Case 1: Joe and Pete have grown their New York financial services corporation, started from Pete’s living room 5 years ago, into a thriving operation with 25 employees, $4 million annual revenues and little debt. Pete received an even more lucrative offer of employment and wants to sell his 50% share to Joe, but they’re light years apart on price and Pete is threatening dissolution. They always meant to do a shareholders agreement but never got around to it. Is Joe out of luck?
Case 2: Since 1996, Sue, Jane and Alex own and manage, through a series of limited liability companies (LLC), several commercial properties in New York City. Jane recently surprised Sue and Alex with a 6-month notice of withdrawal from the LLCs and a demand to be cashed-out for the “fair value” of her membership interests. Cash flow from the properties is not enough to finance a buy-out. Sue and Alex’s new lawyer informs them that the operating agreements don’t address the right to withdraw, hence Jane’s demand is valid under the LLC statute’s “default” provisions. He also tells them that a simple modification to the operating agreements, to take advantage of a 1999 amendment to the LLC statute, would have avoided their predicament. Will Sue and Alex be forced to liquidate to satisfy Jane’s demand?
The above scenarios highlight some of the myriad problems faced by closely held businesses with multiple owners who either neglect to do owner agreements or, having done an agreement, fail to update them to reflect changes in the law and other new circumstances. Such neglect is more common among the smaller businesses that prefer not to spend scarce resources on lawyers. But frequently, even with large businesses, owners are reluctant to formalize or introduce legal change into what seems like a good working relationship. That’s a mistake with potentially disastrous consequences.
First, some basic terminology. The three prevalent business forms are (1) the corporation which has shareholders and is governed by its board of directors; (2) the partnership which has general and (sometimes) limited partners and is governed by the partners; and (3) the LLC which has members and can either be member-managed or manager-managed. In New York as elsewhere, corporations and LLCs are formed by filing, respectively, the certificate of incorporation and articles of organization with the secretary of state. These bare-bone filings, however, do not usually address ownership rights and obligations in any meaningful fashion, which is precisely the function of a good shareholder, partnership or operating agreement.
The owners’ agreement (a term I’ll use to refer to all three types) is the relationship roadmap and insurance policy against “business divorce” litigation and other kinds of nasty ownership and management disputes down the road. So long as the agreements do not violate public policy, the courts of New York, as in every other state, will eagerly enforce the wishes of the owners as expressed in their agreement. The up-front investment in time and legal expense is small when measured against the potential for litigation and other costs of not having an agreement. In some instances, just going through the exercise of putting together an agreement can expose rifts that persuade prospective co-owners to abandon the proposed enterprise.
Likewise, owners’ agreements done years ago—typically at the start-up stage—periodically should be reviewed and updated by qualified counsel. As a lawyer I never cease to be amazed at the number of privately-held companies, with revenues in the many millions of dollars, whose owners continue to operate under boilerplate agreements prepared decades ago when the business fit in a shoebox. As a business grows it requires more sophisticated structures for decision-making on a variety of issues—management, personnel, financial, distributions, tax and retirement planning—that may be out of sync with the initial owners’ agreement. In addition, there may be frequent changes in the law brought about legislatively or by court decision that also warrant updating of the owners’ agreement. This is particularly true of LLCs which New York first authorized in 1994 and which have not yet generated an extensive body of case law construing the LLC statute.
What issues should the owners’ agreement address? Space limitations preclude an exhaustive list, but any agreement will certainly need to address some if not all of the following: