When you or your company — be it a C-Corp, S-Corp, LLC or partnership — sells or transfers ownership through a sale, gift or option, be sure the buyer (or recipient) represents that the stock is being acquired or given for investment purposes only. Also, stipulate that the shares cannot be sold or transferred without complying with the rules of the Securities and Exchange Commission and applicable state laws. Additionally, use the following precautions to protect yourself and your company.

Precaution #1. An investment agreement should be prepared and executed that specifies all of the terms, restrictions and conditions of the stock sale, transfer, gift or option.

Precaution #2. The investment agreement should grant both you (as owner) and your company a right-of-first-refusal before shares can be sold or transferred.

Precaution #3. On the face of the stock certificate issued, print a legend alerting any potential buyer of the following:

• The shares of stock are subject to an investment agreement.
• The shares cannot be sold, encumbered, gifted or otherwise transferred except as stipulated in the investment agreement and in full compliance with the Securities Act of 1933 and applicable state laws.

Precaution #4. Include in the investment agreement that even if right-of-first-refusal rights may go unexercised from time to time, all shares held by any buyer (no matter how such shares were acquired or received) will be bound by the investment agreement and by the written legend on the stock certificate.

Precaution #5. Indicate in the agreement that the stock cannot be encumbered, e.g., used as collateral for a loan. That way, you eliminate the risk that the shareholder’s creditor becomes an owner via a foreclosure on the collateral.

These precautions also apply to stock option agreements with key executives and gifts of stock to your children. Get good legal advice before selling, transferring or giving options on any ownership position, including warrants and convertible securities sold to investors to raise capital for your business. If you now have minority owners, check with your lawyer to be sure their stock or stock options comply with the above precautions.

1. Preserve control by restricting transfers or sales of company stock to persons outside the company or owner’s immediate family.
2. Protect business assets and ongoing operations.
3. Provide cash or other assets (e.g., life insurance proceeds or promissory notes) to the retiring or disabled owner or family of the deceased.
4. Establish a method for determining the value of the business for estate tax purposes and transfer or sale of company stock.
5. Assure sufficient liquid assets are available to fund a buyout, pay federal and state estate taxes, and meet financial needs of surviving family members.
6. Reduce some of the risks inherent in grants of incentive stock awards to key employees.

Structuring a Buy-Sell Agreement

A buy-sell agreement can protect business value, reduce the likelihood and severity of shareholder disputes, and provide for continuation of the business beyond its current ownership. A buy-sell agreement can also be designed to provide income to the retiring or disabled partner or to the family of a deceased partner. Initial questions that need to be considered are:

• Should the buy-sell be cross-purchase or stock redemption? In a cross-purchase, share buyouts are affected by one or more partners buying the shares of another. In a stock redemption, the corporation does the purchasing.
• Should the buy-sell be funded with proceeds from life insurance on each owner’s life, and what cautions should the surviving owners take to assure payment?
• How will the business, or partial ownership interests in the business, be valued under the buy-sell agreement and will it conform to IRS valuation guidelines?
• Is the valuation method dynamic so that the valuation of the business changes as the business changes?
• Will changes in the business value trigger adjustments to mechanisms that will provide buyout funds?
• If insurance is the financing vehicle, should the premiums be paid by the company or the individuals?
• How can you structure the insurance policies to reduce or eliminate income and estate taxes?

Buy-Sell Agreement Checklist

Here are major items to include in a buy-sell agreement.

