Defining Business Ownership Transfer
The business ownership transfer is essentially a legal document which outlines exactly how one or more owners of a business will sell or otherwise transfer their ownership interest to one or more new owners. The ownership transfer may involve a change such as an additional new owner, or an existing owner might retire or become deceased, or divorce, bankruptcy, an owner might just have a change of mind, or perhaps just business liability . The ownership transfer document will typically address these scenarios and will help avoid unexpected events from creating major difficulties related to business ownership. It is important to remember that these events do not need to impact the ability of the business to operate. This is not unlike what often happens in larger businesses in a corporate setting, where management transitions from the top down all the time. The future of the business does not necessarily need to be impacted in a meaningful way. But, even with that said, the business ownership transfer should be thoughtfully planned.
Essential Components of Transfer Agreements
Much the same way the original agreement specifies provisions that address the sale, lease or use of the business assets, the transfer agreement will address key provisions in the buy-out of one partner by another. The specific provisions and their headings will vary from each agreement, so the following example list is meant to be only a guideline of issues that typically need to be addressed in any type of Business Transfer Agreement.
Agreement of Parties. This section defines the contracting parties. If the business entity involved is a limited liability company (LLC) or corporation, it would identify the LLC corporation by the full name and include the extent of each partners’ ownership or interest in the business.
A "Recitals" or Background. This section recites the history of the business, the ownership, and states the reason why the buyout is taking place. This section might contain a provision that gives the business an opportunity to purchase back the ownership interest of the firing partner.
Primary Executory Transactions. This section identifies the three basic areas that will be addressed in the contract and gives each a category heading. These areas would be purchase price and terms of Payment, and the duration of the contract. This is also the section where the use of real property owned by the business would be transferred with the rest of the ownership interest. One of the issues that will have to be addressed is whether the canceled partner remained as an officer or manager of the company.
Form of Payment. At the closing of the sale of the business the buyer will have to pay for the business. Unless the seller requires immediate payment in full, the balance may be due after the close. Sometimes payment is contingent upon future performance of the business based on anticipated net profits, and thus involves cash payment calculated on a formula. Payment may also be in the form of securities or an interest in the new business.
Representations and Warranties. The buying party will often assume that the partners’ legal counsel has adequately represented the buyer’s interest, Such an assumption places the risk of future problems with the seller, However, the Buyer can still ask for a Warranty with these provisions:
Indemnification Provisions. A clause that protects the Buyer from having to assume the liability of the Seller should it come to light that there is an undiscovered problem with the business.
Covenants. This section generally states what will or will not be done. It states what the parties agree to do, and what they will not do, such as a non-competitor clause. And it also stipulates what actions the Seller agrees to take regarding the closing of the sale, such as facilitating the transfer of any pending contracts.
Termination Provision. A termination provision states the circumstances under which the buyer or the seller can terminate the agreement and the procedures that will bring closure to the contract.
Varieties of Business Ownership Transfers
The Transfer of Business Ownership Agreement can take many forms. For example, ownership may be transferred in the context of a merger or acquisition. A merger is the combination of two companies into one entity. Usually both companies’ shareholders must approve the merger. In some cases, only the shareholders of the company being merged need approve the merger. An acquisition involves one company purchasing another. The acquiring company must obtain approval from their own shareholders and those of the company to be acquired. The shareholders of the company being acquired usually do not vote on the transaction.
Another form of business ownership transfer is a stock sale. This is when the shareholders of one company sell its stock to another person or other business. Typically, stock sales require the written approval of the board of directors of the company whose stock is being sold. If the corporation has more than one type of stock, the board must approve each type being sold.
An ownership transfer can also happen in the context of the sale of partnership interest in a partnership or joint venture. In these instances, the persons buying the ownership interest need approval by a majority vote of the other partners or members of the business entity.
The Process of Preparing a Transfer Agreement
A. Parties
The first step is to consider the parties to the transfer. If you are only looking to transfer business entities (shares, partnership interest, etc.), you must name the transferor (seller) or transferee (buyer) as appropriate. If you are also transferring assets, it may be necessary to include all of the owners of the entity (including those who are not transferring their interests) so that all owners will receive an equal benefit from the transaction and be able to enforce the transaction provisions.
B. Sale Price
Next, you must determine the purchase price of the transfer. This may include cash, assumption of a debt of the transferor, or other consideration, which is known as "deferred" or "noncash" consideration. You must also determine the timing of the payment of the sale price (such as on transfer of the business, at a later date, or in installments over time).
