If your agency has more than one owner, you need to have an owner agreement. These contracts go by many names: in an LLC they are called operating agreements and in a corporation they are called shareholder agreements or buy-sell agreements. By whatever name, an owner agreement can be critical in managing disputes among partners or difficult situations like death or disability where an owner can’t act.
If your agency doesn’t have an owner agreement, if you used a generic download when you got together with your partner, or if you haven’t reviewed your owner agreement in a few years, use this as a checklist of things to consider.
Why Is An Owner Agreement Important?
Think of an owner agreement like the backstop at a baseball game. Most of the time the play stays on the field and the players (owners) are able to negotiate the challenges and surprises that come along. But occasionally, something wild or unexpected happens and the backstop prevents the ball from careening into the stands.
An owner agreement does something similar by providing a script if something unexpected and dramatic happens in the operation of the business — such as the death of an owner, an unresolved dispute among owners, or a deadlock. But like a backstop, the agreement is only there if needed. If you and the other owners are managing the play amongst yourselves successfully, you can do what you want (even if that’s different than what the owner agreement says).
So, don’t think of an owner agreement as something that binds you down. Instead, think of something that keeps the ball in play so the game can keep going even when something unexpected happens.
Key Elements of an Agency Owner Agreement
1. Distributions: Show Me The Money
Whether you are taxed as an S corporation or a partnership, the reality of these pass-thru entities is that you are taxed on your share of your agency’s income when it is earned, not when it is paid out to you as a distribution. Because of this, most agency owners take periodic distributions so that they can make estimated tax payments over the course of the year.
When an agency has just one owner, this is an easy conversation with the CPA. But with multiple owners, it is important to have rules about the amount and time of these distributions since each owner’s tax needs will be different. Typically an owner agreement says that the business is required to make tax distributions according to a formula or percentage.
As for non-tax distributions, the amount and timing of those payments are typically as determined by the owners. Whether owners determine this by majority rule or something else is a function of the next section.
2. Management: We Have the Power
The general rule with entities is that decisions are by majority rule. When you have two equal owners, majority rule effectively makes every decision unanimous. But as the number of owners increases, you may determine that majority rule is not best for all decisions.
Often an owner agreement will create two or more classes of decisions that require different levels of approval. Day-to-day decisions are by majority rule while bigger decisions require super-majority or unanimous approval. If you want, you can define multiple levels of supermajority approval for different types of decisions.
The effect of these rules may result in small owners having little control of a business — and that’s typical. Depending on ownership, a small owner can also sometimes act as a critical tiebreaker. It’s important to work through different voting scenarios when setting your management rules to ensure that outcomes are as expected.
3. Right of First Refusal: Let’s Keep This Amongst Ourselves
Every owner agreement typically has a provision saying that if one owner has an opportunity to sell their ownership interest, they must first offer it to the business or the other owners. The reason for this is because when people typically get together to run a business, they do so on the assumption of working together. More specifically, a right of first refusal ensures that an owner doesn’t wake up to find themselves in business with a stranger that bought out a former owner.
These provisions are generally pretty mechanical, but it’s important to pay attention to the timelines for notices, exercise of options, and payment mechanics. It is also common to set out a list of “permitted transfers” that are not subject to the right of first refusal such as transfer to a trust for estate planning purposes. But if a business has a lot of family connection, then permitted transfers might also include transfers to heirs or spouses working in the business.
4. Owner Events: Forever Is a Mighty Long Time
While you plan to be in business together for a forever, the reality is that something will likely happen in the coming years that throws a wrench in the gears. An owner might need to leave to take care of a sick family member, perhaps an owner just isn’t motivated by the business anymore, or maybe there is a death or disability, or it could just be that your group of owners think another owner isn’t carrying his or her weight anymore and needs to go.
Whatever the situation, you need a script to manage these situations. An owner agreement typically says that when any of these events happen, the company or the remaining owners have the option to buy out the shares. LIke a right of first refusal, the reason for a buyout is to prevent a stranger (e.g., heir, personal representative, estate) from owning the shares. In the case of employee-owners, a buyout on termination of employment is important to prevent a former employee from owning the shares. Death often triggers a mandatory buyout when there is insurance.
In addition to describing the buyout, the owner agreement also specifies the price and terms for the buyout. Typically the price is either as agreed by the parties or, if you can’t agree, fair market value is determined by appraisal or formula specified in the agreement. In some instances, book value is used. The price is usually paid via a down payment and then payment over time.
Importantly though, a person stops being an owner on the date the buyout is exercised even if the payments are over time.
Sometimes there is a clause that says if a person is fired for cause, that there is a reduction in price. A discount can sometimes also be triggered if a shareholder quits or retires without a good amount of notice (recognizing that for a key owner to leave on short notice would be very disruptive to the business).
5. Restrictive Covenants: Promises, Promises
An owner agreement also often contains restrictive covenants on the shareholders. These are clauses such as:
- Confidentiality
- Nonsolicitation of clients
- Noncompete with the business
- Company ownership of work product
With nonsolicitation clauses, often there is a discussion about exceptions for when an owner brings particular relationships to the business. They may want to be able to maintain those relationships when they leave the business.
6. Special Provisions
If your ownership group is more than 50/50, you might also consider drag-along and tag-along rights. A drag-along is a right of the majority owners to force the minority owners to participate in a sale of the company that has been approved by the majority. The reason is to prevent a small minority from killing a deal (where the buyer wants 100%). A tag-along is similar but it allows a minority owner to participate in any sale that the majority negotiates for itself (if not a sale of the whole company). The idea here is that if the majority is getting out, that’s a good cue to the minority to do the same.
If your ownership group is 50/50, it’s critical that you have a deadlock resolution provision. This provision says that if a decision can’t be made, one owner can declare a deadlock and set a price for the whole company. Then the other owner decides if they are going to buy out or sell out to the other owner. This ensures that one person ends up with the business (and can make the decisions they want) and the other person gets an acceptable price for the business. It’s a dramatic remedy, but something that is often missing from 50/50 owner agreements. If your agency is owned 50/50 by two people, make sure your owner agreement has a deadlock provision.
Keep it Up to Date
An owner agreement isn’t just set it and forget it. We recommend that you and your partners sit down with your agreement every year or two to see if it needs updates to reflect your goals, legal changes, or changes in your business. If your creative agency needs assistance reviewing your current owner agreement or drafting a new one, contact Matchstick.
