Agree While You Still Agree – The Importance of Buy-Sell Agreements

Hope for the best, but prepare for the worst. When starting a business it is prudent to plan for a business divorce and then hope you never need to implement your plan. By adopting a buy-sell agreement at the start of a business relationship, partners agree how best to part ways equitably before they get to the point where they can’t agree on anything. A buy-sell agreement is a binding contract between shareholders of a corporation, members of a limited liability company, or co-owners of a partnership (referred to in this article as “owners”) that sets forth when the owners can sell their interest, who can buy an owner’s interest, and what price will be paid. A buy-sell agreement is essentially a prenuptial agreement between business owners.

Triggering Events

Death. In a typical buy-sell agreement, upon the death of an owner, the other owners would be required to buy the interests of the deceased owner and the estate would be required to sell it at an agreed price or according to an agreed formula. Buy-sell agreements provide a mechanism for determining the value of an ownership interest for estate tax purposes and for monetizing that value for the estate. The deceased owner’s estate realizes liquidity and can pay taxes due and does not face the uncertainty of independent valuation. From the perspective of the surviving owners, the agreement eliminates the need to address uncertain ownership dictated by the deceased’s will.

Divorce. A buy-sell agreement can be triggered in the event of a divorce and be designed to prevent the non-owner spouse from obtaining an ownership in the company. An agreement could require the divorcing owner to sell his interests to the remaining owners leaving the financial value of the interest, and not ownership and control of the company itself, to be divided between the divorcing spouses.

Disability. If an owner becomes disabled and is no longer able fulfill his obligations, the remaining owners may want the right to buy the disabled owner out. If disability is a triggering event, it is essential to have a clear definition of what “disability” means.

Deadlock. Buy-sell agreements often contain drastic deadlock resolution provisions. If parties cannot resolve disputes either on their own or with the assistance of third parties, then the parties can look to buy one another out. The mechanisms for determining price in the event of a deadlock can vary. Common solutions include “Russian Roulette” (one party serves a notice on the other party, naming an all-cash price at which it values a half interest in the business; the receiving party has the option to either buy the other party out, or sell to the other party, at that price) and “Texas Shoot-Out” (each party sends a bid to third party stating the price at which they are willing to buy out the other party; the highest bid “wins”, and that bidder must then buy [and the “loser” must sell] the other half share in the business).

Determining Value

A crucial component of any buy-sell agreement is to clarify how purchase price will be calculated. The purchase price is a material term of the buy-sell agreement and f the purchase price cannot be determined from the agreement, the agreement will not be enforceable. There are several methods that can be used to determine the purchase price of an ownership interest.

Stated Value . The owners agree on the value and they state the value in the buy-sell agreement. It is important that the owners update the value of the company and the purchase price regularly as the company grows and evolves.

Formula . The owners agree on a formula that computes the value of the company. For example, they might agree that the value of the company is the average of the net profits of the company for its last five fiscal years, or two times book value. The value as of the date of the triggering event would then need to be applied to the selling owner’s interest in the company.

Future Appraisal . The selling owner and the remaining owners mutually select an appraiser to value the company. If they cannot agree, each party selects an appraiser (and pays the cost thereof) and the value of the company is the average of the two appraisals unless the difference between the two appraisals is more than a stated percentage. If the difference is too great, the two appraisers select a third appraiser (the cost is split) and the value determined by the third appraiser.

Terms and Conditions of Purchase

Once an owner becomes obligated to sell and the company or other owners become obligated to buy, the buy-sell agreement sets forth the terms and conditions applicable to the sale. Important terms and conditions to address include: (i) how quickly the closing of the sale will occur, (ii) how much of the purchase price will be paid in cash at the closing and how much will be paid over time, and (iii) how the obligation to pay over time will be secured. Requiring an immediate 100% cash buyout can prevent even the most successful business from buying back an owner’s interest. Having flexible payment terms built into a buy-sell or buyout agreement, signed in advance, can minimize or eliminate disputes in the future.

The best time to enter into a comprehensive buy-sell agreement is at the outset of the business relationship, but they can be entered into at any time. As with all legally binding agreements, the obtaining professional legal and tax advice is strongly suggested.