Do you Have an Up-To-Date Buy-Sell Agreement?

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Judy and John started ABC Manufacturing Co. in 1980.  At the time, they outsourced all their manufacturing needs.  They had no employees and leased a small warehouse.  They prepared a “buy-sell” agreement restricting the transfer of their shares to anyone else and agreed that a “fair purchase” price would be the “book value” of the business.  At that time, the company was not profitable and Judy and John each borrowed the necessary capital to acquire the furniture, furnishings, and equipment of the business.  They also contributed whatever funds were required for the expenses of the business.

The business took off quickly.  Within five years, the sales were $5,000,000 annually.  They hired a sales force and other employees.  Then the business really exploded.  They bought a warehouse and began to manufacture their own products.  The business expanded into several locations and employed 150 employees.  Revenues reached $100,000,000 per year.

Then the unexpected happened.  John suffered a stroke and was unable to return to the business.  According to the buy-sell agreement, he was entitled to receive one-half the “book value of the business” within one year.  According to the buy-sell agreement, John’s share of the company was to be determined by taking the book value of all the assets, and deducting any debt of the business.

Unfortunately for John, ABC Manufacturing Co. was worth substantially more than “book value.”  The main assets of the business were greatly depreciated for book purposes.  The equipment had very little book value and the real estate had also depreciated for book purposes.  The “fair market value” of the real estate was considerably higher.  Based upon “book value,” John was entitled to receive approximately $5,000,000.  In fact, the business had recently received an unsolicited offer for $25,000,000.

This resulted in a “good deal” for Judy.  But she was lucky.  What if she had suffered the stroke?

A buy-sell agreement and its valuation process should be periodically reviewed to ensure that it continues to meet the owners’ needs and expectations.  Suppose the value was based on “fair market value,” which at the time was minimal and was required to be paid within one year?  Now, perhaps fair market value is $25,000,000.  Could the remaining owner’s business pay $12,500,000 in one year?

Events which might cause owners to review their existing buy-sell agreement include:

  • Admission of other shareholders
  • Use of life insurance or disability insurance to fund a purchase
  • Change in tax status, such as from a C-corporation to an S-corporation or a partnership
  • Changes in the business such as having new lines of business, or changing the fundamental business (for example, going from manufacturing to distribution, or to brokered sales)
  • If the shareholders acquire assets for use in the business (for example, they acquire real estate and lease it to the business)

If you have any questions regarding your existing buy-sell agreement or the preparation of a new buy-sell agreement, please call Levin Ginsburg at (312) 368-0100 and ask to speak with Morris Saunders or any of our attorneys in our business transactions department.

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Don’t Let A Creditor Make It Personal

As the owner of a corporation, when you set up your business, you and your lawyer believed that you had taken all necessary steps to protect your personal assets.  After all, the primary reason you set up a corporation was to shield your own assets from your business’s creditors. In order to ensure that your assets are safe from the corporation’s creditors, you need to do more than just fill out the Secretary of State’s paperwork. The corporation must conduct itself as an entity separate and apart from you as the owner.

A recent decision provides a “textbook” example of how an owner of a corporation can put his own assets at risk simply by the way he conducted his company’s business. In Puntillo v. Dave Knecht Homes, the plaintiffs were a married couple who entered into a contract with a home builder, a corporation. The defendants, David and Karen Knecht, were the beneficiaries of a trust that held the home builder’s shares of stock. They were, in essence, the owners of the home-builder corporation.  After the home was completed, it was riddled with defects and the couple obtained a judgment against the corporation. Thereafter, the corporation dissolved and the couple was unable to enforce their judgment.  In the midst of all of it, a new corporation, Dave Knecht Homes, was created with similar ownership, management, staff, purpose and resources as the now asset-less builder.  The defunct builder and the new company used the same line of credit.  Beginning in 2006, Dave Knecht’s personal line of credit began funding the now defunct builder’s operations.  After the new corporation, Dave Knecht Homes, came along, it also used the same credit line. After being unable to collect on its judgment against the out-of-business builder, the plaintiffs sued Dave Knecht Homes and its owners Dave and Karen Hecht personally.  The plaintiffs claimed the new company was merely a successor to the defunct corporation and the corporate veil between the individuals and the successor, Dave Knecht Homes, should be “pierced,” allowing the plaintiffs to go after the individual owners for a corporation’s debt.     

Generally, a corporation that purchases the assets of another corporation is not liable for the debts or liabilities of the selling corporation. There are, however, four exceptions to this general rule of successor corporate nonliability: (1) where an express or implied agreement of assumption of the liability exists; (2) where the transaction amounts to a consolidation or merger of the purchaser or seller corporation; (3) where the purchaser is merely a continuation of the seller; or (4) where the transaction is for the fraudulent purpose of escaping liability for the seller’s obligations. In this case, the plaintiffs successfully argued that Dave Knecht Homes is a “mere continuation” of the former company and the court agreed.  The continuation exception applies when the purchasing corporation is “merely a continuation or reincarnation of the selling corporation.” In other words, the purchasing corporation maintains the same or similar management and ownership, but merely wears different clothes. The Illinois Supreme Court has made it clear that “[t]he exception is designed to prevent a situation whereby the specific purpose of acquiring assets is to place those assets out of the reach of the predecessor’s creditors.” To determine whether one corporate entity is a continuation of another, courts consider “whether there is a continuation of the corporate entity of the seller—not whether there is a continuation of the seller’s business operation.”   Thus, the plaintiffs were permitted to look to the assets of the new company to satisfy their judgment.  Unfortunately for the Knechts, it didn’t end there.

The plaintiffs also argued that the out-of-business corporation served as the Knecht’s “alter ego” and that the court should pierce the defunct builder’s corporate veil and impose individual liability against the Knechts.  A court may disregard a corporate entity and pierce the veil of limited liability where the corporation is merely the alter ego or business conduit of another person or entity.” This doctrine imposes liability on the individual or entity that “uses a corporation merely as an instrumentality to conduct that person’s or entity’s business.” In Illinois, courts use a two-prong test to determine whether to pierce the corporate veil: “(1) there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist; and (2) circumstances must exist such that adherence to the fiction of a separate corporate existence would sanction a fraud, promote injustice, or promote inequitable consequences.

The court found that the Knechts exercised control over the new builder and treated the company’s assets as their own, causing the company to pay significant sums of money for their own personal expenses including federal and state income tax payments, landscaping for their personal residences; personal life insurance premiums and attorney’s fees. Moreover, the Knechts caused the failed company to pay their personal expenses using David Knecht’s credit line.  By causing Knecht’s former company to pay their significant personal expenses, the Knechts treated the company’s assets as their own. The court pierced the corporate veil of Dave Knecht Homes (who it imposed successor liability upon) and allowed the plaintiffs to enforce their judgment against David Hecht Homes and the individual defendants.

In order to insulate yourself from personal liability, as a business owner, the way that you run the business is as important as setting up the corporation in the first place.

For more information, please contact:

Howard Teplinsky at: hteplinsky@lgattorneys.com or 312-368-0100.

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