Insights into Ownership Agreements – part two

How liquid is my investment?

One of the most important considerations for business owners is the liquidity of their investment.  Ordinarily, it will be imperative that there be non-complex mechanisms for business owners to sell their investment and to admit new investors, should additional capital be required.

There are two main ways in which an owner will transfer their interest – voluntarily and involuntarily.

Voluntary transfers

A voluntary transfer process will commence upon an owner issuing a transfer notice in respect of their interests.  Ordinarily, this will give rise to a pre-emptive offer process, where each remaining owner will be entitled to acquire the departing owner’s interests up to the point which maintains the pre-existing ownership proportions (calculated by excluding the interests of the departing owner).

Any interests not taken up in the first round offer can be offered again, in a second round offer, to those remaining owners which took up the first round offer.

Where a sale price is not agreed between the departing owner and remaining owners, then it is important that the ownership agreement contain a mechanism or formula for determining the sale price.

Transfers to third parties

Owners will need to consider what process is to occur, if after the completion of the pre-emptive rights process, there remains unsold interests held by the departing owner.

In order to promote liquidity, this scenario will generally allow the departing owner to cancel all offers under the pre-emptive rights process and sell their interests to a third party within a specified period, for a sale price which is equal to or more than the sale price offered to the remaining owners.

Additionally, owners will need to consider whether, in this scenario, a certain majority of owners can compel the minority owners to sell their interests to a third party which seeks to acquire 100% of the interests in a business entity.  Again, this is vital for liquidity in for business entities with multiple owners.

Involuntary transfers

An involuntary transfer will generally occur where an owner is held to be in default of its obligations under the ownership agreement, in circumstances where the default is not capable of remedy, or where the owner in question has failed to remedy the default within a reasonable period of time.

Events of Default can include the following:

1. an individual associated with an owner ceasing to work in the business;
2. an owner failing to pay an amount due under the ownership agreement, for example the subscription price in connection with the issue of new interests to raise funds;
3. an owner failing to comply with an obligation under the ownership agreement, for example establishing a competing business; and
4. the change in control in an owner entity without the consent of the owners.

Should an event of default occur, it is imperative that any other owner has the ability to commence the involuntary transfer process, regardless of the participation of the defaulting owner.  This will allow the remaining owners to buy out the defaulting owner.  Consideration should also be given to whether a discount should be applied to the sale price of the defaulting owner’s interests, given the cost and inconvenience borne by the remaining owners where there is an untimely departure.

Other transfers

Of course, owners are free to agree on other processes which will give rise to a transfer of ownership interests.  These can include transfers pursuant to:

1. put and call options; and
2. the death or disablement of an individual associated with an owner entity, whereby insurance proceeds are utilised to fund the buy-out of the relevant interests by the remaining owners.

This concludes part two of the Insights into Ownership Agreements series.  Click here to read part one.