• Names of individuals, number of shares (ownership percentage), purchase price, and the corporate or partnership entity involved in the buy-sell arrangement.
• When the agreement will become effective: death, termination of employment, retirement or disability.
• Method of stock purchase: stock redemption, cross-purchase, combination of both, or survivor’s option plan, where the decision is not made until death or retirement of the owner.
• Buy-sell value (price) and method for updating the value over time, preferably every year or two. Keep in mind that the value of many closely held businesses can increase (or decrease) substantially from year to year.
• How the owner(s) will be paid for the stock: life insurance proceeds, promissory notes, other owners’ personal assets, company cash or a combination.
• Circumstances in which the ownership position (i.e, actual shares of common stock) can be hypothecated or otherwise encumbered for loans or other purposes.
• Whether the buy-sell is a legal obligation or only an option to buy or sell.
• Conditions in which the buy-sell is to be amended or terminated. Written approval of all parties or just a majority of shareholders or shares outstanding.
• State law governing the agreement and any alternative dispute resolution provisions.
• “First-offer” or “right of first refusal” clause stating that before a stockholder can sell his or her stock, it must first be offered to the corporation and/or other stockholders.
• Clause binding future owners to the buy-sell agreement (i.e., covering stock options issued to key executives and other employees).
• Provision for an independent trustee if the purchase price of shares is substantial and funded by life insurance. Recommendation: Use a law firm or financial institution to make sure insurance proceeds are disbursed directly to your designated heirs/beneficiaries.

Valuation Methods to Use in Buy-Sell Agreements

Be aware that the IRS can challenge the price at which shares change hands. This occurs most often when no documentation exists to support the business’ value and price per share. Documentation is particularly important if the buyout is substantial. You can support your valuation and buy-sell price by using one or more of the following accepted valuation methods.

• Book Value: Simply the company’s total assets less total liabilities as presented on your financial statements. Tangible net book value also could be used. It excludes all intangible assets such as capitalized financing costs and goodwill.
• Adjusted Book Value: Amends the company’s book value to reflect any difference between book value and fair market value of certain assets and liabilities. For example, book value of depreciable assets such as buildings or equipment are often understated. The adjusted book value method usually renders a value higher than reported book value.
• Replacement Cost: Adjustment of all assets to their replacement value and then subtraction of all liabilities. Usually leads to a valuation that exceeds that of book value and adjusted book value.
• Price-Earnings Multiple (P/E): Value of the business is determined by applying a multiple to earnings of the business. The multiple, and how to apply it, is described in the buy-sell agreement. Important elements should be stipulated, such as type of earnings (pretax, after-tax, EBIT, EBITDA); earnings period (most recent 12 months, most recent fiscal year, average of the past four fiscal years); how debt of the business will factor into the valuation; and what to do if earnings are zero, near zero or negative. Earnings-based methods typically yield valuations far greater than balance sheet methods during periods of high profits. The reverse is true, of course, during periods of low or no earnings.

Your accountant can help you design and apply your valuation method. You might also use two or three of the methods and take the highest average or weighted average.

Additional Considerations

You should take other precautions to assure the buy-sell agreement’s validity and effectiveness. These ideas apply to both existing and new buy-sell agreements.

1. Each stock certificate subject to a buy-sell agreement should have a written legend stating such on the face of the certificate.Example: “These shares are subject to a buy-sell agreement dated ______________.”
2. If the company is to purchase shares, you will have to provide for it in the corporate minutes and possibly obtain approval, in advance, from any minority shareholders. Check with your lawyer.
3. The signed buy-sell agreement must be bona fide, entered into in good faith, and effected on an arm’s-length basis, particularly when transacting with family members. For example, you can’t set a low value on a small portion of your company stock and expect the value to apply to the remaining holdings for estate tax purposes.
4. The buy-sell price per share must be reasonable and legally binding. It cannot be a device to transfer ownership to family members at less than its full fair market value.
5. Include provisions that will aid if an active partner becomes disabled.
6. To defer taxes, you might want to consider building in an installment sale provision. Keep in mind, though, that delaying payments could increase risk of nonpayment.
7. In crafting an effective buy-sell agreement, consider also seeking advice from a mergers & acquisition expert and/or business valuation expert.

Financing the Buyout of Your Stock

Establishing the procedure by which stock is bought and sold on the departure or death of a shareholder is the first step in protecting the company. Providing money to carry out the procedure is the second.

