Business Harmony and the Ownership Preservation Agreement

Date: Oct 16, 2002

Your business co-owner, Lynn, decides it is time to do something different.  In order to raise money for her new passion, she sells her business interest to someone with whom you do not get along.  You are now in an unwanted business relationship which creates tensions that put you and your company ("Company") at risk.  Could this have been prevented?  "Yes" if you have in place an "Ownership Preservation Agreement" ("OPA").[1]

What An OPA Offers When certain pre-specified triggering events occur, an OPA establishes a procedure for the transfer of your Company interest ("Company Interest") in a way that is fair to you and your family and Lynn and her family.  It provides a foundation for continuity and harmony in Company ownership, management, and policies.

How An OPA Works An OPA is your standing commitment to buy Lynn's Company Interest, or sell your Company Interest to her upon the occurrence of a "triggering event".  You may want the right to compel Lynn or Company to purchase your Company Interest if you cause the event.  If you are not the cause, a right of first refusal or the ability to "call" and purchase the Company Interest may be all you need.  These obligations take one of three agreement forms: 

    • In a Cross Purchase OPA, you must sell your Company Interest if you experience a triggering event, and Lynn must buy your Company Interest.

    • In an Entity Purchase OPA, Company is the buyer. 

    • In a Hybrid Purchase OPA, Company has the option to buy your Company Interest, and, if the option is not exercised, Lynn then has purchase rights.

The obligations that appear above as mandatory can be optional. 

Triggering Events You should examine your need for an OPA by considering what happens in the case of five common triggering events:  death; disability; divorce; disagreement; and voluntary disposition (the "Five Ds").

    • Your death could leave your family vulnerable.  Lynn may wish to maintain current salary levels rather than make distributions in the form of dividends.  If her efforts are the real value behind Company, your family's financial security depends on her. 

    • A mental or physical disability may leave you powerless to contribute to Company, and can lead to friction between you (your representatives) and Lynn.  Your disability could force your representative to take steps to dissolve Company in order to raise money to provide for your legitimate needs.  

    • If you divorce and live in a state that gives your spouse some right to assets acquired by you, it may be impossible for Company management and owner relations to continue harmoniously in the midst of a property settlement dispute.   

    • You and Lynn begin to disagree more and more over business operation, policy and direction.  Creeping dissention can lead to stalemate or distrust.   Business acrimony may become personal, and everyone may suffer.  As a result, you want out.

    • For reasons that may have nothing to do with your unhappiness with Company or Lynn, you want to sell your Company Interest. 

If you have any doubts that your family or Lynn will do the right thing if any of the Five Ds occurs, an OPA can alleviate them by providing a way for you to be bought out (or to buy out Lynn) on friendly terms, and in a manner fair to everybody.  The agreement can be tailored to permit transfers of Company Interests to family members or other specified persons outside of any refusal rights or purchase obligations.  This exception may be important to you and Lynn if you both want to sell or make gifts to family members of your Company Interests.

Where Owners Are Not Individuals. An OPA is not limited to existing multi-person businesses owned by individuals.  Start-up and existing corporations, partnerships, limited liability companies, and joint ventures whose ownership consists of entities should make use of an OPA.  In these cases, the Triggering Events typically include direct transfers of the business interest and indirect  transfers of the business interest, that is, a change in the ownership of an owner.

Getting Fair Value. There are several traditional methods to determine the business's fair market value and to set the purchase price for your business interest; namely, agreement by the parties, third-party appraisal, or formula valuation.  Some owners actually solicit offers from unrelated buyers as a means of establishing value.  These methods raise their own unique questions.   

    • If you use agreed price:

      1. Is the price realistic under current circum­stances?

      2. Will the price be periodically reevaluated?

      3. What are the consequences if the reevaluation is not done?

    • If you decide on appraised FMV:

      1. When is FMV to be determined?

      2. Will there be periodic reevaluations of FMV?

      3. How is the appraiser selected and paid?

      4. What guidelines, if any, should the appraiser use in valuing specific property?

    • If you use a formula:

      1. How are book value, earnings, cash flow or such other agreed upon financial barometer defined?

      2. Will there be periodic reevaluations?

      3. What are the consequences if the re­evaluation is not done?

A System of Checks and Balances to Verify FMV. These methods evaluate results from data, and make assumptions and comparisons as to, or in order to get to, the worth of Company and your Company Interest.  None contains a methodology to make sure that the price to be paid by you, Company or Lynn is indeed fair.  How can you be assured of getting a fair price for your Company Interest from Lynn or any of the other parties to the OPA?  How can those parties protect themselves from overpaying?

The answer lies in having an OPA with a marketing process.  Clients like this approach for a number of reasons:

    • The process assures all parties to that agreement that the valuation method price represents true FMV when paid because third party bids are solicited and received.

    • The buyer does not overpay because the price is reduced if the market sets a lower price than that determined by the valuation method. 

    • The process protects overall value because the company must be sold as a whole if remaining ownership is not interested in making the purchase, and remaining ownership from having to match an inflated, unrealistic price. 

    • No owner is precluded from selling because the agreement ultimately forces all parties to agree on a price or go to arbitration. 

Funding the Purchase Price. When you have decided upon an OPA, and agreed upon the triggering events and valuation methods, you will face a practical question - "Where does the money come from to pay the price?"  The answer involves a complex financial and tax analysis of different funding mechanisms, including insurance.  These mechanisms together with methods of arriving at fair value raise their own unique questions that should be discussed thoroughly with the person who drafts the OPA.

Conclusion. Multi-owner businesses present management challenges.  An OPA becomes more imperative with each generational passing of business interests and as the business grows.  Without an OPA, you may be forced to work out all of the details surrounding a transfer of your business interest at a time when your negotiating leverage is compromised.  Consider an OPA an integral part of your business investment and owner relations, to be put in place before one of the Five Ds pits you and your family against Lynn and her family.  No one should leave such decision-making to chance. 

David I. Reader is a corporate and business attorney with tax law training in Keller and Heckman LLP's Business Counseling and Transactions Group. His practice revolves around counseling clients on business entity choice and formation, business entity internal operations and governance, service and product rollout, alliance and consortium building, debt and equity financing, sales, mergers and acquisitions. This article is designed to provide accurate and authoritative information in regard to the subject matters that are covered.  It is published with the understanding that, in this publication, neither the author nor the publisher is engaged in the rendering or solicitation of legal, tax, accounting or other professional services.  If legal advice or expert assistance is required, the services of a competent professional person should be sought.  (From a declaration of principles jointly adopted by a committee of the American Bar Association and a committee of Publishers and Associations)  Keller and Heckman LLP, 1001 G Street N.W., Suite 500 West, Washington, D.C. 20001; Telephone 202-434-4187; Facsimile 202-434-4646; E-Mailreader@khlaw.com.

[1] A "Buy-Sell Agreement," "Cutthroat Buy-Sell Agreement," "Transfer Restriction Agreement," and "Right of First Refusal Agreement" are some of the various references to an OPA.