Firm Ownership: A Share of the Business

Our December "Professional Practices" features a look at taking a share of ownership in a design firm.

12/01/2001


An ownership stake in a design firm is a goal for many ambitious engineers. If the opportunity arises, shares in the business can represent a substantial portion of an engineer's assets and it's critical for would-be owners to protect such a major investment.

Whether it's the case that two or more entrepreneurs envision an enterprise and decide to form a corporation, or someone is invited to join an existing ownership team, a vital document is the shareholders' agreement, covering how the corporation will be managed and how salaries or other compensation will be determined—and adjusted from time to time. An even more important function of this agreement, however, is defining the transfer, valuation and purchase of shares. How to share

There are two basic approaches to shareholder agreements. In a cross-purchase arrangement , a shareholder's estate sells the party's shares to the remaining shareholders, who usually fund their pro-rata purchases through life insurance.

But this arrangement can be very expensive for the remaining shareholders. For example, if there are four shareholders, each will be required to obtain and pay premiums on life insurance policies for the other three shareholders. All told, the shareholders will be required to purchase 12 policies, and the premiums on those policies are not tax deductible.

An alternative is for the corporation to execute the shareholder agreement and agree to redeem the shares. Corporate purchase and redemption is often funded through insurance.

In reality, most agreements combine the two approaches. The remaining shareholders have the first option to buy, pro-rata, shares of a shareholder who is leaving because of termination or retirement, or who is resigning and proposes to sell his shares to a third party. The corporation also agrees to redeem all remaining shares that were not purchased by the other shareholders. Transfers and triggers

Restrictions on transfer of shares are intentionally broad and frequently require the shareholders' unanimous consent for any one of them to sell or pledge his or her shares.

For example, a shareholder may want to transfer shares to a trust without triggering a right to purchase by the other shareholders, who may resist this kind of permitted transferee exclusion because they want to insure that the shares are held only by individuals who will be directly involved in the day-to-day operations of the corporation. Also, under some state licensing laws, only a shareholder's heir who is a licensed design professional may become a shareholder in a design firm.

Shareholder agreements can impose restrictions on any transfer of shares to outsiders and can establish procedures for the valuation and purchase of the shares held by a departing shareholder. The corporation is generally in a better position—through insurance policies—than the remaining shareholders to fund the purchase and redemption of the shares of a deceased or a disabled shareholder. Usually, the corporation will have the primary obligation, and the remaining shareholders have the option to purchase pro rata any shares not purchased and redeemed by the corporation.

For noninsurable events—such as retirement, termination of employment or proposed sale to an outsider—the remaining shareholders generally have the first option to purchase the shares, and the corporation is obligated to purchase any shares not purchased by the remaining shareholders.

Regardless of whether insurance will fund the transactions, there is normally a requirement that the corporation or the remaining shareholders must, in aggregate, purchase all of the deceased or departing shareholder's shares. Most agreements provide that the purchase or redemption price is payable in installments if insurance is not available.

Also, the agreement should define "disability." A long-term disability insurance policy's definitions are helpful in drafting the shareholders agreement. There should also be a procedure for resolving disputes, such as a requirement that a disabled employee and the company jointly appoint a doctor whose determination of disability is binding.

A proposed sale of shares to a third party differs from the other triggers: It avoids the valuation issue, because the value is established by the third party's offer, and the corporation and shareholders can match the offer. There are usually two ground rules. First, the third party's offer—and the joint response of the corporation and the remaining shareholders—must extend to all of the shares held by the shareholder proposing to sell. Second, the third party's offer must: be in writing and signed by the third party; disclose the third party's business and residence addresses; specify the date upon which the proposed transfer will be consummated; disclose all material terms of the offer; and include the third party's acknowledgment that he or she will become a party to the shareholder agreement. The company and the other shareholders generally have 30 to 60 days to notify the selling shareholder of their intent to match the third-party offer. Finding value

Even within the same shareholders agreement, depending on the trigger, there can be several methods of determining the amount to be paid for shares of a departing shareholder.