You can’t assume that surviving owners will have enough personal liquidity to finance the purchase on their own or that they will be eligible to borrow the required amount. The price tag on shares in a profitable, growing company can be substantial. Nor can you assume the company will have sufficient liquidity or access to capital to fund the purchase on its own. You might want to consider another approach for providing the needed money.

Life insurance. Life insurance on the life of each owner can supply all or part of the needed cash. In the case of a stock redemption plan, the company buys the insurance and names itself beneficiary. A cross-purchase agreement could incorporate life insurance by each shareholder buying a policy on the other(s). Any insurance payout is then used to purchase the deceased owner’s interest.

How much insurance? Shares to be covered by insurance on each owner’s life represent a certain percentage of the company’s value at the time the insurance purchase is made. For example, if each of four stockholders owns 25 percent of a company valued at $1.2 million, then $300,000 life insurance must be purchased on each owner’s life. To reflect future increases in the value of the stock, the dollar amount needed to purchase the shares should be adjusted periodically along with the amount of life insurance relied on to finance the purchase.

Joint life or first death. Another possibility, where several owners have roughly equal shares of the company, is joint life or first death insurance. The policy covers all of the owners but pays the life insurance proceeds when any one of the parties dies. The insurance proceeds can be paid to the company or to the others in the group, depending on how the agreement was set up. Of course, if this type of insurance is used, it will be necessary to work out a new arrangement and take out a new policy after the death of any one of the owners.

Covering a shortfall. If life insurance is used, consider including a provision that addresses how a shortfall will be bridged. For example, if the policy pays $200,000 but the buyout is $300,000, should the surviving partner be allowed to pay off the shortfall over a period of years? Will an interest rate apply?

Buy-Sell Taxation

If a buy-sell agreement is funded with insurance, it is critical it be structured in a way that minimizes taxes. Generally, life insurance premiums are not tax deductible and life insurance proceeds are not taxable income when received by the beneficiary. If the company is the owner and beneficiary of the life insurance policy underlying a stock redemption plan, there is usually no taxation. It’s straightforward — the premiums are not tax deductible by the company, so the proceeds received are not taxed.

Problems can occur when the company is not listed as policy owner, but the company owner is. When the company owner dies and the company uses insurance proceeds to acquire stock from the deceased owner’s estate or heirs, the proceeds will be included in the value of the estate of the deceased. This could trigger significant, unnecessary estate taxes.

Estate taxation is complex. Talk to your tax attorney and financial advisor about the proper structure of your buy-sell agreement and related insurance policies.

A less obvious but very real threat to the survival of your business is catastrophe — the sudden and unforeseen event that puts you out of business or inflicts long-term damage. Fire, flood, data breach or events that damage your public image or reputation. Or the loss of a vital customer, vendor, license, employee or representative.

Just as the business owner must work each day to secure profit and liquidity, he or she must protect the business from loss due to sudden, unforeseen events.

Here’s how:

Step 1: Identify Your Most Critical Assets

Begin by listing the assets you use in the creation and delivery of your goods or services and in the operation of your business. The primary asset categories are facilities, inventory, equipment, personnel, data, network/connectivity, voice, hardware, software, licenses, agreements, relationships and reputation. Add to the list items necessary to prove ownership of valuable assets, rights or interests, such as titles and insurance policies. Rank each asset or asset class from most valuable and/or critical to least valuable and/or critical. Estimate the impact that each asset would have if lost. Gauge the impact in dollars, customer relationships, public perception and contingent liability.

Step 2: List Things That Could Damage Each Critical Asset

Brainstorm about all the things that could damage each critical asset and/or sever you from full access. For an asset such as your website, it could be a failure of your server by fire or flood. For a key employee or vendor agreement, for example, it could be an erosion of a personal relationship or a fire or other natural disaster. For a license, it could simply be non-renewal for unknown reasons. For something such as a patent, it could simply be the passage of time. Whatever it may be, list the things that could cause damage or separation.

