Everyone has heard of a Last Will and Testament to dispose of your assets and appoint someone in charge of it, but that does not mean that everyone does it!  Most people die without a will, according to many studies.  What happens to a business entity that you co-own with another person?  That is the subject of this article.  

First, it depends on the type of business.  Historically, before the 2000's, the entity choice was either a partnership or a corporation.  A corporation's shares of ownership were, and still are, freely transferrable, unless there was a stockholder or buy-sell agreement that provided otherwise.  Thus, if a shareholder died, and there was no restriction on transfer, the shareholder's will beneficiaries or heirs under state law, without a will, would inherit the stock.  The result is that a person could end up in business with his business partner's wife or minor children--not a good result. 

In contrast, a limited liability company has ownership interest called "membership interest," and under a company agreement, the membership interest is typically not transferrable.  If there is no company agreement, Texas law provides that a member who dies ceases his membership interest, and his will beneficiaries or heirs become assignees.  An assignee is a person who takes over the ownership interest without getting the full membership interest, so the assignee has no right to vote.  Because the assignees have no right to vote, an effective change in control of the LLC has occurred.  For example, assume an LLC with two members: one who owns 90% and one who owns 10%.  Without a company agreement, Texas law actually says that the two members have equal votes.  How many LLC members know that?  Assume the 90% member dies.  The 90% ownership interest is converted to an assignee's interest of 90%, and the 10% member has 100% of the vote!  What does an assignee have as to rights?  An assignee has the right to receive distributions and allocations of profits and losses and to inspect books, records, and information of the LLC generally on a more restrictive basis than that of a member.

Instead, a buy-sell agreement should be used to provide for the transfer of ownership, the retention of the ownership interest with those who will operate it, and the provision of value to the deceased or departing owner.  In a sense a buy-sell agreement is a "Last Will and Testament" of a business, but it may, and hopefully, only address an ownership interest in it and not the ultimate demise of the business!

Death
A buy-sell agreement should obviously address death.  The deceased member's membership interest (or shareholder's shares) should be acquired pursuant to the agreement, resulting in the remaining owner's full ownership of the company.  The agreement would require the deceased owner's successors, assigns, and executors/administrators to sell the membership interest pursuant to the agreement.  Typically, life insurance can be used to help fund the purchase price.

Other Events under the Buy-Sell Agreement
A buy-sell agreement should also address other terminating events--what lawyers sometimes call the "4 D's."  These D's are (1) death, (2) disability, (3) dissociation, and (4) deadlock or just dissolution. 

If an entity owner, particularly one active in the business, becomes disabled, then the other owners and the company should have the right to acquire (an option) such person's interest; otherwise, the other shareholders and company must answer to and work with someone else: an agent under a power of attorney, a trustee, or a guardian appointed by a court.  These persons may have different ideas about running the business. 

If an owner who is an employee or otherwise a service provider for the company stops working for the company, quits, gets fired, gets convicted or charged with a crime, or loses a license, then the ownership interest should get acquired or forfeited.  For example, in a buy-sell agreement for a law firm, if a lawyer loses his license, then he cannot legally own the interest in the firm, and his interest should get acquired. 

Deadlock: disagreement
Sometimes, companies, particularly 50/50, get deadlocked, and nothing can get done, because the owners often disagree, resulting in deadlock and a company unable to act.  I've heard this story too (and more than once).  The shareholders got along great, but one got comfortable and started spending more time with whiskey than the company.  In an LLC, one member has no right to expel another member under such circumstance under the Texas Business Organizations Code.  Instead, a buy-sell agreement or company agreement should address expulsion, especially in dire circumstances.  Without planning, everything you worked for could get destroyed, and on the way to that destruction, while you are the only one making the company profitable, you are doing it for half the profits in the above example.

​Contact us to discuss the legacy of your business.

At James Law Firm, we have over 20 years of experience helping clients navigate the purchase of a business.  This article gives a general overview of the steps you should take in the purchase of a business.  No steps are necessarily sequential, as the steps may be going on simultaneously. 
You have decided to “become your own boss,” hopefully to obtain time and financial freedom.  Thus, you have already decided to purchase, and you probably already have decided “what” to purchase, meaning the type of business, such as manufacturing or service oriented.  This article discusses what to do after that step.  When you have located a potential target, you should consult a lawyer, because many clients think that they should work out their terms of the deal and provide it to a lawyer to document it—at the tail end of the process.  This approach does not use the lawyer’s experience in dealmaking and does increase transaction risk of a bad deal.  Being a scrivener is not the lawyer’s only task! In fact, most, if not all businesspersons, do not consider all the terms and due diligence items to examine in the purchase of a business by the time that buyer discusses pricing with seller. 

Get Your Team Involved

First, when you have identified that target, you should discuss the target with your commercial banker or seek a referral from your lawyer if you do not have one.  Even if you decide to buy the business with cash, getting insight into from the banker could help, and you might want to establish a line of credit as a contingency for your business.  You should also consult with your lawyer, banker, and financial experts, if you need assistance in pricing the business.  Pricing the business is part art and part science and outside the scope of this article.

