Ohio Practical Business Lawyer & Attorney : Teri Rasmussen : Lane Alton & Horst Law Firm : Commercial Law, Creditors, Business Formation : Columbus, Central Ohio

When considering an exit strategy for leaving the ownership of a business, don't forget to factor in the rights and input on the subject to which your fellow owners may be entitled. In many cases, finding a buyer for your equity stake is only part of the process.

Whether it's a closely held corporation or LLC whose equity holders are owner-operators or an investment vehicle LLC with sophisticated equity holders, the Operating Agreement or Close Corporation Agreement is quite likely to contain some restrictions on the manner in which ownership interests can be transferred to nonowners. Often one such restriction will be a "right of first refusal" which requires that one's fellow owners, and/or the company itself, be given an opportunity to purchase the ownership interest before any sale or transfer to a third party is permitted.

The typical "right of first refusal" generally follows the following sort of sequence:

1.  Getting the Purchase Offer in Writing. The equity holder wishing to sell to someone outside the existing ownernship must obtain a WRITTEN bona fide offer from the propsective purchaser setting forth the material terms and conditions of the offer and the amount of consideration offered.

• YES, it really does need to be written. It doesn't necessarily have to be in the form of a formal purchase agreement, but a few notes on the back of an envelope or business card will probably not be adequate. 
• Bona fide just means it needs to be something that the prospective purchaser really will follow through on and there are not any questionable side transactions (e.g., part of the purchase price is immediately refunded to the purchaser) required to support the proposed transaction. 
• Yes, it does need to be specific. If, for example, payment is going to be made over time, that needs to be explicitly stated.

2. Notifying the Remaining Owners. A copy of the written bona fide offer, together with some sort of written notice setting forth the desire to sell, must be provided to all of the remaining equity holders.

• NO, an e-mail to the remaining equity holders from the owner wishing to sell out which summarizes the terms of a verbal offer is probably not good enough. 
• The precise form of the notice required is generally not spelled out in the Operating Agreement. However, nothing more complicated than indicating it is a notice of the desire/intent to sell is necessary. Some Operating Agreements do require the notice to contain a summary of the terms and conditions of the offer.

3. Waiting for a Response. The company and the remaining equity holders are given a period of time to consider whether they wish to "meet" the offer made and buy back the equity interest. Usually, but not always, the company is given the first "right of refusal" with the remaining equity holders being given a chance to purchase if and only if the company decides not to exercise its right of refusal.

• The amount of time given for consideration of the offer varies, although 15, 30, or 60 days are common choices. Generally the length of consideration time is the same for all parties having a rights of first refusal, i.e. both the company and the remaining owners will each be given 30 days.
• The consideration time is usually cumulative, i.e. the company has 30 days to decide and then the remaining owners get 30 more days after that to make their decision.
  o Occasionally, Operating Agreements provide that the presentation of a bona fide offer permits the remaing equity holders to purchase the subject equity interest at predetermined price, perhaps "fair market value", as determined by an agreed upon formula or method.
• The purchase by the company or remaining equity holders in the aggregate must be for the entire portion of ownership interest being offered for sale - no partial purchases are permitted, although it is often possible for the equity interest to be divided among the remaining owners.

4. Exercising the Right of First Refusal. If the parties holding "rights of refusal" wish to exercise them, they must provide the party wishing to sell with written notice of that intent within the time required. The transaction must then be closed within the time specified by the Operating Agreement which can vary considerably from one Operating Agreement to another. Some Operating Agreements may even prevent a closing prior to the expiration of at least some period of time, i.e. 30 or 60 days.

5. Right of First Refusal NOT Exercised. If the parties holding the rights of refusal choose not to exercise them, the party wishing to sell may proceed to consummate the offer under the terms and conditions disclosed. Generally, if the transaction is not consummated within a certain period of time, perhaps as short as 30 or 60 days, the party wishing to sell will have to go through the entire right of first refusal process again.

Make sure you understand the "big picture" once you've decided it's time to move on and want to transfer your ownership interest in a business to ensure you don't lose valuable time.

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Limited liability companies allow great flexibility for their Member-owners in structuring both economic and management matters. Consequently, when an LLC has more than a single owner, it is important for the Members to adopt an Operating Agreement spelling out how these matters should be handled. An Operating Agreement is similar in many respects and serves many of the same purposes as a Close Corporation Agreement does for corporations with only a few shareholders. Click here to read my blog post on Close Corporation Agreements.

In Ohio, if a written Operating Agreement is not adopted, Ohio Rev. Code Chapter 1705 contains a number of "gap filler" provisions that will be applied to govern the business and legal affairs of the limited liability company. While some of these may be just fine, others are not appropriate in every case. Moreover, in many cases, the "gap filler" provisions are rather vague and likely to lead to expensive litigation when applied to particular situations involving disputes among owners. I use an LLC Formation Client Questionaire with new clients to help gather information useful for tailoring an appropriate Operating Agreement for their particular circumstances.

