Planning for Business Succession and Avoiding Disputes: A Litigator’s Perspective on the Practical Impact of Contractual Buy-out Provisions
January 13, 2021
Buy-out provisions allow business owners to seek to reduce the disruption and uncertainty of future changes in ownership in shareholder, operating, or partnership agreements. Owners of businesses may eventually become non-aligned in their visions or interests for a variety of reasons. Perceived unequal contributions to the business venture is often a culprit. Others include the desired timeline for return on investment or retirement, and differences in risk tolerance. Differences in owners’ personality or management style also contribute to eventual conflict. Finally, non-alignment may exist at the outset between those owners involved in the management of the day-to-day operations of the business and “passive” owners who are not involved.
Eventual non-alignment of owner interests in a successful business of any significant duration is almost certain, and should be anticipated in the foundational agreements. If buy-out provisions are omitted, or no written agreement between business owners exists, then the statutory default provisions for ownership change are limited and not user-friendly. This equates to, at a minimum, great expense, delay, and uncertainty in the event of a dispute over the value of the interest to be obtained, and in many cases involuntary transfers of interests will be unavailable. This leaves the entity in a position where its owners desire a separation but the entity is unable to easily accommodate these wishes. The result can often be protracted disputes and lawsuits which hamstring the operations and potential of the business, if not result in its complete discontinuance. Opportunities to sell the business may be greatly hampered by owners’ disputes. Owner buy-out provisions seek to avoid this situation before the circumstances of disfunction actually arise.
Beyond the mere inclusion of buy-out provisions, the form that such provisions take in business owner agreements will be critical in the scope, length, and cost of the transfer of ownership interests. It is important that the owners’ agreement include the procedure for “involuntary” transfers in clear and unambiguous terms so that, if necessary, judicial review of the process will find clear evidence that it was followed.
Furthermore, the valuation process should be explicit, and made to conform with provisions in the CPLR that will expedite the valuation process and insulate that process from most collateral attacks. Simply providing that an owner’s interests will be “valued” at the time of the buy-out will not necessarily achieve that goal. Minority owners may require court intervention to gain access to information that is pertinent to the value of the involuntary purchase of their interests. Once all necessary information is obtained, two highly-qualified business appraisers can look at the same historical financial information and arrive at polar opposite valuations. Why? Because valuations start with historical financial results but then adjustments are made, discounts are applied, and growth rates are estimated by the appraiser hired by each party. Afterwards, a judge or jury may be required to determine the valuation number as the result of a failure to include specific valuation provisions in the agreement.that was left open an agreement. The eventual trial could take weeks and the litigation could last years. Indeed, simply gaining access to pertinent information about the business may require court intervention.
Business litigators may enjoy this struggle to achieve resolution, but clients usually do not. It can be avoided with clear contractual provisions that provide for an independent valuation according to a set process. Furthermore, CPLR Article 76 permits the proponent of the valuation to seek judicial confirmation through a more-expeditious special proceeding, as opposed to a full-blown action. Finally, the owners can agree in advance to a method of valuation that is not necessarily full fair market value, and can waive contrary statutory provisions. If the process is followed, the valuation itself cannot be collaterally attacked in court.
In sum, explicit provisions may help business owners avoid costly delays in the transfer of interests and the resulting harm to business prospects.
*This is an excerpt from Steve’s CLE presentation made through the Monroe County Bar Association. The CLE was sponsored by the Business Law Section.
Steve Cole is a founding partner of Adams Leclair LLP and serves as the firm’s Managing Partner.