Category Archives: Closely Held Companies

Forming a Texas Corporation – Other Documents You Should Know About

 

Most folks forming a corporation are aware that you file a certificate of formation with the Secretary of State’s office in order to legally form the corporation and then adopt bylaws to govern the corporation’s day to day operations.  There are several other documents important to properly forming a Texas corporation that you should be aware of and I discuss several of them below.

Pre-Incorporation Agreements

Pre-incorporation agreements are those made between future shareholders regarding the formation of the corporation.  These agreements may be formal (preferred) or informal.  Pre-incorporation agreements vary widely but are often used if there is some concern that one or more shareholders may back out of their commitment to form the new corporation.   They are also used to document the future shareholders’ expectations with regard to employment, capitalization, management, and other terms.

In essence, the pre-incorporation establishes a joint venture between the parties for the purpose of forming a corporation and establishing its business.  The pre-incorporation agreement usually terminates upon formation of the corporation.

Subscription Agreement

A subscription agreement is defined as an agreement between a subscriber and a corporation or a written offer by a subscriber to a corporation, before or after its formation, in which the subscriber offers or agrees to purchased a specified ownership interest in the corporation. Pre-incorporation subscription agreements are irrevocable by the subscriber for six months unless otherwise agreed.  The subscription agreement will usually set forth the conditions of the subscription as well as the payment terms and timeline for the subscription.

These agreements are becoming less common because of the ease with which modern corporation can issue new shares in exchange for additional capital but they are still in use today.  One of the reasons they are still in use is to condition the subscriber’s obligation to purchase shares.  For example, the subscription agreement may condition a commitment from the subscriber to purchase shares upon the occurrence of some event, such as, the corporation securing debt financing, a total capital investment amount, a key customer, hiring a key employee, etc.

An important note: it is important for the corporation to be aware of State and Federal securities laws when considering a subscription agreement and issuing stock to an investor.

Buy-Sell Agreement

A buy-sell agreement sets forth the terms under which the corporation or the other shareholders of the corporation must purchase shares from an individual shareholder.  The agreement also sets forth the terms under which a shareholder must sell his or her shares back to the corporation or to the other shareholders.

The buy-sell agreement will usually contain specific trigger events that create the obligation to sell or purchase the shares.  Common examples of these trigger events include death, divorce, and dissociation.  The buy-sell agreement should set forth the manner of determining the price of the shares to be sold as well as terms for payment of the purchase price.  The buy-sell agreement may set forth different prices and payment terms for different trigger events.

The buy-sell agreement may be set forth in a separate written agreement or in another corporate document such as the certificate of formation, bylaws, or a shareholder agreement.

Shareholder Agreement

A shareholder agreement is a critically important document, especially for small or closely held corporations.  A shareholder agreement is a binding contract between the shareholders used to manage their relationship and the governance of the corporation.  The terms of the shareholder agreement may be the only recourse a disgruntled minority shareholder can rely upon to protect his or herself.  Likewise, majority shareholders may benefit from a shareholder agreement setting forth the shareholders’ agreement with regard to management, rights, duties, and standards of care.

The shareholder agreement is often used to modify the standard corporate governance laws in a number of areas by setting forth specific terms to govern issues such as those listed below:

  • placing restrictions on the transfer of shares
  • creating mandatory buy-sell provisions
  • establishing mandatory voting terms or altering voting rights
  • modifying fiduciary duties and standards of care for Directors and Officers
  • mandating dividend payments
  • setting forth restrictions, requirements, or terms for the employment of shareholders or their family members
  • protecting minority interest holder’s rights
  • modifying the reasons when a corporation may be wound up and terminated
  • setting forth methods for resolving management disagreements
  • mandating the election of specific directors
  • placing restrictions on the management authority or discretion of directors and officers
  • expanding the types of actions which require shareholder approval
  • mandating bylaw terms

Initial Organizational Meeting Minutes

As soon as the corporation is formed, the initial Directors must hold an initial organizational meeting although the meeting may be accomplished through a written consent.  Regardless of whether an actual meeting is held or action is taken by written consent, the initial organizational meeting is important to address the following business in addition to other matters:

  • adopting the corporate bylaws
  • electing officers
  • issuing stock and setting forth the consideration to be received by the corporation
  • adopting a minute book to document BOD actions
  • establishing corporate bank accounts
  • authorizing other significant actions such as borrowing money, significant contracts, or leases
  • adopting the corporate share certificate
  • approve the initial stock ledger

Assumed Name Certificate

If the corporation will conduct its business under a trade name or any name other than the one set forth on its certificate of formation, then the corporation must file appropriate assumed name certificates.  These certificates are filed at both the State and County levels.