A typical Operating Agreement sets forth the ownership interest (known as a Membership Interest) held -- and initial capital contribution made -- by each Member and also contains provisions regarding the following:

• purpose for the LLC
• allocation and distribution of profits and losses
• voting rights and procedures
• protocol for member (and manager) meetings
• admission of new members/restrictions and procedures for transferring ownership
• dissolution and winding up of the company

Sometimes an Operating Agreement will also include special provisions regarding the duties of Members and/or Managers. For example, Members or Managers may be required to devote their full attention to the business affairs of the LLC; alternatively, the Operating Agreement may specifically provide that they are free to engage simultaneously in other business ventures. Noncompete or confidentiality provisions similar to those often found in employment agreements may also be included in the Operating Agreement. Members or Managers who fail to comply with these restrictions may be subject to expulsion and forced to sell their Membership Interests if the Operating Agreement so provides.

Purpose for the LLC. Generally the Operating Agreement will provide for very broad purposes for the LLC. However, in particular cases, it may make sense to limit the particular activities in which the LLC is permitted to engage.

Allocation and Distributions of Profits and Losses. Unlike a corporation, the economic rights attached to equity ownership in an LLC do not automatically track the relative ownership interest held by the Member. Thus while a shareholder with 25% of the shares of stock in a corporation (regardless whether an S or C corp) must receive 25% of the corporation's profits and losses. By contrast, an LLC Member with a 25% Membership Interest might receive only 10% of the Company's profits and losses, or 50%, or any other amount the Members have determined to be appropriate. An Operating Agreement can also accomodate various creative arrangements such as ones in which particular Member(s) get a certain percentage of profits and losses up to an aggregate amount at which point a different formula becomes applicable. The possibilities are limited only by the imagination and desires of the Members.

In addition, the timing and rights, if any, for Members to insist on any minimum distributions is often included in the Operating Agreement; whether it should be delineated sometimes depends upon whether one is cosdidering it from the standpoint of the majority or minority owner. In the absence of any specific provision requiring distributions periodically or in any set amount, Members have no right to insist on distributions.

Voting Rights and Procedures. In a corporation, voting rights follow the number of shares held. In C-corporations, voting rights can be restricted by giving different classes of stock different rights, but in S-corporations, that is simply not an option. In an LLC, just as with allocations of profits and losses, the nature and procedure surrounding voitng rights is essentially completely up to the Members to determine. If the Operating Agreement does not otherwise provide, Ohio Rev. Code 1705.24 allows Members to vote in proportion to their contributed capital just as they would in a corporation.

An LLC can be governed in much the same way as a corporation with Members holding "Units" or it can more closely resemble the ways of a partnership. Members in an LLC can decide to vote by their "Uits" or Membership Interest percentage in a fashion similar to that of shareholders in a corporation. They can also decide to vote by "headcount" with each Member being entitled to one vote. It is also possible to have some issues determined by headcount and others by Membership Interest percentage. The Operating Agreement can also designate certain matters as requiring a unanimous vote or a specified supermajority to be properly authorized.

In addition, Members can choose to have the LLC's business and financial affairs handled solely by Managers (who function somewhat analogously to Directors or Officers in a corporation) rather than by the Members. Here the Operating Agreement spells out the procedure for selecting Managers and voting procedures governing their deliberations.

Protocol for Member (and Manager) Meetings. The Operating Agreement will typically set forth how often meetings will occur and explain how Members (and Managers, if applicable) can call a meeting. Members can also decide whether participation by telephone or other electronic means should be permitted

Admission of New Members; Transfer of Membership Interests. Generally, the Operating Agreement will contain some sort of restrictions on the transfer of the respective equity ownership interests held by individual Members. Often there will be a right of refusal granted the LLC and other Members which requires a Member wishing to sell his Membership Interest to allow the company and/or his remaining fellow Members to match any offer obtained from any third party. In addition, the Operating Agreement can require a Member to sell, or the LLC to buy, a Membership Interest under certain circumstances such as in the death, disability or termination of employment by the company; in these cases, the Operating Agreement should also specify a procedure or formula for determining the appropriate purchase price.

Dissolution of Company. The Operating Agreement should also provide for the circumstances under which the LLC can or should be dissolved. Generally this includes by uanimous consent of the Members or by judicial decree, but depending upon the nature of the LLC's business, other triggers may also be appropriate.

Conclusion. The process of working through the Operating Agreement can be a useful one for Members of the new company as it provides a vehicle for discussing many important issues.

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Thinking about rewarding a loyal employee by giving him or her a small ownership piece of your company?  Figure you'll still "call all the shots" because your ownership piece is so much bigger?  You may be unpleasantly surprised if you and your new business "partner" don't see eye to eye on how the business should be operated or what price it should be sold for.

