Structuring an Agreement that Works
I spoke with George Pappas, a Clearwater, Florida-based attorney specializing in business and title law. Pappas says that if a company is structured as an LLC (Limited Liability Company), the owners have flexibility to change the operating agreement to add members and change their roles according to the needs of the company. LLCs have the benefits of a partnership structure with the protection of a corporation, so the operating agreement can be changed as circumstances change over the years. “An LLC allows an owner to create a structure for acquiring shares of the company, usually through an employee agreement,” he says. “The key is to have clear and explicit definitions of the roles and limitations the new minority owner would have.”
Once a timeline for the owner’s exit has been established, the operating agreement can define how the key employee’s minority ownership will work within the company. Owners don’t generally gift the ownership to employees; it’s more common to have the employee earn shares through years of service or a cash buy-in at an agreed-to price. It’s common for the owner to gradually back out of the business, letting the key employee take on some operational duties while learning from the owner, who still maintains control of the company.
Since owning equity in the company has tax implications for the employee, he should take time to consult with his accountant to make sure the agreement Is structured properly for his financial situation.
Expectations can change with ownership, and the current owner will have to think carefully about how the personalities will be able to get along. Will this employee make a good business partner? Does this person have strong relationships with other staff, and will things remain smooth when circumstances change? Will the other employees feel slighted? How will you handle those issues if they come up?
A well-written agreement helps the owner avoid conflict with the new minority co-owner, says Pappas. Defining roles clearly will prevent disagreements and legal wrangles over financial and business issues that can ruin the relationship and harm the company.
The aim of the agreement is, of course, to let the owner exit the company. The operating agreement usually allows the key employee to have first right of refusal on purchasing the company. The agreement should also clearly specify what happens if the employee does not want to or is not able to purchase the company or leaves before the agreement timeline. They’ll also have provisions for what happens if the company’s value changes dramatically for the better or worse.
Even if the employee cannot buy the company, he also cannot stop the owner from selling. So-called “drag along” clauses prevent a minority owner from holding up a sale to a third party when the owner is ready to sell, though they often include compensation for the shares the minority owner holds.
George Pappas says that selling the company to key employees is a valid way to reduce risk for the organization and its future performance, ensure continuity for customers, workers, and vendors, and maintain the goodwill which is a significant part of the company’s value.