Step 3: Develop Mitigation Plans

For each “thing” that could cause loss, develop a mitigation strategy. For example, if a key asset is a relationship with a person or organization, your plan might include:

i. strategy to reduce reliance on the relationship

ii. multi-point strategy for keeping the relationship

iii. development of contractual protections, such as non-compete, non-solicitation or cancellation notice provisions
iv. transfer of risk, such as the purchase of a key-man life insurance policy

If the key asset is, for example, “inventory,” you might work to:

i. reduce the risk of fire by installing a sprinkler system and/or updating the wiring in the facility

ii. ensure full loss coverage with insurance

iii. develop a strategy for quickly sourcing inventory and securing a temporary place for operations (in case of a loss of the facility)

Step 4: Periodic Review of the Plan

Over time, your business will evolve. Your risk exposures will evolve as well. To be sure you’re doing what you can to ensure the continuity of your business, periodically pull out your continuity security worksheets. Go over them thoroughly and update them. Spot new risks and develop and implement strategies for mitigating exposure.

Keep in mind that identifying your critical assets can take some time. List them yourself and then periodically revisit the list. Some key assets/risks can be difficult to spot. Persons of different vantage points and experiences can be of great help, so put some of your employees and advisors on the task. Ditto for the list of risks to each critical asset.

Your most important job, as a business owner, is to ensure the survival of your business. Profitability is essential, but don’t forget about the risk in unforeseen events. Identify your critical assets, the events that could damage them, and then develop a mitigation plan for each.

For most businesses, profits are down. Revenue is down. No doubt, valuations based on profit or revenue are down. So if you’d like to increase your ownership percentage, would you like to buy when the price is high or low?

Low, of course.

So how about now?

Just food for thought. Of course, if your partners also hold this right and could buy you out at a predetermined formula price, don’t show them this article!

If your business has outstanding borrowing (bank or credit card loans) and has been profitable in one of the past two years but is now suffering “immediate financial hardship,” you may be eligible for up to $35,000 of interest-free money.

That’s right. As part of the America’s Recovery Capital (ARC) program approved by Congress in February, the Small Business Administration (SBA) rolled out new aggressive loan programs to support small, struggling businesses. The loans are available to established, viable, for-profit small businesses that need short term help to make their principal and interest payments on existing business debt.

The $35,000 interest-free “ARC Loans”, as they are referred to, can be obtained from SBA approved lenders (i.e. banks).

The SBA defines “immediate financial hardship” as a “change in the financial condition of the company including, but not limited to, declining sales, frozen credit lines, and difficulty meeting payroll or paying rent or making loan payments.” Businesses also must be able to demonstrate, through quarterly cash flow projections, that they can continue operations and repay the ARC loans. For more on eligibility, click here.

Borrowers will not have to pay any up-front loan fees. ARC loan proceeds will be disbursed directly to the creditors listed by the borrower in the loan application. Creditors will receive the funds over a six-month period after the loan is approved. Repayment need not begin for a year after the last loan disbursement. The repayment term is five years.

ARC loan proceeds can be used to pay home equity loans or credit card debt … so long as the funds borrowed were originally used for business purposes only. Loan proceeds cannot be used for new capital expenditures or repayment of existing SBA debt that was incurred prior to February 17, 2009.

The ARC loan program kicked off June 15 but many banks have been slow, or have declined, to enroll in the program. The reasons cited by the banks have generally been one or more of the following:

1. lack of awareness about the program
2. lack of information about the specifics of the program
3. concerns about whether the bank will be able to earn an acceptable profit margin on the loans

Banks will receive from the U.S. government an interest rate of prime plus 2% and a 100 percent guarantee against loss of principal.

Loans will be available through Sept. 30, 2010 or until all funds have been expended, whichever comes first. SBA officials expect 10,000 ARC loans will be issued prior to the cutoff date. Only one loan per applicant is allowed.