C. Assets Subject to Transfer
With respect to the business entities you are transferring to, detail all of the business owners’ interests in the transfer section (e.g., shares, partnership interest). You can transfer specific property and contract rights by name (e.g. inventory) or type (e.g., all furniture and fixtures). If a certain property will not be part of the sale or needs to be leased, it can be noted here as well.
D. Assumed Obligations
In the paragraph following the assets to be transferred, you should identify all liens, debts, and obligations that will be assumed by the transferee. In addition, identify any liabilities or lawsuits that the transferee is "stepping into the shoes of," or taking over, from the transferor, and any potential liabilities or litigation brought against the transferor that the transferee will also be responsible for.
E. Schedules
If any further detail is required, such as a complete list of assets and any related contracts being transferred, copies of the business contracts, addresses, and legal descriptions, you should include them as attachments or schedules to the transfer agreement.
Importance of Legal Compliance and Considerations
In addition to the economic advantages of a Transfer of Business Ownership Agreement (TBOA), the legal framework provided benefits for the business entity as well. Clearly documented buy-sell transactions and family succession plans are major key factors that will minimize risk perceptions among legal counsel, accountants, investment firms, banks, and directors and officers (see Aseey et al.). Furthermore, TBOAs can help bolster the business reputation on both a personal and professional level, as long as the written document is formal and explicitly lays out the expectations amongst the parties involved. "Whether sale of ownership is voluntary, corporate stock, or other contractual obligation, clearly defined guidelines are a requirement for the successful operation of the business" (Heim et al.).
A TBOA may also reduce disputes between buyers and sellers by defining key operational and financial details in a way that leads to an easier and more equitable resolution . The American Bar Association (2013) identified some of the most common unresolved issues, such as restrictive covenants, buy-in or buy-out pricing, real estate valuations, pre-emptive rights for minority shareholders, and insurance policies, as issues that a Transfer of Business Ownership Agreement can help to clarify. This bylaw policy can also reduce legal and accounting fees that may arise from transferring the ownership of a business, as counsel can quickly reference the guidelines laid out in the TBOA. Consequently, the TBOA becomes a risk deterrent to third parties who would otherwise be wary of entering into business relationships with the company, knowing the business structure has consented to a clearly defined operational blueprint (see Lombardi and Summers). Overall, legal provisions outlined in a TBOA can positively enhance the operational capacity of the business and the degree of market activity that the business can maintain.
Common Ownership Transfer Pitfalls
Business owners may face numerous challenges when transferring ownership. In some cases, business owners may overlook the need to plan for a buy-sell agreement entirely. Or they may lack the professional assistance to foresee or address certain problems that can impact the timing or price of ownership changes.
Failure to Use Life and Disability Insurance
Even if sufficient death or disability insurance is owned by the business entity on each owner, problems may arise if the insurance proceeds are not paid to the business entity or an individual who has agreed to purchase the owner’s interest in the business.
Failure to Update the Buy-Sell Agreement
Buy-sell agreements must be carefully reviewed to ensure they are consistent with other documents that govern the business, including legally required organizational documents, such as articles of incorporation or bylaws. A business owner may have more than one buy-sell agreement. For example, the business itself may own policies that will purchase the deceased owner’s stock, while the estate may own policies that will provide cash to the personal representative to fund purchase of the business interest from the decedent’s estate. Or the business may be organized as a partnership or limited liability company and financed through loans that must be repaid on sale of an ownership interest. Business owners may change their form of ownership to take advantage of business growth or income tax laws, or to provide for affordable sale of the business to family members. When the ownership form changes, buy-sell agreement provisions should also be changed.
Failure to Plan for the Both the Possible Sale of the Business and For Its Continuation
Buy-sell agreements must address the possibility of both sale of the business and its ongoing operation. Liquidation events may include retirement of an owner leaving the business entity with no continuing owner, bankruptcy or other revenue problems, termination of the business (for example, expiration of a business lease), or the death of an owner. An illustration of how these issues can shape a buy-sell agreement is provided in Estate of Living Trust Dated June 30, 2002 v. Commissioner, 129 T.C. No. 13 (April 29, 2007).
