The focus of this article is on small businesses, in the sense that there are only a small number of owners and the owners are employees of the company. These businesses were formed by the employee-owners and have no history of a public offering. The company could be a personal services company or closely held, whether officially adopting that designation or not.
Succession planning acknowledges that employee-owners will not continue running the business into eternity. Employee-owners will move on, retire, become incapacitated or die. But with succession planning, their business may continue.
An employee-owner is any owner who also works in the company. They may receive pay on a W-2 basis or through a draw that is treated as income or a 1099-NEC.
Texas entities are governed by the Texas Business Organizations Code, and all references to entities in this article refer to Texas entities. The entities discussed herein are corporations and limited liability companies. The strategies in this article will have limited application for a sole proprietorship, which is an individual who has gone into business without forming a business entity. Some may apply to partnerships, but the planner should review relevant TBOC provisions for the specific type of partnership at issue.
I. Closely Held Business Versus Personal Services Company
According to the IRS, closely held businesses are those where more than 50 percent of its ownership is by five or fewer individuals, and it not a personal services company.
A personal services company is one whose principal activity is performing personal services, with more than 20 percent of its compensation costs paid to employee-owners. Personal services include any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law firms and the performing arts.
II. Types of Succession
Employee-owners are mortal, and the best chance of continuity is when employee-owners begin with the end in mind.
Employee-owners can leave through voluntary transfers, like sales, and involuntary transfers, like death, divorce, bankruptcy or incapacity.
A. Succession of Governance Versus Succession of Ownership
Governance refers to control. Entities are governed by their governing documents and governing authority. Ownership provides legal rights and responsibilities to the entity, including the right to share in the profits of the company. In small businesses, governing persons and owners are often unified, but that is not required.
1. Governance
Corporations are governed by directors, who are elected by the shareholders. Directors do not have to be shareholders, unless the bylaws require it.
Limited liability companies can be governed by members or managers. Managers of manager-managed LLCs are appointed or elected by the members and can be removed by the members. A manager does not have to be a member of the LLC. The strategies herein work best with a manager-managed LLC.
Partnerships are governed by the general partners. Limited partners are not allowed to govern. TBOC Chapter 152 governs partnerships.
Texas professional entities include professional corporations, professional associations and professional limited liability companies. Generally, PCs and PAs are governed like corporations, and PLLCs are governed like LLCs. Special rules regarding professional entities are beyond the scope of this paper and can be found in Title 7 of the TBOC.
All entities are allowed to have officers, and the duties of the officers are as determined by the governing documents or the governing authority that elects or appoints the officers. Corporations are required to have a president and secretary, and they may have other officers. Officers do not have to be owners.
Emergency Succession of Governance
Single member LLCs and sole shareholder corporations should consider having another person who serves as their emergency successor, in the event of short- or long-term disability. Emergency provisions can be included in the governing documents for the entity, or in a stand-alone policy, signed by the governing authority.
In a manager-managed LLC, emergency provisions in the operating agreement can name a temporary manager to act.
In an LLC or corporation, emergency provisions can name an emergency action officer.
Permanent Succession of Governance
Ideally, a departing owner will resign their positions in governance. Governing documents should include provisions address the death, incapacity or disability of the company’s governing individuals and spell out the method of their replacement.
2. Ownership
Ownership of corporations is through shares, which are also called stock. LLC ownership is held in either units or percentages. Partnership ownership is in percentages of ownership. Collectively, this article refers to these as ownership interests. LLC member interests and corporate stock are personal property that can be transferred, voluntarily or involuntarily. Partnership interests are also transferable, per TBOC §152.401.
B. Voluntary Transfers
1. Sales of Ownership Interest
All the sales options in this article will be exempt from SEC registration in that there will be no public offering and all buyers will be employee-owners, or accredited investors as recognized by the SEC. The agency defines accredited investor using measures of wealth and income thresholds and other measures of financial sophistication. Chapter 10 of the TBOC governs mergers, interest exchanges, conversions and sales of assets.
2. Asset Purchase Agreement Followed by Winding Up
Buyer Does Not Buy the Entity; Assets Being Transferred; Liabilities Stay with Seller
In this scenario, the employee-owners are all selling. It is a complete transfer of the business operations, customers, etc., by selling everything the business owns but not the entity itself. The selling entity retains all potential liabilities and only sells the assets of the business.
