What is an Owner Agreement?
An owner agreement, sometimes referred to as an operating agreement, is a key component of many business and personal relationships. At its core, an owner agreement is a contract between the owners of a business or even of a family, real property, or other asset. Though primarily used in the context of more formal legal entities, such as a corporation or a limited liability company, owner agreements may also be used to address issues such as which family member is responsible for upkeep of the family’s vacation home or how the proceeds of the sale of a family heirloom will be distributed. Here, we will focus on owner agreements that are used in the corporate entity context. Typically, an owner agreement governs how the owner or owners – whether a single shareholder or multiple shareholders in a closely held corporation or limited company – will act, make decisions outside the ordinary course of business, and treat one another. If there are multiple owners, it outlines how major decisions will be made, how profits and losses will be distributed, the procedure for selling an interest in the business, buyout procedures, how the death, disability, retirement or resignation of an owner will be handled, restrictions on transfer of ownership interests, and methods for determining value and price of the interest . Owner agreements are particularly critical for closely held companies. A "closely held business" is a business where the majority of interests are owned by not more than five owners, where stock is not actively traded on the open market, and where the owners themselves usually control the business. In a closely held corporation, the owner is often both the President and the sole shareholder, or a small group of people own the company. The process for valuation and management of the company is usually defined in detail in the owner’s agreement. Such agreements also provide greater protection to minority shareholders by ensuring that their rights are not unfairly impacted by majority shareholders. Owner agreements are sometimes thought of as only being required when the company structure is established. However, the value of such agreements cannot be overstated. A company’s ownership can change during the life of the company due to death, retirement, unexpected liquidation, and dissolution. Owner agreements set forth the rules to be applied to unusual transactions, thereby avoiding the undesirable situation where a minority owner can disrupt the current situation of management or financial distribution.
Different Types of Owner Agreements
Various types of owner agreements exist, which may be appropriate for different entities and situations. The most common of these are the partnership agreement, the shareholder (or equityholder) agreement, the joint venture agreement, and the operating agreement. Other forms of written or oral owner agreements may exist, but these four categories cover most of the situations that arise in the ownership of private businesses.
Partnership Agreements are likely the most well known. If two or more individuals or entities desire to own a business together, there is a good chance a partnership will be formed. If so, the owners may desire to enter into a partnership agreement. A partnership can be governed by the Michigan Partnership Act, MCL 449.1101 et seq., or by a written or oral partnership agreement. If these parties do not prepare an owner agreement, they will be subject to the provisions of the Michigan Partnership Act. Among the most important things you need to know about partnership agreements are: Basically, unless one of the partners contracts away their right to receive "liquidating distributions," the owners will continue as partners under the Michigan Partnership Act, despite the fact that business has failed. Furthermore, if a partner misappropriates funds from the partnership, the other owners may be able to make such a partner pay back all funds "misappropriated." Thus, if you own a business with someone else, you may want an owner agreement to avoid the pitfalls of the partnership act.
Shareholder Agreements are often associated with corporations. Fortunately, there is no requirement for an agreement between shareholders to exist. However, it is very rare that shareholders would not be better off with an agreement to govern their relationships with the business, other shareholders, and third parties (employees, customers, suppliers, etc.). Corporate shareholders may use several agreements to govern their internal relationships including a buy-sell agreement; a shareholders agreement; and/or an employment agreement. Generally, shareholders will enter into some form of agreement in order to address the following issues: management, voting control, liability, funding, income, distributions, buy-sell, and termination, among others. A corporation will probably be better off if it has an agreement with its shareholders.
Joint Venture Agreements are contracts between two or more entities that cooperate for a limited time in a business relationship. Joint ventures are not always easy to identify and at times may be confused with partnerships. However, joint ventures exist to accomplish something unique, rather than as a means of carrying on a continuing business. Joint ventures may involve more than two entities, may exist for more than one purpose, and may even be on a revolving basis for specific projects. A joint venture may be governed by a separate agreement, even if an agreement exists for the joint venture parties to form another entity (e.g., a corporation or limited liability company).
