One important issue that individuals organizing a new business entity must consider is what will happen in the event one of the owners wants to voluntarily withdraw from ownership in the entity. By “withdraw”, we mean that the owner wishes to return the ownership interest (stock for a corporation or membership interest for a limited liability company) to the company or to the other owners in exchange for some form of compensation. This issue is commonly overlooked in the organizing process, perhaps because the ambitious and optimistic organizer is not mindful of the fact that one day he/she may want to leave. As a result, many new entities do not enter into written agreements dealing with this important issue.
It is essential that the owners consider this issue as part of the organizing process. Some common reasons for an owner wanting to withdraw are the following:
1. Disagreement with the business direction of the entity;
2. A falling out with the other owner(s);
3. Relocation, medical problems or other personal reasons;
4. Desire to cash in the investment or the need for money.
The place to insert a withdrawal provision for a limited liability company is the company’s operating agreement. For a corporation, it is a shareholder agreement. Here are a few common ways to handle a voluntary withdrawal:
1. The withdrawing owner automatically forfeits his/her ownership interest without compensation;
2. The entity or other owners are forced to buy-out the withdrawing owner’s interest for an fixed price or a price set by a formula (some formula examples are: appraisal by expert, book value, or a multiple of earnings);
3. The withdrawing owner can sell his/her interest to a third party bona fide purchaser after giving a right of first refusal to the company or other owners;
4. The entity has the option to buy-out the withdrawing owner’s interest for an agreed price, which if not exercised, allows the withdrawing owner to retain economic ownership rights (i.e. right to receive profits), but lose other ownership rights (i.e. the right to vote on business decisions).
In crafting the withdrawal provisions, organizers should take into account the respective duties of the owners to the business. If the income of the business is directly generated by the services provided by the owners (i.e. doctors of a medical practice or attorneys of a law firm), the organizers should probably avoid a situation where one owner can withdraw from providing services, but continue to receive the profits of the business. For those entities, options 1 and 2 above are more suitable. On the other hand, for entities with passive investors, the owners may prefer option 3 or 4 above.
If the entity is going to use a forced or optional buy-out mechanism, it is critical that the agreement clearly states how the buy-out price is determined, and when the withdrawing owner will be paid. Most buy-out formulas are tied to the profit of the business in previous years, plus the value of existing assets. When crafting the buy-out mechanism, the owners should take into account the projected cash-flow of the business and hedge against the risk that the company will be unable to buy-out the withdrawing owner in a lump sum.
The attorneys are Gross & Romanick are well-versed in structuring operating agreements and shareholder agreements to suit the specific business needs of their clients, including carefully crafting withdrawal provisions.
