It is common in business for an employee to reach a senior role and be offered the opportunity to buy into the business, in recognition of their value and anticipated future contribution.  How the “buy-in” occurs will depend on the legal structure of the business, for example whether it is a company or a partnership arrangement. 

How does an employee receive ownership of part of the business?

Company

If the business the employee is buying into is a company, then they will be transferred shares in the company.  There are two ways this can be done:

1.    Carving off shares from someone else’s shares, or a portion from every other shareholder’s shares.  In this case, the people or person transferring the shares, as well as the person who receives the shares, sign a share transfer form together.  In some cases this might be a retiring director/shareholder selling their shares entirely to the new shareholder buying in; or

2.    Issuing brand new shares in the company.  This will require approval from 75% of the existing shareholders, and will mean that if the company started with a certain number of shares, the number will now be higher, and therefore that voting rights will be affected.   A person gets shares this way by virtue of a notice of issue of shares, then a share transfer form signed by the company and the buyer.

In both of these cases it is important to consider any existing pre-emptive rights, as sometimes a Constitution or Shareholders’ Agreement will require that any shares being transferred are offered to existing shareholders to buy first.

Shareholders’ Agreement

If there is a Shareholders’ Agreement in place, the terms of that must be followed. This will often require the new shareholder to sign a Deed of Covenant or Accession agreeing to be bound by the terms of the Shareholders’ Agreement.  Sometimes an incoming shareholder (the employee buying in) may try to negotiate changes to the Shareholders’ Agreement, although generally the existing terms remain in place. 

A Shareholders’ Agreement may also require the new shareholder to be bound by a restraint of trade, which may not have previously been included in their employment agreement.  This is a restriction on the shareholder competing against the company for a length of time and in a particular kilometre radius after departure.  It may also include not contacting existing clients of the business. 

We have other articles about restraints of trade which you can find here, Note that in general they are quite difficult to enforce, and may only be enforceable if they are ‘reasonable’ for the proper protection of the type of business involved. 

Partnership

With a partnership, a new partner buys an interest in the partnership.  There is no transfer of an interest from one person to another, as there is with shares in a company.  The buy-in can be recorded in:

a.    A variation to the Partnership Agreement;

b.    A Deed Of Accession or Deed Of Covenant whereby the new partner agrees to be bound by the terms of the Partnership Agreement; or

c.    A new Partnership Agreement.

Which of the above options is used will depend on the size of the partnership.  If there are only a small number of partners, then creating a new Partnership Agreement is more likely to work, as it enables all the partners to be involved in setting the terms of the arrangement but will not be too cumbersome to negotiate. 

In bigger partnerships, which can involve as many as 100 partners, something like a Deed of Covenant would be more common as it is impractical and unwieldy to re-negotiate new terms each time a partner changes.

How does an employee pay for their part of the business?

The mechanics of paying to buy in will depend on the financial situations of the company or partnership and the employee buying in. 

Common ways that an employee might pay are:

a.    The employee pays cash for the shares or interests;

b.    The partnership or company provides a ‘loan’ to the employee, which is paid back - by deductions from dividends in the case of a company, or from drawings in the case of a partnership.  There may be a defined timeframe within which the loan is to be repaid;

c.    The employee enters into a loan from a bank, which the company or partnership often guarantees.  The cash provided from the loan is a cash injection into the company or partnership, and then the loan is repaid from the dividends of the company or drawings of the partnership.  There may be some tax implications, which should be discussed with an accountant.

d.    There may be variations to these arrangements where a retiring owner is selling all or part of their interest in the business, and these will depend on the particular circumstances in each situation. 

In some cases, the employee may buy shares or interests gradually over time.  This can be advantageous where the employee is not in a position to make the full purchase outright, and/or where an existing shareholder or partner is gradually exiting the business.  Gradual purchase arrangements are generally more complex to record and implement, but the principles and documents are similar to those set out above.

It is advisable for the employee buying in to take their own legal advice, to make sure that they understand the arrangement, terms, and documents fully.  The employee’s lawyer will likely want to review all the relevant documents, other than the financial statements for which accounting advice should be obtained.  The employee needs to know what their rights are going to be, in terms of things like voting for directors, voting on major transactions, how they transfer their shares if they wish to exit, and also things like “drag along” and “tag along” rights, where there can essentially be compulsory buy outs or sales of the shares of a minority. 

Taking advice is important

If you are an employee wanting to buy into the business you work for, or a business owner looking to bring on an employee as a shareholder or partner, it is essential that you take legal advice from a lawyer experienced in this area who can make sure the legal arrangements best reflect the circumstances.

Leading law firms committed to helping clients cost-effectively will have a range of fixed-price Initial Consultations to suit most people’s needs in quickly learning what their options are.  At Rainey Collins we have an experienced team who can answer your questions and put you on the right track.