In an attempt to make sure all businesses across the country benefit from the new loans, there will be an ARC loan cap of 50 per week for each SBA-approved lender and no more than 1,000 loans issued from any one lender in total.

Start-up businesses are not eligible for the ARC loans.

According to Dr. Jay-Kent Ferraro, this is quite common. “A great many business owners derive their identity solely from their business or financial success,” he said. “The only place they feel alive is in their business. Most are Type-A personalities. Success-oriented. So long as they’re successful, their sense of self-esteem remains intact, but it’s a shallow and tenuous existence.”

Just a Matter of Time
“The thing is, businesses and careers are filled with peaks and valleys,” says Claire Cornell, assistant director of the Family Owned Business Institute at the University of Tulsa. “No one achieves success perennially. Business is about persevering through the peaks and valleys. It’s about resilience.” Ferraro, a counselor, life coach and organizational consultant, says business owners who have a more healthy and diversified set of self-esteem anchors will be more resilient. Better able to endure the ups and downs. Less likely to turn to self-destructive behaviors when things aren’t going their way. Ferraro urges business owners to find activities that provide them with meaning and enjoyment, such as hobbies, community service or more involvement in their loved ones’ lives.

What About You?
Unfortunately, most business owners don’t know how unbalanced their lives are until it smacks them in the face. So Ferraro encourages owners to look at their lives objectively. Take, for example, the business owner who describes himself as a devout family man but spends only two hours a week with his wife and children. Or the business owner who travels 150,000 miles a year on business but never takes a family vacation. “Imbalances such as these show a huge disconnect between what a person thinks and actually does,” says Ferraro. “You may think you’re a family man, but your actions show otherwise.”

Epidemic
“This problem – the tendency for business owners to over-rely on their financial success for their happiness, identity and sense of self-worth – is more prevalent than people think,” says Ferraro. “Today, a lot of business owners are being exposed. They’re finding out the hard way. Personally struggling mightily because they’re not proud of how their business’ financial statements look. Even so, few are talking about it because they’re either brain dead and don’t know what’s going on or they think that talking about it, or acknowledging it, is a type of weakness – a vulnerability they cannot allow. To these people, to admit vulnerability is almost a sign of failure, so there’s a tendency to avoid that type of discussion.”

This Too Shall Pass
Cornell says failure presents an opportunity for growth. Tim Farley agrees. It’s been eight years since Farley lost his home, business, identity and sense of self-worth, but he’s recovered. Now he says, “We’re on our feet financially. I have a good job and little stress. I know who I am and think my self-worth is robust and is spread across a much wider base. I’m not sure if I’d even change a thing. I now know that I was in an unhealthy place long before the financial problems. My self-worth rested squarely on one narrow leg – business success. It’s like the hand of God gave me exactly what I needed – a major life shake-up. Incidentally, I think I’m wiser as a business person now. Much more realistic. Much more respectful of what it really takes to start, capitalize and grow and succeed in business. I may even venture out again into the world of business ownership. If so, I think I’d have a greater chance of success and also a greater ability to handle struggle or failure.”

Today, the company no longer exists. It filed for bankruptcy and was liquidated this spring. What went wrong? Take a look at summary financial information for the company in 2004 and the most recently completed full year, 2007.

Here’s what happened. Perhaps we all can learn from their mistakes.

• A single customer accounted for 60% of their revenue in 2004, well over 30% in the flanking years, too. Jack and Seth knew this customer concentration was a big risk, but they ignored it. They were just so enamored of their newfound prosperity that they failed to acknowledge that the foundation was weak. The customer bought nothing from Jack and Seth in 2007.

• The large customer was a sizeable flooring retail chain. The big purchases in ’04 were largely the initial stock-up of Jack and Seth’s product. Once the customer’s inventories were stocked, sell-through (i.e., buying from end-users) was required to pull additional tile through the chain. Unfortunately, and despite Jack and Seth’s optimism, the line performed poorly and eventually was discontinued. The customer had cautioned Jack and Seth that the original volume purchases were to fill the retail shelves and that sell-through was needed to make this partnership a success. Tragically, they ignored this sobering reality.