Failure to Consider Qualified Plans, Including Current Employer Plans and IRAs
Depending on the circumstances, the value of the employer plan, which includes life insurance benefits, may be included in the value of a business interest. Thus, failure to value this benefit and incorporate it into the business valuation and buy-sell agreement may lead to challenge by the IRS in the employer plan and by other owners in estate tax audits. Life insurance and retirement plans may also have particular distribution requirements that affect the timing of a consistent distribution of corporate assets to shareholders or partners.
Failures to Anticipate Potential Claims of Creditors of Owners of Business Interests
A buy-sell agreement may effectively remove the equity value of the business due to the economic depression or other business factors. Creditors of the business owner may attempt to secure a claim against the business interest and foreclose on equity in the business that otherwise would be protected.
Impact of Advisors and Other Professionals
The process of transferring business ownership, whether through a sale, inheritance, or other method, is not something that can be accomplished without the help of qualified professionals. Business owners must grasp how professionals can help them create an effective Transfer of Business Ownership Agreement.
Business advisors, such as accountants and financial planners, and attorneys assist in preparing this type of agreement. While legal and financial forms vary by state, a Trade Name Agreement, Transfer of Business Ownership Agreement, Shareholder Agreement, or Articles of Dissolution will often be necessary.
Attorneys and accountants have a big picture view of your business, especially if they’ve worked with you for some time. Because of this, they’ll see what’s missing in your business, and can help you make the decisions that matter regarding your business and its future. These big picture advisors are important to transfer business continuity.
Owners need the legal knowhow of an attorney not just when starting a business, but particularly when transferring business ownership. Likewise, an accountant will assist with illustrating distributions and involvement of co-owners. Together, they create a solid Transfer of Business Ownership Agreement.
An accountant will ensure the overall plan has been created broadly enough to diminish tax liability and legal requirements as much as possible. A Tax Planning Agreement will help you make sound decisions and prevent unnecessary entity taxes.
Insurance agents who deal with businesses are experienced in helping you protect your business from loss that might occur during Transition. They cover property, liability, and business interruption, and recommend coverage that minimizes loss. If you do need to integrate business values, such as carefully choosing and purchasing stock from previous owners, there are financial advisors who will offer the protection you need.
Your business structure also needs to be maintained during Transition. A business broker, like a realtor, assists in marketing businesses for sale and helping you find buyers. Your accountant, attorney, and financial advisors will help pricing the business, but the business broker will ensure it has been accurately represented in the market.
Working with a team of advisors throughout the Transfer of Business Ownership process will help you avoid paying more than you have to for life insurance policies and properly transferring stock and other property. They’ll also have the expertise to assist you in following the rules while covering contingency plans and plans for the future.
No business is immune from facing a Transfer of Business Ownership, and it will be easier on everyone if you consult others about how to make the process go as smoothly as possible.
Examples of Transfers and Case Illustration
In one case, a successful middle-market manufacturing business was owned by three brothers. For many years they had been trying to grow the company but had difficulty gaining traction against low-priced global competitors. A long-term bank relationship manager then had the foresight to recommend overhauling the business structure to improve management effectiveness and financial agility. The three brothers each had different management styles and different degrees of investment in the success of the company. One brother had an engineering background, another a manufacturing background and the third a sales background. So, under the guidance of their business consultant, they created an L.L.C., divided the assets into three parts, and shifted each member’s responsibilities according to their core competencies. The change came with its share of challenges, but ultimately produced a substantially more valuable company. Feeling better motivated with new responsibility and more control, the three brothers grew revenue ten percent a year. Two years later, they sold the business for almost double the price they would have achieved prior to the management restructure.
In a different situation, a national services business was acquired some years before at a fair price but during a recession . After the recession, the company should have experienced strong growth but did not. A deep-dive due diligence investigation took place. This included an exhaustive review of the company’s compensation plan; it revealed that the top two tiers of unvested stock options, contingent on top management achieving certain financial results, carried an aggressive leverage ratio of 75 percent. This proved to be an enormous disincentive for the management team and the owners. The seller’s management reimbursement was excessive and should have been substantially less. Although the acquired business had escaped with high value from the recession, the new owners had not managed it effectively once the company was in their hands. With this knowledge in mind, the buyers negotiated pricing, taking into consideration the reimbursement overhead that was reduced once acquired. The buyer ended up paying a much lower price for the business because it expected to invest a substantial amount of time and money in order to maximize the success of the acquisition. It was the business ownership transfer agreement that became the means by which the new owners evened the scales—rather than merely minimize the risk associated with it—forcing the sellers to take some of the risk inherent in a sale.