Friends + business partners = Recipe for Disaster OR makings of success?
There are often times we are called upon to make a ‘captain’s call’ on various company situations when business partners are in dispute. As the company accountants, we are the ‘trusted advisors’ and when partners cannot resolve an issue amongst themselves, they often reach out to the ‘voice of reason’ for the solution.
Unintentionally this puts us in an unenviable position, especially when we might be personal friends with both or all shareholding families.
One situation that can arise (thankfully not often) is where one of these shareholders has unexpectedly passed away. We are generally contacted shortly after the event, and given a brief from the grieving spouse and their business partner (and close friend) that involves ‘sorting it all out’.
Our commentary below focuses on what can happen if this unfortunate event is not considered at the outset of any business relationship between friends, and is true for any business relationship.
Imagine the following scenario….
Aaron, Jeff, and Josie are shareholders in a relatively new company that is already experiencing success. The shares in the company are owned according to the expected level of contribution to the business, 35%, 30% and 35%. Aaron and Jeff have known each other since high school and their families are close friends. Josie is an acquaintance of Jeff’s and is well known in the industry as being very talented.
The business continues to grow, and late last year at one of their Director lunches, they all agreed that they thought the business was worth about $5million.
Tragedy strikes one weekend, and Jeff is killed in an accident.
Putting aside the emotional stress of this recent news, we, as accountants, are shortly thereafter called upon to ‘sort it all out’.
The actions and outcomes that come into play with this company and the underlying business in the next few months can go down two distinct paths depending on whether the Directors have planned and prepared for shareholder issues or whether they have not.
Fact: If there are no pre-existing arrangements in place, the death of a shareholder can mean having an unknown person (the beneficiary of the shares, in this case Jeff’s partner) actively involved in the business or an unwilling shareholder as part owner of the business. Jeff’s shareholding (30%) and the attached rights, transfer through his Estate to his partner.
The remaining original shareholders (Aaron and Josie) are not satisfied with this arrangement as Jeff’s partner has not worked in an office for more than 20 years, and has not been happy with the way the company is being run.
This is a real dilemma for Aaron and Josie. They could offer to buy back Jeff’s shares from Jeff’s partner, but they are not guaranteed that Jeff’s partner will sell them the shares. On the other hand, if Jeff’s partner did want to sell the shares, would Aaron and Josie have enough free cash to buy those shares? And even if they did have free cash available to purchase the shares, there is no guarantee that Jeff’s partner will agree to the value that Aaron and Josie put on Jeff’s shares. Previously they imagined that the company was worth $5million, so 30% would be $1,500,000.
As you can see there are tough times ahead for the company.
Consider now, a situation where Aaron, Jeff and Josie, took advice and prepared a Shareholders’ Agreement that considered many other issues as well as the death or incapacity of one of the shareholders, and they also prepared ‘Buy-Sell’ agreements, for precisely this situation.
Buy-Sell agreements are legal agreements that define exactly what happens in a series of scenarios (including death) that may result in the disposal of one shareholder’s shares in a company. The Buy-Sell agreements specify how the company will be valued (and by whom) and how the shares (including Jeff’s) will be managed, after a specific occurrence.
Aaron, Jeff and Josie’s Buy-Sell agreement specifies that Jeff’s shares will be purchased by Aaron and Josie. When they were finalising the agreement, the shareholders made sure that sufficient insurance policies were taken out to fund situations just like this. Therefore Aaron and Josie will use the insurance proceeds to purchase Jeff’s shares from Jeff’s partner at the value as determined according to the terms in the agreement. The value determined in accordance with the agreement was actually $7 million, therefore Jeff’s partner received $2,100,000.
As a result, the buyout of Jeff’s shares is at no cost to Aaron, Josie or the company, other than the annual insurance premiums, and they now have full control of the company again. Jeff’s partner receives a cash payment of $2,100,000 as determined by the agreement and has no further connection to the company and underlying business.
If you are in business with other shareholders, you and your business face significant stress if you don’t have a valid and up to date Shareholders’ Agreement and more importantly, Buy-Sell Agreements in place.
If you would like to discuss any aspect of this article with us, please call your Allan Hall advisor.