August 25, 2017

Beware of the Shoot-Out

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Small business owners dream, plan, worry and work together to insure the future they share together in their businesses. But inevitably that relationship will come to an end. Whether it is by death of one of the owners, a falling-out or any of a number of other reasons, there will come a time when the interest held by one of the owners is going to pass to someone else. Left unrestricted, the interest of the departing owner will continue to be held by him as an often unwilling or even antagonistic outsider, by his spouse or family who will then become totally dependent upon the remaining owners or by a competing interest to whom the former owner wishes to sell. 

To protect the company, the ongoing owners and the separating owner the parties will frequently sign agreements that provide that on the separation of one of the owners, or when an owner wishes to sell his interest or at certain other times the business has a right to buy back the interest of the separating owner and/or the separating owner (or heirs as the case may be) has a right to compel the company to buy back that interest. 

These purchase and sale agreements can use a variety of pricing methods. They can call for appraisal by the company’s regular accountant or other independent business appraiser. They sometimes use a baseball type valuation where each side names a value and a 3rd party picks one or the other. They can even periodically designate an agreed price at which the interest will be purchased and sold if the separation occurs within a specified period of time. All of these methods have their advantages and disadvantages. 

One currently popular method of valuing the business on a separation is sometimes referred to as the “Shoot-Out.” By this method, one party or the other as defined by the agreement names a price for the interest, then the other side of the transaction has the right to either buy the interest at that price, or to demand that the owner who wanted to sell must buy out his co-owner at that same price. This method has the appeal and advantage that it forces honesty because a party must be willing to either buy or sell at the price he/she names – rather like the parent who asks one child to cut the last piece of cake but the other child gets first pick. 

But be careful with the Shoot-Out. Equal treatment really only works for equally situated parties.  Oftentimes a company will be owned equally by two parties in unequal circumstances. If one party is far better off financially than the other, then the party who is not as strong financially is placed in a terrible disadvantage if he ever wishes to separate and is faced with a Shoot-Out. If one party, say, comes to no longer trust the other and reluctantly decides to leave the business, but does not have the financial ability to buy-out the other owner, even at a fair price, then he/she is stuck with the choice of having to either (a) stay in the business with a “partner” he/she no longer trusts, or (b) offer his/her shares to the other at a price low enough that he could afford to buy out the partner if the partner elects to sell his own interest at that price rather than buy at that price. 

Similarly, the wealthier owner can really force the less wealthy owner out of the business at any time by offering to sell the wealthier owner’s interest at a price he/she knows the less wealthy owner can’t pay – even if it is a fair price. Since the less wealthy owner can’t afford to buy the wealthier owner’s interest, the less wealthy owner who was happy as a co-owner is left with the only option being to sell his interest to the wealthier owner. 

The Shoot-Out, then, tends to keep the less wealthy owner from being able to sell and to allow the wealthier owner to be able to force the less wealthy owner out of the business. This can effectively lock the less wealthy partner in the business, and that may be precisely what the parties intended, but often the less wealthy owner is surprised to find himself locked into ownership (or forced out when he can’t match the wealthier owner’s price).  

There is a place for the Shoot-Out (and other problems than those generated by unequal financial resources), and while some of its worst features can be controlled by careful drafting, it is usually only for owners whose circumstances are sufficiently equal that the effect of its apparently equal treatment is actually equal between them. 

Whenever starting a new business, or buying into an existing one, the prospective owner must carefully consider the buy-sell agreement, never accept a form type agreement not custom-made to his specific circumstances and must not be automatically drawn with closed-eyes enthusiasm for the new venture into the apparent fairness of a Shoot-Out clause without fully thinking through how it will really work in his/her case.