The Big Question: Asset Purchase or Stock Purchase?

Second, your attorney should focus your attention on the correct deal points.  Most importantly, when you locate the target business, are you going to purchase the assets of the business with a new legal entity that will operate as the name of the target business, or will you acquire the stock or membership interest of the target and take over the exact same entity?  These two options present different risk assessments and pricing differences.  Most importantly, the pricing difference is huge!  You would not buy the assets of the business for $x or the stock of the company for $x, the same price!  When you buy the assets of the business, the buyer can depreciate the hard assets over a few years, or, better, expense the assets under Section 179 or under a bonus depreciation method in year one or over two years.  In addition, any amount paid over the hard assets of the business and receivables gets allocated to goodwill, and this asset is expensed (amortized) over 15 years.  In contrast, when buying stock, membership interest, or partnership interest, there is generally nothing to depreciation or amortize (there are some nuanced exceptions such as buying 100% LLC interest classified as a partnership).  The expense deductions should be discounted to present value to determine the current value of these tax benefits.  As a result, a buyer might determine to buy the assets of the business for $1,000,000, but buy the stock of the company for $700,000, after taking into account the present value of the tax benefits over 15 years. 

The second difference between a stock purchase and an asset purchase is the assumption of liabilities.  An asset purchase should have a carefully crafted provision regarding the purchase of the assets and a limited and specific liability assumption, such as liabilities arising under assumed contracts for obligations to provide services or goods after closing.  The asset purchase agreement does not assume all liabilities.  In contrast, a stock purchase results in the purchase of the corporation (or LLC) with all its known and unknown liabilities in it.  Thus, representations and warranties (basically, promises regarding what is getting sold) are more crucial, and buyer should want assurances that seller will be on the hook for unknown and unexpected liabilities or for any shortcomings in promises.  In summary, the risk assessment and pricing are much different in a stock or membership interest purchase than an asset purchase.

The most important aspect of the negotiation with seller over price is what you are paying AND what you are getting.  Nothing is more cringy when asking the client who answers that he does not know the answer to the question, “So are you paying $3,000,000 for the assets or for the stock?”  How do you have an agreement in principle without knowing what you are buying?  Unfortunately, this problem requires backwards negotiation.

On the Road to Buying: Letter of Intent

In negotiations with seller, seller will often ask for a Non-Disclosure Agreement.  This document should be reviewed by buyer’s counsel, to ensure that its obligations are not overburdensome or laden with liquidated damages for the breach of the agreement.

Seller should ask for certain items in the investigation of the business; this investigation is called “due diligence.”  Due diligence concerns not only financial aspects and performance of the business, but also the corporate or LLC charter and authorization to do business, ownership, assets, liabilities, employees, employee benefit plans, laws and compliance with laws and regulations, environmental, safety, employees legally authorized to work in the country, condition of assets and real estate (if any), existence of brokers, contracts, customer and vendor relationships, liens, lawsuits and investigations, and more.  Buyer should work with buyer’s counsel in the review of due diligence documents. 

Ideally, buyer should collect as much information and analyze it before entering a contract.  However, sellers are sometimes wary about providing all the access before such point, particularly identity of customers.  An option is to offer a letter of intent.  A letter of intent is supposed to be just what it sounds: an expression of intent (or interest) in buying seller’s business.  It is not supposed to be binding, but it will have a few binding obligations, such as confidentiality.  Poorly drafted letters of intent, specifically the DIY documents, lead to lawsuits, because the heading “letter of intent” is not binding on whether some document is a binding contract.

Contract Drafting and Closing

At some point, buyer becomes ready to make an offer.  Generally, purchase price and payment method are worked out, and hopefully, an asset purchase or stock purchase is agreed.  A buyer could also mention that buyer would not pay the same price for the stock as for the assets—just to set an expectation.  A seller who sells the stock at a lower price may come out with more money after income tax, depending on seller’s other income and stock basis.  Ideally, Seller will have counsel or a CPA who can explain this dynamic.

When the offer is made, contract drafting should start.  I like the idea that any kind of agreement in principle should include the agreement with such representations and warranties regarding the business as the buyer and seller may agree.  The best place to state this goal is in the letter of intent.
In the contract drafting, buyer should discuss with buyer’s counsel whether the deal will be a “sign and close,” whereby the parties sign the agreement and immediately close, or an “executory contract,” whereby the parties sign one day and close later.  Purchases with real estate will most likely consist of the executory contract.  If buyer needs certain contingencies or further due diligence review, then the executory contract should be used.  That way, seller is bound to the contract, while buyer works out buyer’s contingencies on financing and due diligence completion.  If buyer has ready financing, no real estate is involved, and closing document preparation is in process, a sign and close deal is doable.  I have done each one.
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The above process is a general overview, and it should not be considered legal advice.