A buy-sell agreement is a contract by which the owners of a business address the circumstances under which they can and must sell their ownership interests. Any business which has more than one owner should have some form of a buy-sell agreement. However, most small businesses fail to enact them for a variety of reasons. Some owners do not want to think about an owner leaving the company. Others are concerned about the time and expense involved in negotiating such an agreement, or wish to avoid discussing potentially sensitive topics such as what happens if one of the owners dies, or is fired from the company.
Prudent business owners view such concerns as secondary to the critical importance of their company having a clear path of succession. Existing owners need to know that they will be able to exit the company and receive fair value for their equity, with minimal disruption to the ongoing business operations. Remaining owners need to be certain that they do not unexpectedly end up in business with another owner’s heirs, creditors, or ex-spouse. A proper buy-sell agreement helps to ensure smooth business transitions by addressing several key considerations:
Triggering Events. A primary goal of the buy-sell agreement is to identify the events which will “trigger” a purchase and sale of an owner’s interest in the company. Common triggering events include the death, disability, retirement, divorce, bankruptcy, or termination of an owner’s employment.
Redemption or Cross Purchase. A key provision in any buy-sell agreement is whether the company redeems the departing owner’s equity interest or the other owners purchase it, and whether that purchase is mandatory or optional. There can be significant tax and operational impacts on the company and the owners, so careful consideration and consultation with the company’s legal advisors is important when deciding on these provisions.
Voluntary Transfer. Some companies that wish to allow for voluntary sales of an owner’s equity to third parties will grant the existing owners a right of first refusal to purchase the selling owner’s interest in the company. Additional provisions, such as “tag along” rights, permitting other owners to participate in a voluntary transfer, or “drag along” rights, where the majority owners can compel other owners to go along with a decision to sell, are but two examples.
Valuation. One of the most difficult terms to negotiate in the buy-sell agreement is valuation. At the time the agreement is prepared, the owners have no way of knowing what the future value of the company might be. There are three different methods most commonly considered by companies for determining valuation. The first is a fixed value by agreement. Under this method, the parties agree on an initial value and also “agree to agree” on a new value periodically. Often the owners get too busy to reassess the value of the company, or wish to avoid any confrontation associated with changing value. The value set forth in the agreement can rapidly become outdated, and quite different from the true value of the company. The second method often used is a formula agreed to by the parties. Formulas can vary depending on the type of business and typically take into account various indicators of the company’s financial performance. The third option is appraisal, under which one or more appraisers are hired at the time of the triggering event to value the interest of the departing owner. It is important that companies utilizing an appraisal method include in the buy-sell agreement any agreed upon factors for the appraiser to consider or disregard, such as goodwill. The owners should also state whether they wish to apply any discounts to the base value determined under the agreement. One example would be a discount in the event a departing owner refuses to return company property or joins a competing business in violation of the company’s non-competition agreement.
Terms of Sale. Depending upon the valuation, a departing owner’s interest in the company may be worth a substantial sum. Life insurance policies for the benefit of the purchaser on the life of the other owners can be used to fund purchase obligations in the event of an owner’s death. However, in other instances, the buy-sell agreement can provide for a portion of the purchase price to be paid at closing, with the remainder paid pursuant to a promissory note over a number of years. The note may be secured in order to provide the selling owner with assurances that he will receive the full value of his interest in the company.
A carefully drafted buy-sell agreement is among the most critical business documents for any closely held business.
David Tenzer is an attorney with Glenn Feldmann Darby & Goodlatte. Visit www.gfdg.com to learn more.