Every business owner faces the question of whether to share ownership of his or her company with others.  Sometimes it happens early in the company's life cycle and is seen as a way to attract and compensate talent that might otherwise not be available to a young business.  It may also arise as the founder of the business approaches retirement and seeks a successor.  Other times it may simply seem like the "right' thing to do to reward and motivate loyal employees.

Whatever the reason, it is important to understand what sharing ownership really means under Ohio law.  Selling or giving even a very small ownership stake to someone else can restrict your rights to control the company and its operations in ways you may not have intended or even considered.  This is because under Ohio law, owners in small privately held companies owe one another a "fiduciary duty" to treat one another fairly.

It may seem logical to reward longstanding loyal employees with "skin in the game" by giving them an actual ownership interest in the business they have served so well for so many years.  Giving your new business "partner" access to financial data and other company books and records may seem like an excellent way to further motivate and recognize a deserving employee.  You may also feel you need to do this to attract key talent at a crucial point in the company's life cycle when you might not otherwise be able to pay a competitive compensation.  

In a business context, however, allowing others to hold even a very small ownership stake may come with rights and responsibilities you weren't counting on.  Are you willing to have this individual hold up the sale of the entire business?  What about letting your new co-owner influence and affect when the company repurchases some or all of your ownership stake?  What happens when this person leaves the employment of the company voluntarily or at your insistence?  If your new co-owner becomes intolerable to work with, ending the relationship is no longer as simple as saying "you're fired!"  Even something as ordinary as employing an owner's children in the business can be a problem if the same opportunity is not available to all owners.      

Fiduciary Duty of Owners to Each Other. Under Ohio law, owners of small businesses with only a few shareholders, members, or partners have a "fiduciary duty" toward one another.  Essentially, every owner must treat every other owner "fairly" when it comes to the company's business and financial affairs and opportunities.  The interests of the company must come before that of any particular owner. 

Using one's controlling ownership interest to cause the company to take action(s) unfairly favoring the majority owner at the expense of those with only a small ownership interest is not an option.  "Sweetheart" deals with other businesses resulting in financial benefits only to those with the largest ownership share become suspect. 

Effect on Exit Strategies.  Adding another owner can also affect exit strategies.  By statute, minority shareholders in a corporation have the right to demand the "fair cash value" of their shares upon the sale of the corporation or substantially all of its assets.  This becomes important if the corporation is struggling and the minority shareholder believes the majority stakeholder is selling out for too little.  It can also be an issue if the majority owner is perceived to be getting a "juicy" consultant arrangement with the new owners.  Receipt of any extra "premium" payment for the control a majority owner's ownership share provides may also be successfully attacked in some cases.  Similarly, having the business to buy back the shares of the founder's widow at a premium might seem fair, but if the same opportunity is not given to owners with smaller equity stakes, a breach of fiduciary duty may have occurred. 

Firing Your New Business "Partner".  Have you considered how your new shared ownership of the company complicates terminating that person's employment should that become necessary or desirable?  While you may not be immediately aware of it, granting an employee an ownership interest can subtly change the at-will nature of that employment.  You may no longer be able to terminate that person's employment for no reason other than you felt it was time. 

Now courts will require demonstration of a "legitimate business purpose" for terminating a fellow owner's employment, no matter how small the ownership interest held.  Termination must be based on a good reason.  It cannot be merely the product of a strategic move by the majority owner to "squeeze" the minority out of the company on overly favorable terms to the majority stakeholder.     

Firing your fellow owner because he or she cheated on your child/sibling or because they have simply become insufferable is unlikely to qualify.  Even something like declining productivity may not be enough in some cases.  Vehement disagreement about what direction the company should take which results in the majority owner believing his employee-owner is not satisfactorily pursuing the proper course may, or surprisingly often, may not be sufficient grounds for terminating the employment of a fellow owner.

LLC Applications.  Nor is this a problem restricted to corporations.  While no statute exists, courts have generally applied the "fiduciary duty" rule to limited liability companies, as well as corporations. 

Why Does It Work This Way?  Why do courts restrict the rights of the principal owner of a business this way?  Courts protect owners with only a small equity stake in the business because, unlike shareholders of large public corporations, they have no readily available market in which to sell their ownership interest and recoup their investment.  In addition, courts recognize that owners in privately held businesses often depend on their continued employment with the company for their livelihood, regardless of the size of their ownership interest.

Things to Think About Before Sharing Ownership.  So what can you do if you still want to include your employee in ownership?  Make sure you understand what you are also giving up before you bring someone else in as an owner.  The key is often to make sure everyone understand the ground rules from the beginning.  Explain in detail, in writing as well as orally if possible, how this will affect the employment relationship.  Be clear and specific as to what your expectations are concerning such matters as possible sale of the company or repurchase of your ownership interests.

A shorter version of this article was recently published in Columbus Business First, the Central Ohio Business Authority. 

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