CONFLICT ISSUES IN THE SALE OF CLOSELY HELD BUSINESSES | TENSIONS AMONG FAMILY MEMBERS
The sale of a family business or any business with multiple owners creates potential conflicts among the owners as well as potential issues for the attorney representing the sellers.
Among these issues are those related to employment/consulting agreements, noncompete agreements, indemnification clauses, and dispute resolution as part of the sale.
Identify these issues early and the sale process will go smoothly.
Identify whether conflicts arising among the owners to levels requiring separate legal counsel.
The sale of a business is often the largest and most important business decision an individual will encounter during the ownership of the enterprise. If the business has multiple owners, particularly family members, the process can become more stressful due to the various interests and conflicting positions that may arise.
In most sale transactions, the active managers receive consulting or employment contracts from the buyer for services post-closing. To ease the transition period, often the buyer will want the former managers to stay with the business for several months or a year or two. In other instances, long-term management retention is a critical component of the sale. The amount of the compensation paid could be perceived as part of the purchase price if the amount is in excess of what would typically be paid to a third-party manager. In addition, the length of any consulting or employment agreement, as well as the benefits demanded by an active manager, may put such individual at odds with the other owners. Such manager may be prepared to stop the sale because his or her demands will not be met. This creates an irreconcilable conflict for the attorney handling the sale. Often this potential conflict is known at the beginning of the sale process, and the sale attorney should advise the manager to engage separate counsel. At times, the conflict does not arise until midway through the process. At that point, the sale attorney must recommend the manager retain separate counsel so that the attorney can fulfill his or her duties to the other owners.
On a related issue, often there is only one owner involved in the business while the other owners remain in the wings or uninvolved. In connection with the purchase of the business, the buyer will expect the owners to provide noncompetition covenants that preclude the owners from entering another business that competes with the sold business. The non-active owners will generally have no problem providing a noncompetition agreement, whereas the active owner may have an issue agreeing to anything that deprives him or her from engaging in activities that have been his or her livelihood for years. The active owner may insist on compensation for this prohibition. From the buyer’s perspective, the noncompete is part of the purchase price. To the buyer, how the purchase price is allocated and paid among the owners is generally not a critical issue.
If the active owner has at least a majority of the business, there is generally not a separate payment to him or her in consideration of the noncompete. Where the manager has a minority ownership interest, however, it is not unusual for the individual to insist upon and to receive separate compensation for such covenant. The size of such payment could put the owners in a conflict situation, and the attorney who is handling the sale of the business must be cognizant of the conflict that has arisen among these clients. Obviously, any payment made entirely to the active owner reduces the size of the payments made to the nonactive owners. If the active manager receives an employment or consulting agreement, a noncompete provision may be contained in this agreement abating, to a degree, the need for a separate payment.
One caveat is that several states, including California and Oklahoma, do not recognize noncompete provisions in an employment setting as a matter of public policy; however, even these states will enforce noncompete provisions from owners selling their business. Consequently, even if noncompetes are contained in employment or consulting agreements, buyers will also insist such provisions be included in the sale agreement or an ancillary agreement.
A third area of potential conflicts arises in the provision of indemnification. In the sale agreement, the sellers will generally provide the buyer representations, including, among other items, ownership of the assets, the lack of environmental or tax issues, the collectability of receivables, or the condition of the building or equipment used in the operations of the business. Buyers will look to all of the owners of the business to give these representations. The nonactive owners are reluctant to provide indemnification with respect to facts relating to a business of which they have little knowledge. The active manager may be willing to provide such representations, but will be reluctant to be responsible for more than his or her pro-rata share, particularly if his or her ownership percentage is substantially less than 100 percent. From the perspective of the active manager, all owners have participated for years in the profits of the business and should then also participate in the provision of standard representations.
This area of conflict is often resolved by placing a portion of the purchase price in escrow for a certain period, generally 12-24 months. The escrowed monies provide the sole source of funds available to the buyer for breaches of representations or warranties. Funds that remain available for distribution to the sellers after the end of the escrow period are then distributed pro-rata among the owners. In lieu of an escrow, often a portion of the purchase price is evidence by a promissory note. The buyer can utilize offset rights under the note to satisfy the indemnification obligations.
From a Seller’s perspective, obviously an escrow is preferable since it eliminates the risk that the buyer will financially be unable to make note payments or allege false or weak claims for indemnification. So long as the Buyer has the funds due to the Seller, the Buyer remains in a stronger position. If neither Buyer nor Seller has control of the funds, there is an incentive for both sides to reach agreement on the disputed claims. However, ensuring all Buyers have the funds available at closing to pay the full purchase price is not always possible, and taking a note may be the only avenue available to effect the transaction.
Buyers will generally want the Sellers’ indemnities to be joint and several. A buyer will not want to chase multiple sellers for their prorate shares. Minority owners generally refuse to give indemnities for the full indemnifiable amount. A majority owner often will be prepared to provide the full indemnification, provided all owners execute a contribution agreement. The contribution agreement requires all owners to reimburse, pro rata, any owner that is obligated to pay more than its proportionate share.
Finally, multiple owners will have multiple views on the resolution of disputes that may arise post-closing. Although the agreement of all or the majority of the owners may be necessary to sell the business, if an issue arises over an indemnification claim or interpretation of a contract provision, the Buyer will want to deal with only one representative of the Sellers. Accordingly, the definitive agreement should specifically appoint a single representative or small committee with authority to negotiate on behalf of all Sellers’ disputes that might arise with the Buyer. This representative should not be the active manager if such individual is, post-closing, an employee or consultant to the Buyer. This creates potential conflict by placing the individual between the current employer and his or her former partners.
The sale of a family business or any business with multiple owners creates potential conflicts among the owners as well as potential issues for the attorney representing the sellers. If these issues are identified early and are properly addressed, however, the sale process can go smoothly.
Michael Ellis is a corporate and securities attorney with over 40 years’ experience. He practices in the Cleveland office of Buckingham Doolittle & Burroughs, LLC. His focus includes the area of mergers and acquisition and counseling clients, including start-up and emerging growth companies, in equity, debt, and other capital financings. He also advises shareholders and partners in corporate formations and other governance issues.
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