Stock Ledger

The new corporation will also need to create its stock ledger.  The stock ledger will serve as the corporation’s official record of stock ownership in the event there is any dispute as to what shares the corporation has issued and who owns those shares.

Key Issues That Should Be Addressed in a Buy-Sell Agreement for Texas Businesses

Buy-Sell Agreements should be found in every private company with multiple owners.  They are invaluable in any number of situations as a tool to avoid deadlock, discord, receivership, or winding up and termination of a company.  Buy-sell agreements may be separate stand alone documents, they may be part of the entity’s governing documents, or they may be part of other agreements between the entity’s owners.

Buy-sell agreements require a certain degree of foresight and prediction about where the company will be a number of years in the future.  These expectations change over time so the owners should periodically review their buy-sell agreement to confirm that it still meets their needs and expectations.

So what are the key issues that a buy-sell agreement needs to address?

Triggers in Buy-Sell Agreements.

Triggers go to the heart of the buy-sell agreement as they dictate the type of events that will cause the terms of the buy-sell agreement to come into effect.  Common triggers are retirement, deadlock, and death.  Other triggers include the voluntary or involuntary transfer of an ownership interest, resignation, or the termination of employment of an owner-employee.

When it comes to determining what triggers a party chooses to include in a buy-sell I find that it is often best for the party to consider what situations he or she wants protection from.  Some common situations to consider include:

  • Protection from the risk of a divorcing owner’s spouse gaining an interest in the business (Texas is after all a community property state).
  • Protection from the risk of other owner’s combining their interests to the detriment of an individual owner.  The “bully” scenario.
  • Protection from another owner with greater resources buying additional control.  Should owner’s have equal opportunity to increase their share of ownership interests?
  • Protection from the risk of bankruptcy of an owner.  Bankruptcy courts wield a lot of power with regard to disposing of debtor’s property.
  • Protection from disagreement among the owners on whether to accept a purchase offer from a third party.  Should the majority be able to force a sale?
  • Protection from termination of an employee-owner’s employment.  How would the former employee feel if his or her salary is terminated and distributions are not made?
  • Protection from a failure to make distributions.
  • Protection from (or requirement for) the application of a minority or lack of marketability discount to any redemption or cross-purchase.  The application of minority or lack of marketability discounts is a hotly contested issue when not specifically addressed with prior planning.

Valuation Methods for Buy-Sell Agreements.

There are a number of valuation methods for a buy-sell agreement.  In some agreements the valuation is set with objective and specific standards such as multiples of earnings, capitalization rate, or book value.  Other agreements might favor a subjective standard or establishing a methodology over objective numbers. Subjective standards typically require the use of third party professionals to establish the valuation.  In this scenario, the buy-sell agreement should outline the factors that a valuation professional may or may not consider in the valuation as well as the process for selecting that professional.

Which method is best depends upon the nature of the business and often times may vary within the buy-sell agreement based upon the trigger event.  For example, a valuation for purposes of redeeming the interest of a deceased owner could be very different from the valuation method used when one owner is opting out or threatening the sale of his interest to a third party.  In the former scenario it might be more appropriate to allow for a valuation that considers future profits and opportunities, while the latter scenario might warrant application of a discount for lack of marketability or minority status.

Funding of Buy-Sell Agreements.

The best drafted buy-sell agreement can be rendered worthless because of inadequate planning for how the parties will fund the required purchase under that agreement.  One of the most common funding mechanisms is insurance but this funding method is typically only available in limited circumstances such as death of an owner.  So what are the other options?  Borrowing, installment sales, and personal resources are the most common alternatives though each has certain benefits and risks associated with them.

Borrowing the funds to implement a purchase pursuant to a buy-sell agreement necessarily assumes that the borrower (whether another owner or the entity) will be able to secure a loan.  Prudent planning may necessitate clauses in a buy-sell agreement that require sufficient reserves, whether in cash or assets, to increase the likelihood that the purchaser will be able to secure funding necessary to effect the purchase.

Installment sales are another alternative that usually come with the benefit of avoiding the need to qualify for a loan.  This is a significant benefit that can allow for less hassle and an efficient implementation process when the buy-sell agreement is triggered.  However, this structure can carry significant risk for the seller as the payment structure relies heavily on future income.  What happens if revenues decline?  Will the seller be compensated for the additional risk with a higher interest rate on the payments?  If so, what is the appropriate rate?  Will the buyout payments receive priority?  Is the seller going to take a security interest in business property or possibly the personal property of the other owners?