Operating Agreements are used by the members (or owners) of a limited liability company. The operating agreement governs the rights and duties of the parties, as well as the management of the company, similar to a partnership agreement or shareholder agreement. For example, an operating agreement might provide how the owners or managers are to be compensated. An operating agreement may be the "be all, end all" of agreements between the parties in a limited liability company, but similar to a corporation or partnership, an operating agreement may exist with other contracts (for example, employment agreements), depending on the circumstances.
Essential Considerations for an Owner Agreement
To ensure that everyone is clear on their rights and responsibilities, an Owner Agreement should be entered into by all Owners in the development. The Owner Agreement is a legal contract between Owners that governs how the business relationship operates. This contract is put in place to avoid the "bait and switch" that can occur if there is no written agreement in place and a disagreement arises. While the Owner Agreement will vary from community to community, there are certain key elements that should be included in any Owner Agreement.
2. Terms and conditions. Term – or how long the Owner Agreement will last (e.g., usually 1 year). Conditions (such as notice requirements, the requisite vote of the Owners required for certain Listed Actions, and payment terms).
3. Responsibilities of parties – it is important to be clear what each party is responsible for to avoid later disputes, confusion or disagreement. This section should include responsibilities concerning:
a. Maintenance.
b. Repairs.
c. Upgrades.
d. Capital expenditures.
e. Depreciation.
f. Disposition of assets.
g. Terminates, Involuntary, and Limiting Transfer Conditions.
- Insurance – types of required insurance and duration.
- Default – what happens if an Owner defaults or violates the agreement (e.g., Rights upon bankruptcy).
- Sale of Assets – what happens if an Owner wants to sell their interest (e.g., Right of First Refusal / Buy out rights).
- Defaults – what can happen in the event of a default.
- Payment Terms – how and when payments are to be made.
- Approvals – property rights to an Owner for non-Residential uses.
- Non-Competition Provisions – where an Owner agrees not to compete with the Owner.
- Allocating Rights – allocating purchasing rights to other owners in the event of sale.
- Limiting Transfers – restrictions on transfers or sale of owning interests.
- Confidentiality – a provision agreeing that all parties will keep the trade secrets confidential.
- Preferred Rates – special rates or pricing for other cooperating parties.
- No Interference – restrictions on an Owner’s ability to interfere with other Owners.
- Termination Events – provisions that can trigger the termination of the agreement.
How to Draft an Owner Agreement
Once you have developed means of determining ownership, the next step is to draft the actual owner agreement. The specific form language will, of course, vary depending on whether you are dealing with a non-competition agreement, an shareholder agreement or an employment agreement. However, there are a number of critical elements common to all owner agreements.
First, the agreement should be consistent with your business goals. For example, which events or conditions will trigger the buyout obligation or buy-sell right? The agreement should address whether certain actions or agreements will result in a forced buyout (such as divorce or personal bankruptcy) or if a "good leaver/bad leaver" mechanism will be triggered or a right of first refusal will arise if an owner’s children or business partner’s heirs inherit his interest in the business? Second, the agreement must be clear on how to price the buyout. Will the buyout amount be based on a book value accounting set forth each year? Will the buyout be based on an appraisal process? The agreement should set forth the procedure for performing the valuation (i.e., agreement of the parties, arbitration or court appointment of an Appraiser). In addition, the agreement should set forth the timing and manner in which the buyout payment will be paid (i.e., lump sum lump payment, installment payments, promissory notes, etc.). Third, the agreement should establish and set forth the conditions under which a default will be deemed to have occurred, the rights of the non-defaulting party, and the procedure for declaring a default and enforcing the remedy. Keep in mind that to comply with the 20% capital gain tax rate on long term gains, at least 51% of the equity of the company should be owned by individuals who are not current employees or independent contractors. Negotiating the terms of an owner agreement will undoubtedly require the participation of a number of your stakeholders in addition to your lawyers. You will need input from your accountant to determine whether you want to use the valuation methodology that will be implemented under the owner agreement for both your business accounting, as well as for federal income tax purposes. You will want to ensure that your insurance professional is aware of the owner agreement, so that he can address the need for life insurance products. Your financial and business advisors should also be involved to ensure that the drafting of the owner agreement is consistent with your plans for the growth and development of your business, and other forms of owner agreements that may present in the future. The owner agreement must be clearly understood by all parties, and drafted in a way that satisfies enforceability requirements, in order to avoid enforceability problems in the future. In addition, the owner agreement must be periodically revisited as the business grows, to ensure that it is consistent with the ever changing business environment.
