Buy-sell agreements are a top planning tool for closely-held businesses. A well-crafted agreement helps avoid conflict and plans for both expected and unexpected transfers of the ownership interests in the event that an owner dies, becomes disabled, divorces, or simply wants out.
Buy-sell agreements can be stand-alone contracts, but they are more commonly part of a corporation’s shareholders’ agreement, a limited liability company’s operating agreement, or a partnership agreement.
The structure of a buy-sell agreement can be a redemption agreement, a cross-sell agreement, or features of both.
Limiting Transfers Is A Good Thing
The fundamental principle of a buy-sell agreement is that it limits transfers of ownership interests (be they corporate stock, LLC units, or partnership interests). In start-ups, there may be an initial period during which no voluntary transfers are allowed. This allows for stability during the critical early years of a fledgling business. When a sale is allowed, often the other owners and/or the company have a right of first refusal before an owner can transfer their interest to a third party. Sometimes the other owners and/or the company have an obligation to buy the interest. A company purchase is called a “redemption.” A co-owner purchase is called a “cross-sale.” Both optional and mandatory buy-sell provisions ensure that the remaining owners get some choice in who their future co-owners might be.
Trigger Events Set The Plan In Motion
When a trigger event occurs, the buy-sell plan is put into motion. Common involuntary trigger events include death, disability, divorce, bankruptcy, and termination from employment. Voluntary triggers include an owner wanting to sell to a third party or simply wanting to get out of the business for any number of personal or professional reasons, including retirement or resigning from employment.
Each trigger event may have its own game plan, or trigger events can be grouped into categories. Most trigger events anticipate that the ownership interest will be transferred as a whole, but it is also possible to “unbundle” the decision-making rights from the economic interests. An example would be when a deceased owner’s heirs continue to receive profits from the company, but the co-owners retain control of the company and its confidential information.
A Pre-Arranged Purchase Price And Terms
How is it possible to know how much a business is worth years ahead of time? A thoughtful buy-sell agreement will address the purchase price in several ways: (1) as determined by a professional appraisal at a certain time or (2) the agreement will specify a valuation formula. Certain discounts can also be applied. A qualified appraiser can be chosen in advance, or the agreement can lay out a a method of selecting an appraiser when the time comes. A third option is that some companies will also routinely seek valuation periodically, for example, for purposes of investor reporting, commercial borrowing, gifting, or employee bonus purposes.
Moreover, the payment terms are often agreed upon in a promissory note. For example, 20% of the purchase price at closing, the remaining purchase price to be paid over a certain number of months or years at a particular interest rate pursuant. Savvy owners will also fund or partially fund the buy-sell agreement by purchasing life insurance or disability insurance, providing liquidity for the exiting owner’s family and/or the company, which can use the insurance proceeds to fund the buy-out and/or replace the exiting owner’s services to the business.
Takeaways
- Buy-sell agreements provide certainty and reduce conflict during the most stressful and difficult times in the life cycle of a business and its owners.
- The buy-sell provisions of a shareholder agreement, operating agreement, or partnership agreement are not boilerplate! Always hire a local business lawyer to tailor the agreement to your particular company.
- Your buy-sell provisions are an opportunity to link your business goals to your personal finance goals.
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