• Terms of the sales to the large retail customer allowed unsold product to be returned. So, in effect, a sale was not really a sale until it actually was sold to an end-user. Again, Jack and Seth ignored this reality, booked the revenue and profit in their accounting system and ignored that the goods might end up back in their own warehouse. In fact, this is what happened.

• Given that Jack and Seth were buying inventory from a Chinese manufacturer and selling most of it to a retailer that had almost unlimited rights to return it, Jack and Seth should have negotiated the right to return unsold inventory to their supplier. But Jack and Seth were so excited to get the supply contract that they gave in on this demand. It cost them their business.

• Despite all of this uncertainly, Jack and Seth went on a buying spree and, even worse, took on debt to finance it. They added staff, purchased a nice new warehouse, and bought fancy new trucks, forklifts, computers, software, inventory management system and furniture. They both bought expensive new homes. As a result, expenses and fixed obligations rose drastically.

What could they have done differently?

Certainly, the first big risk that they took was agreeing to buy large amounts of inventory with no right to return. Securing this deal term would have helped a lot. They probably should have held out or found another supplier. Often, you secure your victory before the game is ever played. That is when the rules (terms) are established between the parties.

Second, they should have had the maturity and humility to accept that their success was on very shaky ground. Sure, they were having some success, but it’s the long run we need to work to win, not the short one. Given that their sales were pumped up by a single large customer that was “stocking up” but had a right to return the purchased goods, Jack and Seth should have remained very cautions. They should have worked hard to minimize the inventory they carried, kept expenses low and avoided fixed obligations both personally and within the company.

If they would have done these things, their business could still be in business today. Sure, they could have done other things: maybe being tougher on return rights granted to their large customer, maybe refusing to personally guarantee the bank debt. But both of these would have been difficult to obtain and neither gets at the root of the problem. The fatal flaw was failing to address reality. To succeed in life and in business, we have to be optimistic advocates of our own interests and prudent protectors against things that could take us down fast.

Many appraisals are not worth the paper they are written on. So to help you build a framework to more accurately understand appraisals of any type of asset-real estate, autos, boats, jewelry and businesses-here are two important things you need to know:

1.    An appraisal does not provide the value of an asset, but rather a person’s opinion of the value of an asset. The following are as important as the appraisal itself:

a. Experience of the appraiser, including recent experience appraising assets similar to that of the subject.

b. Formal education of the appraiser, including specialized training in appraisal.

c.    Methodologies used in performing the appraisal at issue. The appraisal report should clearly describe the data gathered and considered and the analysis conducted, so that the reader of the report can follow and understand.

d. What methodologies could have been used but were not, and why.

e. What assumptions were made and how might they have impacted the conclusion.

f. How the final value was determined.

g.    Whether the appraisal was performed and value conclusion rendered in an arm’s-length manner in all respects, or whether the appraiser might be biased in some manner.

2.    Generally, anyone can legally offer his/her services as an appraiser. But organizations that rely on appraisals, such as lending institutions and the Internal Revenue Service (IRS), will often establish qualifications that appraisers must meet.

For example, IRS requires that a “qualified” appraisal be obtained to substantiate any non-cash deduction claimed for more than $5,000. IRS defines a “qualified appraisal” as one conducted by a “qualified appraiser” in accordance with generally accepted appraisal standards.

A “qualified appraiser”:

• Has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations prescribed by the Secretary of the U.S. Treasury.

• Regularly performs appraisals that he/she receives compensation for.

• Meets such other requirements as may be prescribed by  the Secretary of the U.S. Treasury in regulations or other guidance.

Critical to understanding the value conclusion in an appraisal is to understand the definition of value used by the appraiser for the appraisal. Typically, the definition will be fair market value (FMV). You should review the definition. It is specific  and informative:

Fair market value (FMV) is the price that property would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.