Additional Matters to Address with a Buy-Sell Agreement.

A significant consideration is determining how the purchase and sale will be structured.  There are usually two options: a cross-purchase or a redemption.  In the cross-purchase scenario, the interest is purchased by all or some of the other owners of the entity.  Under the redemption scenario, the interest is purchased by the entity itself.  Each has its own benefits, impacts, and risks to the other owners and prudence dictates carefully considering each scenario to determine how the purchase and sale should be structured.  This is another area where the structure of the transaction may differ based upon the triggering event.

A buy-sell agreement carries with it certain additional requirements to be effective.  For example, a buy-sell agreement that imposes restrictions on the transferability of corporate stock carries with it certain notice and record keeping requirements that must be met for those restrictions to be enforceable.

In addition, effective implementation of a buy-sell agreement may require amending the entity’s governing documents, shareholder or partnership agreements, or other documents related to the entity.

When should you hire an attorney to negotiate your agreement?

Business owners, partners, managers in closely held companies all share a very common trait – they like to do things themselves.  Why pay someone else if you can do it yourself?  The first question every business owner usually asks before spending money is whether the expenditure will provide convenience, cost savings, expertise, or will it make them more money?

So when should you look at bringing on an attorney (or other adviser) to assist with negotiating a contract, lease, asset purchase, business investment, or other deal on behalf of your company?  I’m not talking about for his or her expertise with the subject matter, I’m talking about practical reasons why it might make sense to hire someone to negotiate for you instead of doing it yourself.  I believe there are a number of reasons why a business owner could get a better deal by hiring an attorney to negotiate their next agreement and I’ve discussed them below.

You are not comfortable with confrontation or saying “No.”

Negotiations are difficult and this remains true if they are conducted in a polite and cordial manner.  There is no avoiding the fact that there is conflict inherent in every negotiation.  Some people are not comfortable dealing with that conflict.  This leads to bad deals because the you avoid discussing difficult issues instead of dealing with them.  This also leads to unfair deals because you are afraid to simply say “No” or are willing to give up too much to avoid the conflict rather than working through it to develop a mutually acceptable resolution.

You should bring in an adviser if you are too emotionally involved to maintain objectivity.

Sometimes you are just too emotionally involved in the deal.  Whether because of the deal’s importance to your company or the fact that it is your “baby” that is being discussed and dissected during the negotiations, it is often hard to separate the emotion from the discussion.  This can make it difficult to maintain your objectivity and appreciate the other party’s position.  This can cause you to reject perfectly reasonable positions taken by the other party due to a defensive or emotional reaction.

Emotions can also drive you to make a bad deal simply to get any deal.  Often business owners are so invested in their product or service that they will give up more than they should simply to get a deal done because they believe so strongly in what they are selling that they will make any sacrifice to see it succeed.  Instant gratification can be a strong and powerful emotion to contend with.

You should bring in an adviser if the personalities require it to get a fair deal.

Sometimes you just know that you aren’t the best person to handle the negotiations.  At the end of the day its about business.  Its about getting the deal done.  Whether its because of personal issues with the other party or past dealings, sometimes you just know that your involvement will cause the other party to take a difficult posture solely to “beat” you in the deal rather than negotiate reasonably.  Using an adviser can mitigate those personality issues because he or she has no skin in the underlying deal.  A neutral adviser can also take the air out of a party who is posturing simply to “beat” you because you are no longer involved in making the deal.

You should bring in an adviser if you get too excited.

When you near the end of any negotiation that you have an interest in, it is natural to get excited.  Particularly in business, you often see the light at the end of the tunnel and race to get the deal done because carrying out the terms of the deal (and getting paid) is more important to you than negotiating it.  Often this can lead you to leave little things on the table that collectively would make a big difference for your company or it could even lead to a bad deal that over looks important details.  If your excitement makes it difficult for you to slow down to evaluate and re-evaluate the overall deal then you may do well to hire an adviser to handle the negotiation.

How Business Planning Can Benefit You and Your Company

I’ve often found that the concept of “business planning” is a little esoteric for clients who aren’t quite sure what it means, how it works, or what sort of benefits they receive through planning.  So let me answer those questions here. Who Needs Business Planning Services? Everyone.  That is the easy answer but the practical… Continue Reading

Closely Held Corporations: Characteristics, Minority Shareholder Rights, and Control Issues

Closely held corporations present unique legal issues on a number of fronts.  The limited ownership group makes personal relationships more important and increases volatility amongst the group.  Owners of closely held companies tend to be more involved in the operations of the company. What Is a Closely Held Corporation? The most general definition of a… Continue Reading