Protect Yourself When Gifting, Selling or Transferring Ownership

Quick Take: When gifting, issuing, transferring or selling ownership interests in your business, such as stock, units, warrants, options or convertible securities, talk to your attorney. Tell him or her you want to:

• Restrict transfer or sale.
• Get a right of first refusal on future transfers, for both you and your company.
• Prohibit hypothecation (pledging interest as collateral for a loan).
• Investigate tax implications.
• Put an agreement in place that addresses what will occur if and when the employee departs if shares are provided to an employee as incentive.
• Be sure to comply with securities laws.

There are many circumstances when you may want to sell, transfer or give ownership:

• Giving stock to your children or spouse
• Granting stock options to key employees
• Entering into a buy-sell or stock purchase agreement
• Raising capital with warrants (option to buy stock) or a convertible security (right to convert debt or preferred stock into common stock)

You should take great care anytime you give, sell or transfer ownership interest in your business. As long as you want it to continue to be YOUR business - and you want the freedom to manage it as you see fit - be sure you retain control over who can become partners and/or co-owners. A bad partner/co-owner can be a very bad thing indeed. A minority owner doesn't control the company, but he or she can become a real irritant, or worse.

This could happen to you:

1. You give some stock to your daughter. She gets divorced and her ex-husband winds up owning part of your business. He demands regular financial reports and claims you are cheating on taxes.

A. You give stock to an employee as an incentive to stay and grow with your company. After a few years, you have a falling out and you fire him. He goes to work for the competition and exerts his right to know what is going on at your company.

B. Your son uses his stock as collateral for a loan. He defaults, and now the lender is your minority stockholder.

Smart business owners don't let these things happen. They use common mechanisms to establish control when giving or selling stock for any purpose - and to any person or firm. Of course, this applies to ownership interests you issue (from stock held by you) and any issued by the company (new issues or Treasury shares).

Imperative #1: Restrict the Stock

When ownership is transferred (by gift, sale or whatever) to a person or entity, the seller provides the recipient with a piece of paper such as a stock certificate or option to buy stock. Before you do this, print a legend on the face of it. The legend will refer to a letter that outlines the restrictions by which the ownership interest is encumbered. Here is a sample legend:

Sample Restricted Stock Legend

The shares represented by this certificate have been acquired for investment and have not been registered under the Securities Act of 1933. Such shares may not be sold or transferred or pledged in the absence of such registration unless the company receives an opinion of counsel reasonably acceptable to the company stating that such sale or transfer is exempt from the registration and prospectus delivery requirements of said act. In addition, the use and transfer of these shares is limited and restricted by an investment agreement, copies of which may be obtained at no cost by written request made by the holder of record of this certificate to the secretary of the corporation at the principal executive offices of the corporation.

No doubt you noticed the SEC language that dominates the above. There are strict and complex laws that govern transfers of ownership interest in companies. Certainly, you don't want to run afoul of them. It is common practice to include in any stock legend protective language that addresses these laws, so we've included it in ours. The language that is germane to this article is found at the end of the sample legend and is in bold. But the SEC language alone places some burdens on the transfer of shares.

Again, this legend would be printed prominently on the stock certificate or other piece of paper that evidenced the ownership interest. Note that the above is just a sample. Talk to your attorney before transferring any ownership interest. We highly recommend that if your primary attorney is not experienced in private business ownership transfers (i.e., securities), find one who is.

Investment Letter: This is simply a document that outlines restrictions on ownership interest. It could have any number of names, such as stockholder agreement. We suggest that it provide the following restrictions:

1.    Restrict future sale or transfer of the shares.

2.    Grant a right of first refusal to both you and your company.

3.    Prohibit pledging of the stock as collateral for a loan or other transaction (referred to as "hypothecate").

4.    Require compliance with federal and state securities ("blue sky") laws.

5.    Shares are and remain subject to the terms of any stockholder agreement, buy-sell agreement, employee ownership plan or option plan, or any other agreement that might be in effect. Be sure to include name and execution date of any such documents. See page 14 for a sample Investment Letter.

Right of First Refusal: This gives you some control over who might become an owner of your business by sale or other transfer of shares that are held by a person or entity to whom you have sold or given shares. We say "some" control because transfer is not prohibited, but a right of first refusal will give you the right and ability to block a transfer by matching the terms under which a transfer is set to take place.

Note: You might ask why we don't suggest you simply prohibit a transfer. This, of course, would be ideal, but it is our understanding that case law holds that such a provision might constitute "unreasonable restraint" and thereby be rendered void and unenforceable. Check with your attorney.

Buy-Sell Agreement: We strongly suggest that every business with multiple owners executes a buy-sell agreement, possibly funded by life insurance, which provides for automatic purchase/sale of shares upon the death, disability or retirement of any of the owners. There are two primary types:

Stock redemption: Corporation buys stock from stockholder(s).
Cross-purchase: Individual stockholders buy stock from one another.

Be sure to consult your tax advisor or attorney, because there could be differing tax results among the different types of transactions.

In addition, the buy-sell agreement can specify whether it is mandatory (you must buy the stock) or optional (right-of-first-refusal). The agreement should establish the price at which the interests will be purchased/sold. And instead of a set or static price, we suggest that the agreement include a formula for determining value, one that will continue to remain valid and "fair" as the business evolves and changes over time. Failure to have such a provision will almost certainly result in a dispute over valuation.

Employee Stock Ownership Agreement: If you award or sell ownership or options on ownership to employees as a way of attracting and retaining key employees, you must put in place an agreement that governs and restricts the employee's ownership of the stock. The agreement should make the shares subject to all the restrictions discussed in this article, but also address what occurs if and when the employee departs your company. Typically, options become void and interests are re-purchased. If, for any reason, employees retain ownership of shares after they depart your employ, will they have a right to data on your company if they go to work for or become a competitor?

Caution for S-Corporations: If your business is an S-corporation, you should include an automatic restriction on the sale or transfer of any stock position that would invalidate the tax status of your S-corp. This is because the transfer of stock to another corporation would disqualify a business from being taxed as an S-corp. As a result, you would revert back to a C-corporation - and you know what that means (i.e., double taxation).

In summary, when selling or issuing ownership interest in your company, do the following:

1.    Seek the advice of an attorney skilled and experienced in securities laws.

2.    Legend the stock certificate.

3.    Execute an investment agreement.

4.    Restrict the transfer or sale.

5.    Get a right of first refusal on future transfers, for both you and your company.

6.    Prohibit hypothecation (pledging of the interest as collateral for a loan).

7.    Prior to any transfer, investigate the tax implications to both parties.

8.    If the shares are provided to an employee as incentive, put an agreement in place that addresses what will occur if and when the employee departs.

9.    Take prudent and proper action not to run afoul of state and federal securities laws.

Do these things and you will save yourself considerable time, money and trouble over the years.