Wednesday, October 12, 2011

Shareholder Agreements: Define BuyOut Terms

In a prior posting, I noted the importance of setting forth clear terms for buying out another member (LLC) or shareholder (corporation).  For example, the buyout terms/shotgun clause can be set forth in the Operating Agreement of an LLC (or a separate agreement between certain members) or in a shareholder agreeement of a corporation.  The dispute between father and son of Amercian Chopper fame illustrates the need to clearly delineate the terms of any option.  (Paul Teutul v. Paul M. Teutel, 2010 NY Slip Op 09248 (2nd Dept. Dec 14, 2010))  

The father and son had an agreement that included an option for the Paul, Sr. to purchase the shares of Paul, Jr. "for fair market value, as determined by a procedure to be agreed to by the parties as soon as practicable."  Paul, Sr. sought to exercise the buyout option, which Paul, Jr. opposed enforcement of the option.   The Appellate Court ruled that while the reference in the clause to "the term of 'fair market value' in and of itself may be 'sufficiently precise' ... the plaintiff and the appellant went further and expressly agreed to later agree on a procedure for determining the shares' fair market value."  Significantly, the Court, quoting prior precedent, stated that for a closely held corporation (i.e.small prviately-held business) where ownership is held by a small group of shareholders and shares are not easily sold, the fair market value of the stock "'involves a certain degree of inexact valuation and subjectivity, making the procedure by which fair market value is determined of particular importance.'"

The Court reasoned that, as opposed to cases cited by Paul, Sr. where the parties had agreed on an (albeit flawed) procedure for determining fair market value of the stock, the clause here was simply an agreement "to later agree on a procedure for determining fair market value," and thus was not binding.

THE LESSON: The valuation of the stock/membership interests does not have to be determined at the time of drafting the option (buyout clause), but there must be clear terms as to the procedure for valuing the stock.  One alternative is to identify a 3rd party, like a CPA, as the person who will determine valuation and perhaps agree to share the expenses of the valuation.

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