Example 1: If you give used clothing to the Salvation Army, FMV would be the price that typical buyers actually pay for clothing of this age, condition, style and use. Usually, such items are worth far less than what you paid for them.

Example 2: If you donate land and restrict its use to agricultural purposes, you must appraise the land at its value for agricultural purposes, even though it would have a higher FMV if it were not restricted.

Whether you are obtaining an appraisal for yourself or interpreting one provided to you on a business matter, keep these things in mind, particularly that the appraisal is just one person’s opinion of value and that the appraiser’s opinion is never more valid than the facts it is based on. Without a disciplined review of relevant facts, the appraisal opinion is simply a guess.

1.    Is sufficiently sophisticated and knowledgeable in business affairs, so as to understand risks of the business and the investment. Or is represented by a knowledgeable investment adviser and lawyer.

2.    Understands restrictions on the stock.

3.    Has sufficient financial capacity (net worth) to absorb any loss in the investment.

Always use a lawyer experienced in securities transactions when you sell stock and equity interests in a business.

When gifting, issuing, transferring or selling ownership interests in your business, such as stock, units, warrants, options or convertible securities, talk to your attorney. Tell him or her you want to:

• Restrict transfer or sale.
• Get a right of first refusal on future transfers, for both you and your company.
• Prohibit hypothecation (pledging interest as collateral for a loan).
• Investigate tax implications.
• Put an agreement in place that addresses what will occur if and when the employee departs if shares are provided to an employee as incentive.
• Be sure to comply with securities laws.

There are many circumstances when you may want to sell, transfer or give ownership:

• Giving stock to your children or spouse
• Granting stock options to key employees
• Entering into a buy-sell or stock purchase agreement
• Raising capital with warrants (option to buy stock) or a convertible security (right to convert debt or preferred stock into common stock)

You should take great care anytime you give, sell or transfer ownership interest in your business. As long as you want it to continue to be YOUR business – and you want the freedom to manage it as you see fit – be sure you retain control over who can become partners and/or co-owners. A bad partner/co-owner can be a very bad thing indeed. A minority owner doesn’t control the company, but he or she can become a real irritant, or worse.

This could happen to you:

You give some stock to your daughter. She gets divorced and her ex-husband winds up owning part of your business. He demands regular financial reports and claims you are cheating on taxes.

A. You give stock to an employee as an incentive to stay and grow with your company. After a few years, you have a falling out and you fire him. He goes to work for the competition and exerts his right to know what is going on at your company.

B. Your son uses his stock as collateral for a loan. He defaults, and now the lender is your minority stockholder.

Smart business owners don’t let these things happen. They use common mechanisms to establish control when giving or selling stock for any purpose – and to any person or firm. Of course, this applies to ownership interests you issue (from stock held by you) and any issued by the company (new issues or Treasury shares).

Imperative #1: Restrict the Stock

When ownership is transferred (by gift, sale or whatever) to a person or entity, the seller provides the recipient with a piece of paper such as a stock certificate or option to buy stock. Before you do this, print a legend on the face of it. The legend will refer to a letter that outlines the restrictions by which the ownership interest is encumbered. Here is a sample legend:

Sample Restricted Stock Legend

The shares represented by this certificate have been acquired for investment and have not been registered under the Securities Act of 1933. Such shares may not be sold or transferred or pledged in the absence of such registration unless the company receives an opinion of counsel reasonably acceptable to the company stating that such sale or transfer is exempt from the registration and prospectus delivery requirements of said act. In addition, the use and transfer of these shares is limited and restricted by an investment agreement, copies of which may be obtained at no cost by written request made by the holder of record of this certificate to the secretary of the corporation at the principal executive offices of the corporation.

No doubt you noticed the SEC language that dominates the above. There are strict and complex laws that govern transfers of ownership interest in companies. Certainly, you don’t want to run afoul of them. It is common practice to include in any stock legend protective language that addresses these laws, so we’ve included it in ours. The language that is germane to this article is found at the end of the sample legend and is in bold. But the SEC language alone places some burdens on the transfer of shares.