Owner Agreements: Common Errors
It’s important to have an owner agreement in place, but it’s equally important for all parties to understand what clauses should be included and the consequences of a poorly drafted owner agreement. We refer to this as a "common mistakes clause" because we often find it’s a common mistake when drafting an owner agreement. Below are the most common mistakes which I’ve seen in owner agreements and recommendations to avoid these mistakes.
A lot of times if a business was set up with little planning, when you look at the owner agreement there’s often no provision for what happens if one or more of the owners of the business want to sell or one owner wants to leave. This could have devastating impacts to the business if it is a closely held entity with the other owners unwilling to buy out the other owner.
We strongly encourage you to have a "buy-sell" clause in the owner agreement which will state when and how an owner can sell his or her interest, including how the purchase price would be calculated. A company may have 2 options if an owner does not want to sell but buys another business:
· If the owner buys the new business in his/her name or in any entity that he/she controls, the owner agreement should provide for a merger clause. For example, if Jim Smith owns ABC Company, Inc. and buys XYZ LLC, the two companies could merge together.
· If the owner buys the new business in his/her name personally or in any entity not controlled by the owner, the owner agreement should give the other owners the right of first refusal to purchase the new business upon Jim Smith’s sale of it to them .
If you have an owner agreement in place that states the distributions in the form of profit is to be in accordance with their stock or membership percentages, then you need to be aware that your distributions may be taxable even though there are no profits. This is because the IRS will treat your distributions as dividends unless the distributions are first allocated to losses and deductions of the business. A better way to go would be to have the owners agree to only distribute profits in accordance with their percentage of ownership. This could be more in line with preserving the capital in the business in tough situations.
Assuming that the owners have agreed to a buy-sell clause in the owner agreement that provides for the purchase of the selling owner’s interests by the remaining owners at a certain price, it does not mean that it’s really enforceable. For example, if the owners had purchased a life insurance policy on his/her life and stated in the owner agreement that the company will purchase the selling owner’s interest at the price of the policy, it does not mean that will actually happen. It is not uncommon for the buying owners or company to want to pay for the selling owners’ interest on time. In that case, the selling owner’s interest could be encumbered. For example, let’s say that the selling owner wants to remain an owner until his payment is complete. Any proposed financing should have a priority mechanism in place if the company files bankruptcy.
Owner Agreements and the Importance of Using Legal Counsel
When you choose to enter into an owner agreement with your partner, whether the agreement is a limited liability company operating agreement (an "LLC Agreement"), partnership agreement or otherwise, even if you have a working familiarity with the English language, you need the assistance of legal counsel. This is because an owner agreement is a contract, and its provisions prevail over the default statutory terms provided by the laws of the state where the business entity is organized. Many of the matters that are covered under state law may be counter-intuitive for business persons but have strong legal significance and wide implications. An owner agreement can bring both peace of mind and financial security to your business if it is well thought out and drafted; conversely, if it is poorly prepared, it can spell turmoil and lead to litigation. Legal counsel can assist you in drafting, reviewing and negotiating terms to ensure that your interests are adequately protected.
Complying with the Laws that Govern Owner Agreements
To ensure that an owner agreement is compliant with all relevant laws and statute, as well as enforceable in court, it is important to work with legal experts who can guide a strata towards developing the specific types of by-laws that will best meet the needs of a particular strata . The strata should ask their strata manager for names of lawyers who are experts in the area of strata law. A strata plan should revisit its owner agreement regularly and have its lawyer review the owner agreement every few years to determine whether it may need to be updated due to changes in the law, circumstances of the strata plan or other factors.