin, co-owners typically focus on their part of the business. It’s common for one or more co-owners to develop the belief that their contributions to the business are more valuable than the contributions of the other owners. As a result, they may not want to address these issues, fail to appreciate the value of their co-owners, or more importantly, not be able to reach consensus on the key issues.
Another major concern to address up front and each year thereafter is determining the value of the company through the valuation process.
It’s critical that the parties agree:
- How to value the business (i.e. what valuation formula)
- Who is to conduct the valuations
- How often to conduct valuations
- When to conduct valuations and for what purpose
- Whether the valuation will be binding upon the parties
Ideally, these issues should be addressed before the business gets off the ground and begins to build value.
Lastly, it’s important for co-owners to agree how they will resolve any issues related to the buy-out process without having to litigate. Ideally, there should be a “deadlock provision” within the buy-sell terms to describe how the co-owners will mediate a resolution in the event of a stalemate, and/or work through a mandatory buy-out in the event they cannot resolve their differences.
Absolute’s Recommendation for a Co-Owner Buy-Out
We’re supporters of working through the buy-sell issues at the onset of the business, anticipating that the needs of the parties and the business will change over time. If the business is already in operation the co-owners should contact their attorney and establish these buy-sell terms immediately.
Have your buy-sell provisions reviewed and amended periodically (at least every two years) by a trusted advisor to address all current issues. Also ensure that the provisions meet the needs of the co-owners when one decides to retire or withdraw from the business, becomes deceased and or permanently disabled or experiences financial insolvency or bankruptcy.