Winding Down/Winding Up
Some refer to the end of an entity as winding up and some as winding down, but both terms refer to finalizing the business of the entity after it is no longer doing business. The TBOC refers to this as winding up and defines it as, “the process of winding up the business and affairs of a domestic entity as a result of the occurrence of an event requiring winding up. After the purchase is completed, the selling entity is usually precluded from doing any business and can wind up. It is sometimes advisable to postpone winding up and have the entity remain in place to receive funds paid over time, to allow for resolution of any other open issues or for the entity to enforce obligations of the buyers in the asset-purchase agreement.
C. Involuntary Transfers
Ownership interests can pass involuntarily through an owner’s death, bankruptcy or divorce.
Since the other owners do not intend to be in business with the assignees under these scenarios, it is imperative to have language limiting the powers of the new owners of these assigned interests, or TBOC provisions will govern what happens.
Drafting for succession needs to address inheritance of ownership interests; transfer through bankruptcy; transfer to former spouse in divorce.
III. Buy-Sell Agreements
These agreements require the owners to sell their ownership in the company upon the occurrence of specified events, like death, divorce, loss of license, etc. They also specify who is going to buy the ownership interests, either the entity itself or other owners. They should address the valuation of the business and the time frame for the purchase. Valuation formulas may differ based on the reason for the valuation.
Absent these provisions, upon the death or divorce of a member, TBOC §§101.1115 and 101.111 apply for LLCs, and TBOC §152.406 specifically addresses the effect of death or divorce on a partnership interest if it is not covered by an agreement of the partners.
Buy-sell agreements can be in a separate buy-sell agreement or the terms can be included in an LLC operating agreement or bylaws of a corporation. These agreements should be endorsed by the spouses of any married owners. For this reason, it is often simpler to have a separate buy-sell agreement that is referenced in the operating agreement or bylaws.
1. Restricted Security
Because the buy-sell agreement limits transfer of the ownership interest, the ownership interest is considered a restricted security. If ownership is certificated, the stock certificates should contain an endorsement, similar to the following. If this is a corporation, rather than an LLC, change Company to Corporation and change Members to Shareholders. Adjust the number of owners to match the reality of the entity.
The voluntary or involuntary encumbering, transfer, or other disposition (including without limitation, any disposition pursuant to the laws of bankruptcy, intestacy, descent and distribution or succession) of the Interest evidenced by the within Certificate is restricted under the terms of an Agreement, dated [DATE], by and among the Company and the Members, [Member 1], [Member 2], [Member 3], and [Member 4], a copy of which Agreement is on file at the principal office of the Company. Upon written request of either such Member of the Company, the Company shall furnish, without charge to such Member, a copy of such Agreement. By accepting the Interest evidenced by this certificate, the holder agrees to be bound by the Agreement.
2. The Minimum
To be a buy-sell agreement, the fundamental requirements include: when ownership interests must be bought by the entity or by other owners; and when an owner, whether a party to the agreement or an assignee, must sell their ownership interests.
3. Best Practices
Well-drafted buy-sell agreements will address: valuation under various scenarios, including voluntary and involuntary transfers; methods of payment and timing of payments; consequences if the buyer balks or is unable to comply.
IV. In Summary
Upfront planning for succession, before conflicts or transitions arise, will allow employee-owners the security of knowing what to expect when life changes happen. Well-drafted succession plans can prevent litigation and other expensive disputes.
Hear and learn more updates on Texas legislation passed in 2023 affecting the governance of Texas entities by attending the “Choice, Governance and Acquisition of Entities” CLE course that will take place in Dallas on May 31. Other important topics relating to Texas entities will be addressed at the conference including, among other things, the Corporate Transparency Act, use of artificial intelligence in the boardroom, multistate tax update, funding sources, asset purchases involving a limited liability company, fiduciary duties of directors, drafting and planning for succession in a closely held business and earnouts in merger and acquisition transactions. Register today by visiting the event website.
Penny Robe is a former in-house lawyer and is now a legal adviser to small businesses. She is a past recipient of the Collin County Pro Bono of the Year Award and currently serves on the board for Legal Aid of Northwest Texas.