Ownership Transfer Restrictions by R. Scott Alagood
Many individuals form business organizations for various reasons. Some of the most common reasons are to address tax matters, limit liability, provide a specific or perpetual duration, and address ownership transferability issues. The Texas Business Organizations Code (“TBOC”) authorizes individuals to form three general type of entities: partnerships, corporations, and limited liability companies (“LLC”). While there are other forms of entities which may be used for particular professions or other specific uses (such as non-profit or limited liability entities), these three forms comprise the most commonly used entities. The partnership form is further divided between general partnerships and limited partnerships.
Why is it important to address transferability issues in a business organization? For one, the success of a business, particularly a small business, typically hinges upon the abilities of the owners who are usually also the managers. It is important that each owner know with whom he or she is conducting business. Furthermore, the owners at some point may wish to sell their interests in the entity. Since there is no ready market for investors of small businesses interests, transfer restrictions in the form of buy-sell agreements can be used to create a market and set a reasonable price. In other instances, transfer restrictions can assist with compliance of state and federal laws. Certain corporations may be exempt from securities registration under federal and state law where transfer restrictions are used.
In most instances, the owners of a business organization may set up their own transfer rules in a written agreement. For corporations, those rules may be set forth in the Bylaws, but are typically found in a separate document referred to as a shareholder agreement. For partnerships, transfer restrictions are set forth in a partnership agreement. For LLCs, the company agreement contains the transfer restrictions.
If the owners fail to provide their own transfer rules, the TBOC will regulate such transactions. Leaving aside the corporate form, the rules set forth in the TBOC for partnerships and LLCs are similar. Before becoming an assignee partner or member, consent of all of the partners or members must first be obtained. In those instances where consent has not been obtained, a transfer of an ownership interest will not result in the assignee achieving partner or member status.
However, the mere assignment without consent (absent an express written agreement to the contrary) will not void the transfer of the interest to the assignee. Unless restricted or prohibited by the partnership or company agreement (or other document), a partner or member may freely assign his or her interest to another party. The preceding rule also applies to the transfer of corporate shares. However, without the consent of all owners, the assignee will not be entitled to exercise the rights or powers of a partner or member in the entity. Nor will the assignee become liable as a partner or member solely because of the transfer. Instead, the assignee is entitled to be allocated any income, gain, loss, deduction, credit, or similar items, and to receive distributions to which the assignor was entitled, to the extent such are part of the assigned interest.
For corporations, the owner’s (or shareholder’s) interests in the company are generally freely assignable unless otherwise agreed to in writing between the owners or disallowed under the TBOC. For small business corporations, the implementation of a shareholder’s agreement is of particular importance. The shareholder’s agreement allows the owners to predetermine the manner in which their relationship will operate and is akin to a partnership or company agreement. Without a shareholder’s agreement, minority shareholders may have little or no recourse to control how disputes are resolved. They may be unable to remove themselves from the corporate ownership structure without a significant financial loss. Majority shareholders may try to squeeze or freeze out the minority shareholders and force them to sell their interests for less than they are worth.
Shareholder agreements will usually contain one or two types of transfer restrictions: mandatory buy-sell and first option buy-sell agreements. A mandatory buy-sell is triggered by a specified event, such as the death, disability or divorce of a shareholder. When the event occurs, either the corporation or the other shareholders are required to purchase the shareholder’s interest pursuant to specified pricing and payment terms contained in the agreement. A first option buy-sell reserves the right of all shareholders or the corporation to purchase shares in preference to third-parties. As opposed to the mandatory buy-sell, the first-option buy-sell does not require that the other shareholders or corporation purchase the selling shareholder’s interest, but instead allows them to do so if they so choose. If the option is not fully exercised, then the shareholder is allowed to consummate a sale to a third-party.
Restrictions on transfer are important aspects of doing business as a Texas business organization. Failure to obtain and use them can result in unintended consequences to the business and its owners.