The most straightforward valuation occurs when a third party makes a bona fide offer to purchase a shareholder's shares. The offer establishes the price of the shares and the other terms and conditions of sale. The only real question is whether the remaining shareholders and the corporation will exercise their option to collectively purchase all of the shares at the same price—and on the same terms and conditions—or whether they will allow the sale to the third party to proceed.

Alternatively, a preemptive offer can be a useful valuation technique when one shareholder wants either to liquidate his position with the firm or to buy out other shareholders. In this case, a shareholder notifies the others that he is willing either to sell all of his shares at a certain price or to buy the same number of shares from the other shareholders for the same price. It is presumed that the specified price will be fair, because he does not know whether he is selling his shares or buying shares held by others.

A third approach is for the corporation to purchase insurance payable upon the death or the permanent disability of each shareholder. In this case, the valuation of the shares is really determined by how much the corporation can afford to pay in premiums for the insurance. It should be noted that the annual premiums on the individual policies may be treated as additional income to the individual shareholders.

Finally, a fourth approach—often used in connection with a shareholder's retirement, resignation or termination—takes one of three forms:

  • Net worth. To determine the per share price, the company's net worth—assets less liabilities—as of the valuation date is simply divided by the number of shares outstanding. It is certainly easy to determine book value, but it will not reflect the value of the company as a going concern, or its earnings potential. These book-value determinations are usually limited to the negative departure situations, where the shareholder has resigned or has been involuntarily terminated.

  • Formula. To better reflect a company's potential, some agreements include a valuation formula. One example takes the most recent earnings before tax deductions; multiplies by a factor appropriate for the industry; adds cash or marketable securities; subtracts interest-bearing debt or capitalized leases; and divides the result by the number of shares outstanding.

  • Appraisal. Some shareholder agreements provide that upon the occurrence of any triggering event, the company's accountant shall commission an independent financial advisory firm to conduct a valuation study.

Whatever the approach, or combination of approaches, every few years the shareholders should review the agreement and make adjustments that reflect the firm's financial condition.



Productive Partnerships: Project Teams Work Together

Partnerships for architectural and engineering projects have one broad objective: to combine ideas, talents and resources to nurture an effort from start to successful completion. Along the way, partners overcome obstacles, uncover hidden opportunities and increase a project's ultimate value.

But rarely do such relationships just happen. The partners must be compatible in vision, approach and work styles. They must know how to trust and communicate with one another, when to stand firm and when to compromise.

Partnering with the client has become extremely popular in the design and construction industry, especially for public sector projects. This form of partnership brings together owner, architects, engineers, contractor, subconsultants and other stakeholders at the outset. A meeting, which is usually facilitated by an outside specialist, serves as a forum to discuss individual and common goals, exchange ideas, assign responsibilities and delineate processes.

These participants develop a charter that formalizes the project's fundamental goals and tenets and commit to upholding it. The partnering process continues throughout the life of the project, through constant communication and periodic review meetings to evaluate progress and identify areas for improvement.

"Partnering is the application of good project management and communication principles to large, complex projects," says Bob Sims, a director of programming, strategic planning and design services for Forth Worth, Texas-based Carter & Burgess. "It's very good for team-building and achieving consensus. Collaboration may be a more accurate term, because everybody is bringing together their best ideas to produce a better result for the client."

Partnering also provides valuable information and insights for clients who may lack the time, expertise or resources to oversee large, complex projects. The best relationships strike a proper balance between too little stakeholder input and too much.

One of the most important features of the partnering process has been the involvement of perhaps the most important partner of all: the public. Such input is critical to achieve consensus and support from the people who will be paying a significant share of the project's costs, says Sims.

"By getting the public and user groups involved early in the process, we can balance their interests against budget and other project goals, refine cost and quality goals and communicate everybody's expectations," he says. "They become, in effect, part of the design team."



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