When drafting governing agreements (“agreements”) for a corporation, partnership or LLC, provisions addressing the transfer of ownership interests (“interests”) are often not given the attention they deserve.
If an agreement is silent on the issue of transferability of an interest, generally it is presumed that the owner’s interest is freely transferable. While in certain situations that may be acceptable, it is important to consider events which may warrant stricter provisions on transferability. Among these events could be: (i) sale of an interest to a third party; (ii) a third party offering to purchase an interest; (iii) the bankruptcy/insolvency of an owner; (iv) the death of an owner; (v) the divorce of an owner; or (vi) an owner ceasing to be employed by the company.
Transfer provisions are many and various, and practically anything can be drafted, but the following clauses (or combinations of these) are commonly used depending on the event:
Consent of all owners: A very simple rule, which is effective for many situations, is that no interest can be transferred without the consent in writing of every owner. While this approach may work in many small private companies, it may be less appropriate as the number of owners increases since it will give every owner a veto right over what may be a perfectly reasonable transfer.
Family provisions/Other Owners: Some agreements allow interests to be transferred freely to family members (as defined) or other owners while transfers to anyone else are restricted.
Pre-emption provisions: Typically, these provisions provide that the company and/or the other owners have the option or right of first refusal to purchase an interest should one of the events described above occur before an owner can freely transfer its interest to another party.
Drag along and tag along: A drag along clause usually provides that if a majority owner wants to sell the entire company, the other owners must sell their interests at the same price. This stops a minority owner from blocking the sale. The majority ownership required tends to vary from a simple majority to perhaps 90%, depending on the circumstances within the company. A tag along clause says that if the majority owner sells its interest, the minority owner is entitled to sell a portion of its interest on the same terms. Drag along and tag along clauses tend to be included together, but can be included separately.
Equally as important as addressing transferability provisions, owners should take time to discuss how an interest is valued and the payment terms for any interest that is transferred. With the sale of an interest to a third party, the value will most likely be the offered price for the interest while transfers for other events will typically be the fair market value of the interest or, in some cases, the book value of the interest. Discussions should include any discounts to be applied in valuing the interest. Finally, as it relates to the payment for an interest, the owners will need to discuss if payment is to be in cash, by a promissory note or some combination of the two, and if payment is by promissory note, the interest rate, term and security for payment.
