DEVELOPING AN OWNERSHIP AGREEMENT
(Source: “Managing a Small Business, Made Easy”)
book in the Entrepreneur Made Easy Series

Many small businesses involve two or more partners, owners or stockholders who have agreed to pursue a small business endeavor, including personal financial investment, based on a verbal agreement and a handshake. This approach may work quite well as along as conditions are “normal” and until one of the following happens:

• Your partner gets a divorce and his or her ex wants your business or, nearly as bad, wants to take his or her place in management

• A disabling disease strikes your partner, preventing him or her from continuing participation in the business

• Your partner suddenly dies and his or her heirs believe that they have a right to help you run the business or be paid a large sum of money for your deceased partner’s interest

• Your partner decides he or she has had enough of the business and wants out, demanding payment for what he or she perceives to be his or her “fair share,” which is usually well in excess of its true value

It must be clear from these simple scenarios that if you have a partner, co-owner, or stockholder, you need an Ownership Agreement (be it a stockholders agreement, partnership agreement or some other title). Your attorney must confirm that the agreement is legally binding to all parties thereby protecting all owners’ interests. The Agreement should contain the following business elements that are agreed upon by the co-owners at the outset of the business, at a time when all is “fair weather” and only positive conditions prevail:

1. A way out – if any partner or shareholder decides that he or she wants or needs to dispose of their interest and withdraw from the business, the Agreement should allow for this possibility and prescribe how to accomplish this withdrawal. However, the Agreement should also place appropriate restrictions on the transfer of ownership interest to protect the remaining owners and the business.

2. Procedures to be followed in case of the death of a partner/shareholder – if a partner or shareholder dies, the Agreement must specify the disposition of his or her financial interest in the business and at what value (see #8 below)

3. Procedures to be followed in case of the disability of a partner/shareholder – the Agreement should set forth the procedures to be taken in the event that a partner/shareholder becomes permanently disabled, restricting his or her involvement in the business. It should also define the term “disability.”

4. Procedures to be followed if a partner/shareholder becomes a party to a divorce – it is not uncommon for the ex-wife or ex-husband of a partner to want to include the partner’s financial interest in the business among the assets to be distributed in the divorce proceeding. The remaining partner’s may not wish to have a new partner (i.e., the ex-wife or ex-husband). The Agreement must address this concern, perhaps requiring the partner to sell his interest in the company back to the business if he becomes involved in a divorce. It is always possible to allow him to reinvest later.

5. Procedures allowing a partner/shareholder to be terminated for just cause – over long periods, people change in ways that may affect their ability to properly contribute to the well-being of the business. Sometimes it is necessary to terminate an employee, even one who is a partner or shareholder. The Agreement must allow for the termination and also provide for returning the terminated partner’s financial equity in the business to him.

6. Procedures for allocating profits among partners – although this may be applicable to members of an LLC, it is especially needed for any type of partnership. The provision may also define how the partnership interest or percentage ownership is determined and how it may be modified.

7. A definition of the authority and responsibility of the owners in managing the business – management responsibilities of each owner, if not spelled out in the Articles of Organization or Incorporation (or by laws), should be defined in the Agreement, including the “pecking order.”

8. The method of valuing a partner/shareholder interest – a valuation method should be agreed upon and established in the beginning of the business entity, not after someone dies, withdraws, or becomes a party to a divorce. There are several ways to value an ownership interest; the one selected should be unambiguous, easily determined at any time, and fair to all parties. Your CPA and your attorney can help you with this.

Failure to establish a fair and reasonable Agreement at the outset of a business invites a lawsuit at a later date, especially if outside parties become involved. Write down how you and your co-owners believe the Agreement should be and take it to an attorney to finalize.