Buying Out Your Co-Owner

by Mary Hanson

Most owner-operated businesses started with 2 or more owners do not make it to the 10-year mark with the same owners. Typically, one of the original owners buys the other owner or owners out.

The reasons for the split are rarely related to trust or trustworthiness. (Certainly, if you do not trust someone, never, ever get into business with them.) Issues arise from lifestyle issues, personality differences, decision-making, goals, and work attitudes. It is rare for two individuals to have goals and attitudes similar enough to allow the successful long-term co-ownership of a business. Often one individual is more dedicated to work (or is more of a workaholic) and eventually feels that he or she is carrying the burden of the business. Sometimes one individual faces personal problems, family issues, or health problems that take their focus away from the business. It may be understandable. But it is not fair.

Being on different wavelengths in managing a business is not just frustrating. It is damaging to the business.

When things get to that point, what will you do?

Most businesses owned by two or more people are operated as a corporation. The buyout of an interest in a corporation is the purchase of stock, either by the remaining owner or by the corporation itself. The departing co-owner does not ordinarily get any assets of the business. It is not a split of assets, but a purchase and sale of corporate shares.

The format of the purchase is similar to the purchase of an entire business as a corporate acquisition. The key issues are purchase price, terms of payment, collateral to assure payment, restriction on competition, protection of proprietary information, and agreement regarding liabilities.

Purchase price

How do most co-owners agree on a purchase price? The most common method is by negotiation and agreement, without any formal appraisal. The advice of the corporation’s accountant should be valuable, assisting the co-owners in assessing the value of the business considering the financial statements, cash flow, debt, liquidity of assets, and the tax consequences of the buyout.

A tax advisor plays an important role for the buyer of the stock, by warning the buyer of tax consequences of such a purchase. Unlike the purchase of a business as an asset purchase, there is no opportunity to allocate the purchase price to different assets and get the benefit of depreciation. The purchase of stock is not tax-deductible. And tax advice for the seller considers the impact of capital gains taxes from the sale of stock and income tax from any continuing employment income, dividends, and any other aspects of the agreement between the parties.

Payment terms

Like any other purchase, the typical payment terms are a substantial amount paid as a down payment, and payments made over a number of years. The substantial down payment assures the seller that the buyer has a commitment and something to lose if the business is not handled well. In addition, it assures the seller of getting paid at least that amount, if no other payments are made. The payments over time assure the buyer that the seller has something to lose if his or her actions impair the business. It leaves something to be negotiated and adjusted if disputes arise from the transaction.

Collateral

There’s no assurance of getting paid quite like good collateral. The three most common types of collateral behind the promissory note from one shareholder to another are personal real estate or a pledge of the stock purchased (when one owner is buying out another) and the assets of the business (when the corporation is buying back a shareholder’s stock).

Covenant Not to Compete

If you are buying out a co-owner and paying a serious price for it, it is important to include a covenant not to compete in the buyout agreement. Such a provision is enforceable in California under the same statutes that apply to the purchase of a business.

Even if your partner is ill, is retiring, is moving away, or otherwise has no plans to compete, not having a covenant not to compete can be an expensive mistake. Your former partner may intentionally or unintentionally compete or assist others in competing against you if you do not make this an issue. If the departing partner says he or she is definitely leaving the business and has no plans to compete, he or she should be willing to sign a broad non-compete with no reservations.

Protection of Proprietary Information

A departing owner knows the trade secrets, customer lists, methods of operation, and other valuable information of the business. Whether or not there is any covenant not to compete, the proprietary information of the business should be protected. Even in situations where a co-owner leaves and is allowed to take his or her own customers, the parties should identify and agree to protect valuable proprietary information.

Liability

Don’t even think of discussing price and payment terms without addressing the issues of liability. If the business has been around for a long time, there will be many types of liability to consider.

When it comes to liability, buying out a co-owner is quite different from purchasing a business. If you were buying a business, you would have the seller make representations and warranties that the assets are in working condition, that the financial statements are true and correct, etc., and include in the final agreement an indemnification provision making the seller liable for any violation of the warranties, any misrepresentation, and also for liabilities arising out of the operation of the business prior to the transfer of ownership.

When one owner buys out another, quite often both the buyer and the seller have the same knowledge about the liabilities and potential liabilities of the business. And they often share the same liabilities – including personal guarantees of bank loans, leases, and other corporate obligations.

Instead of having the seller accept all business liability up to the date of closing on the sale of stock, and having the buyer accept all liability from the date of closing (as in the purchase of a business by a new owner), the buyout agreement is often more creative in handling the different types of liability.

The creative arrangement between the parties may include some split of liability that might arise from past operation of the business, an agreement regarding insurance coverage and payment of premiums, and an indemnification obligation in exchange for modification of the purchase price.

If the departing owner did have more knowledge or control of the operation of the business, it may be appropriate to require the departing owner to make warranties and representations and indemnify the corporation and other shareholders from liability.

If there are real disputes between the parties over money owed, compensation, reimbursement, wrongful termination, breach of contract or other “claims,” the parties should seriously consider including a release among their documents, in which one or all parties release one another from liability. This can be a tricky release to draft, and should be done very carefully, since an unintended result may be to release an offending co-owner from liability the other parties know nothing about, or from liability that should be shared among the parties.

It is typical that the departing owner will want to be relieved of as much liability as possible – especially personal guarantees and any contracts that are in the owner’s personal name. The owner who is selling his or her shares will often feel that the transaction is worthwhile if it significantly reduces his or her personal liability. Conversely, if the corporation or other shareholders are unable to get the departing shareholder released from loans or other obligations, it may not be “worth it” to sell out, even at a generous purchase price.

In any event, the departing shareholder typically wants to resign as a director and as an officer of the corporation, have his or her name removed from the records of the State Board of Equalization and Employment Development Department, and be released from any personal guarantees on corporate loans and lines of credit.

Other loans, obligations, amounts due, adjustments, advances, and anything else of any nature between the departing co-owner and the corporation should be paid off, forgiven, or resolved in some manner so that as many issues as possible go away.

A valuable benefit of buying out a co-owner (or being bought out) is the resolution of disputes, issues, difficulties, and claims, as well as some fair agreement on handling liabilities that arise from the past business operations. If potential disputes are left for another day, the emotionally key benefit of “closure” is missing.

And ...

Don’t forget to consider the changes that will need to be made in the corporate records. After a co-owner has been bought out (and his or her shares of stock have been transferred to another shareholder or back to the corporation) and he or she has resigned as a director and officer of the corporation, the remaining owner or owners must fill the vacant offices and decide what to do with a vacant seat on the Board of Directors. If just one shareholder remains, the most appropriate action is to reduce the number of directors on the Board to one, by amending the bylaws of the corporation.

Both the departing co-owner and the remaining owners will want to amend the Statement of Information on file with the Secretary of State. That form shows who the officers (President, Secretary, and Treasurer (CFO) of the corporation are. The Statement of Information can now be completed online at the Secretary of State’s website (www.ss.ca.gov).

Mary Hanson, MBA, Attorney at Law (310) 543-1355 Torrance (Los Angeles County), California USA