Again, this legend would be printed prominently on the stock certificate or other piece of paper that evidenced the ownership interest. Note that the above is just a sample. Talk to your attorney before transferring any ownership interest. We highly recommend that if your primary attorney is not experienced in private business ownership transfers (i.e., securities), find one who is.

Investment Letter: This is simply a document that outlines restrictions on ownership interest. It could have any number of names, such as stockholder agreement. We suggest that it provide the following restrictions:

1. Restrict future sale or transfer of the shares.
2. Grant a right of first refusal to both you and your company.
3. Prohibit pledging of the stock as collateral for a loan or other transaction (referred to as “hypothecate”).
4. Require compliance with federal and state securities (“blue sky”) laws.
5. Shares are and remain subject to the terms of any stockholder agreement, buy-sell agreement, employee ownership plan or option plan, or any other agreement that might be in effect. Be sure to include name and execution date of any such documents. See page 14 for a sample Investment Letter.

Right of First Refusal: This gives you some control over who might become an owner of your business by sale or other transfer of shares that are held by a person or entity to whom you have sold or given shares. We say “some” control because transfer is not prohibited, but a right of first refusal will give you the right and ability to block a transfer by matching the terms under which a transfer is set to take place.

Note: You might ask why we don’t suggest you simply prohibit a transfer. This, of course, would be ideal, but it is our understanding that case law holds that such a provision might constitute “unreasonable restraint” and thereby be rendered void and unenforceable. Check with your attorney.

Buy-Sell Agreement: We strongly suggest that every business with multiple owners executes a buy-sell agreement, possibly funded by life insurance, which provides for automatic purchase/sale of shares upon the death, disability or retirement of any of the owners. There are two primary types:

Stock redemption: Corporation buys stock from stockholder(s).
Cross-purchase: Individual stockholders buy stock from one another.

Be sure to consult your tax advisor or attorney, because there could be differing tax results among the different types of transactions.

In addition, the buy-sell agreement can specify whether it is mandatory (you must buy the stock) or optional (right-of-first-refusal). The agreement should establish the price at which the interests will be purchased/sold. And instead of a set or static price, we suggest that the agreement include a formula for determining value, one that will continue to remain valid and “fair” as the business evolves and changes over time. Failure to have such a provision will almost certainly result in a dispute over valuation.

Employee Stock Ownership Agreement: If you award or sell ownership or options on ownership to employees as a way of attracting and retaining key employees, you must put in place an agreement that governs and restricts the employee’s ownership of the stock. The agreement should make the shares subject to all the restrictions discussed in this article, but also address what occurs if and when the employee departs your company. Typically, options become void and interests are re-purchased. If, for any reason, employees retain ownership of shares after they depart your employ, will they have a right to data on your company if they go to work for or become a competitor?

Caution for S-Corporations: If your business is an S-corporation, you should include an automatic restriction on the sale or transfer of any stock position that would invalidate the tax status of your S-corp. This is because the transfer of stock to another corporation would disqualify a business from being taxed as an S-corp. As a result, you would revert back to a C-corporation – and you know what that means (i.e., double taxation).

In summary, when selling or issuing ownership interest in your company, do the following:

1. Seek the advice of an attorney skilled and experienced in securities laws.
2. Legend the stock certificate.
3. Execute an investment agreement.
4. Restrict the transfer or sale.
5. Get a right of first refusal on future transfers, for both you and your company.
6. Prohibit hypothecation (pledging of the interest as collateral for a loan).
7. Prior to any transfer, investigate the tax implications to both parties.
8. If the shares are provided to an employee as incentive, put an agreement in place that addresses what will occur if and when the employee departs.
9. Take prudent and proper action not to run afoul of state and federal securities laws.

Do these things and you will save yourself considerable time, money and trouble over the years.