Jerrod, 58, and Penelope, 54*, each hold a 50% stake in a clothing distribution company they founded 15 years ago. Penelope’s the CFO and Jerrod’s president and head of sales. The firm has annual revenue of $25 million, netting $2 million after salaries of $400,000 each to Penelope and Jerrod. Their marriage has been shaky the last five years; this year they split, creating planning issues their advisor will need outside experts to resolve.
There are three children: Cecilia, 30 and Edmond, 26, both from Penelope’s previous marriage, and Sam, 16, whom Penelope and Jerrod had together. Cecilia is a sales manager and Edmond is a warehouse supervisor at their parents’ firm.
*This is a hypothetical scenario. Any resemblance to real persons or circumstances is coincidental.
Partner, Audit & Advisory, Crowe Soberman LLP in Toronto
Jerrod and Penelope met and married when they were employees at a competitor firm. Their financial situations were similar, so they didn’t bother with a marriage contract or shareholders’ agreement.
The split leaves them with three options:
- They manage their differences and stay in business together.
- They can’t co-operate, so one buys the other out.
- One or both sell to a third party.
A shareholders’ agreement is the key tool for managing multiple possibilities under each of these scenarios. But, before they draw one up, they need a separation agreement.
This typically covers property, spousal support and child support. It can also address family-related company matters.
For instance, Penelope may worry that, if she lets Jerrod buy her out, he’ll hand Cecilia and Edmond pink slips out of spite. Jerrod may be deterred by potential wrongful dismissal suits, but it still makes sense to use the separation agreement (or another, separate agreement) to prevent the firings, says Neil Maisel, a partner at Crowe Soberman.
Penelope could also insist on requiring all three children being treated equally. So, if Jerrod eventually transfers 10% ownership to Sam, then Cecilia and Edmond would get the same.
Degree of difficulty
Jordan Caplan, also a partner at Crowe Soberman, explains the shareholder’s agreement should cover terms and conditions, if Jerrod and Penelope stay in business together. It would also detail what would happen under various sale scenarios, if either Jerrod or Penelope dies or becomes disabled, or if either of them go bankrupt.
A shotgun clause is advisable, says Caplan. If Penelope offers to buy Jerrod out, the clause requires that he either sell or buy her shares at Penelope’s offer price. This keeps Penelope honest, because if she low-balls him, he can simply refuse to sell and walk away with her shares at a major discount. Say Jerrod wants to retire early and has an outside buyer for his shares. If Penelope wants to keep going, she will rightly be concerned about who her new co-owners will be. The agreement covers that concern, says Caplan. “If she doesn’t approve, she’ll have the option to either buy Jerrod’s shares on the same terms and conditions the third party offered, or sell her shares to the third party.” Jerrod and Penelope may both want to sell, but that doesn’t mean they’ll agree on what the best price is. For example, an outside buyer may offer $15 million. Penelope knows it’s a great price in a tough market and could want to close. But Jerrod could claim the price is too low.
A good shareholder’s agreement can help prevent such disputes from holding up a sale. It will include language requiring Jerrod and Penelope to make an effort to get the best price. It will also say, if they can’t agree on whether to accept an offer, the one who claims it’s too low must buy the other’s shares at the offered price. “The idea,” explains Maisel, “is that if it’s worth more, as you claim, you should be happy to buy me out at what you think is a discount.”
The agreement will also cover compensation, should Jerrod and Penelope continue as business partners. Caplan and Maisel say this could get complicated, given that Jerrod’s may be worth more to the company. When they were married and drawing $400,000 salaries, neither cared if the other was worth more or less. “That’s because it’s all going into the family pocket. But what happens if Jerrod were to say to Penelope, ‘I’m worth my $400,000—or more—but no company would pay you $400,000 for the job you’re doing.’ ”
Adds Caplan: “As important as the CFO is, the reality is that business is about relationships, and with Jerrod being the face of the company, he could take customers or suppliers with him should he leave.” Jerrod could bring in a compensation specialist who might determine, for instance, that he’s worth $500,000 and Penelope $300,000. Jerrod might then tell Penelope he’s prepared to continue with her only if she accepts these salaries.
Maisel warns this might not be the best course, even if the compensation specialist is right. That’s because Penelope could threaten to use the asymmetry as the basis for a spousal support claim. If successful, Jerrod would end up paying a portion of what he gained to Penelope in the form of support. There’s no guarantee Penelope would succeed. Still, it makes sense, says Maisel, to codify the original compensation arrangement in the shareholders’ agreement if they intend to continue as business partners.
A spousal support claim could also arise if one buys out the other. It all depends on the sale price, Maisel notes. “Say her half’s worth $10 million after tax. It may be that the investment income she earns on it will be sufficient to meet her living needs. A judge may say, ‘You’ve got $10 million; you could easily earn 5% on it conservatively, which is $500,000. You don’t need any more support.’ ” The agreement must also cover the possibility that Jerrod, for example, remarries and gets divorced. “It should say something to the effect that, ‘If you get married, you must have a marriage contract stipulating your future spouse can never acquire your shares,’ or ‘Your shares shall be excluded from any net family property calculation,’ or both.” This would preclude future spouses making a claim on the shares.
Despite the bitterness of their split, Penelope and Jerrod decide to continue as business partners. Against his advisors’ counsel, Jerrod hires a compensation expert because he’s convinced he’s worth more than Penelope. The expert says Jerrod’s salary should be $450,000, and Penelope’s $275,000. Penelope warns she’ll file a spousal support claim if Jerrod insists on including these salaries in the shareholders’ agreement. He’s willing to take his chances and a legal battle ensues.
The court agrees with Penelope, so financially Jerrod ends up where he started—less $200,000 in legal fees, just as his advisors warned.
The legal battle has made it impossible to continue as business partners. Constant bickering in the boardroom and time away from work negatively affect business and employee morale. The best option is to sell.
Neither Jerrod nor Penelope is keen on leaving the business, but they realize selling the whole company is the only option. They can’t work together, and their behaviour during the split has poisoned their once-strong relationships with management and other staff.
No one within the company’s senior management can get financing, so Penelope and Jerrod approach their old bosses, who are happy to get rid of a competitor. They heard Penelope and Jerrod’s personal animosity was driving the sale and used it to their advantage, whittling down the price to below fair market value.
Originally published in Advisor's Edge
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