Let’s say you own a family business, an LLC, equally with your brother and sister. All of a sudden, your sister wants to sell her 1/3 interest in the business to Archie, your arch-nemesis. You and your brother don’t have to admit Archie as a partner, but you can be sure that thirty-three cents on every dollar the business earns goes right to that weasel Archie. If the business were incorporated, Archie would be a 1/3 owner, and depending on the business’ articles or bylaws, might have a seat on the board. Surely, when you and your siblings started the business you never thought any of you would be selling your interest- especially not to that good-for-nothing reprobate. However, without a transfer rights restriction agreement, your sister can take Archie’s money to the bank before you even see his smug face as he walks right into your office like he owns the place. Maybe one of these would be a good idea.
On the other hand, let’s say you and your siblings weren’t allowed to sell your interests to anyone not approved by the other two. You decide to move across the country and decide that you want to sell your shares. Well, if your siblings won’t approve anyone who wants to buy the shares, can you require them to purchase your interest? At what price? See, a good transfer rights restriction agreement won’t just allow partners to veto transfers, it’ll provide a mechanism to determine the terms of sale.
Though I described an agreement that required a non-selling partner to approve the buyer, there are a few ways to restrict interest transfers that are not so adversarial. One is the common “Right of First Refusal,” in which the partners have the right to match any offer a partner has received for his or her shares. This ensures that the remaining partner(s) will pay the fair market price for the shares, allowing the former partners peace of mind that neither of them got a raw deal. On the other hand, this type of agreement may scare off potential suitors, as they don’t like the idea of investing time and money into purchasing the shares, only to have them snapped up by existing partners after they’ve made an offer. With fewer suitors, it is likely that the selling partner will not receive as much for their shares as they otherwise might. However, in delicate situations like family businesses this may be the best structure, despite its price disadvantage.
The “Right of First Offer” requires that a selling partner first offer their interest to the current partners. Generally, the price of such a sale would be determined by a formula that would approximate the value of the company. In the case of a large company, an investment bank might be hired to determine a value. Third-party or formulaic pricing is necessary to ensure that the selling partner cannot just sell his or her shares to a third party because they’re willing to pay more. This agreement structure ensures that buyers won’t be spooked by the prospect of a partner “stealing” the interest from under their noses. In turn, there will likely be more potential buyers and a higher sale price.
However you design it, though, just about any agreement is better than none.
This article first printed in the Autumn 2009 Madison Business Law Quarterly "Think of Everything, Act Accordingly."