Do We Really Need a Buy-Sell Agreement?

1/15/2002

What are the risks?

Business owners can ward off disruptive -- and sometimes destructive -- discord by using a comprehensive buy-sell agreement.¹ A buy-sell agreement is a binding contract which requires one party to sell and another party to buy a specified ownership interest when a triggering event occurs. Triggering events can be the death, disability or withdrawal of an owner or they can be other voluntary or involuntary transfers such as a divorce. Without a buy-sell agreement or other transfer restrictions on any ownership equity in the business, an event such as the death, disability or divorce of an owner can cause long-term difficulties in the management of the business -- and may even lead to the collapse of the business.

Oh, it won’t happen to me

Anyone can find themselves suddenly thrust into a stressful situation that could have been eased by some advance planning. For example, assume a small business has two unrelated equal owners, Mike and James. Mike and James are both active in the business and have been friends for many years. Suddenly, Mike dies without a will. His assets pass to his heirs -- a wife and two grown children -- who decide to keep the stock in the business. Now, James must deal with these three individuals as the owners of the other half of the business. Even though James never had to discuss business decisions with them in the past, he now shares ownership with three other people.

Or perhaps Mike’s heirs decide that they want cash for Mike’s interest in the business. So they sell their shares to a third party. This third party could be any individual or company, and James may find that the new owner does not share the same goals for the business that he does.

Imagine a different scenario. James’ son is diagnosed with a rare and serious disease. A specialist in California is one of only a handful of doctors with any experience in treating the disorder. Unfortunately, the treatment is expensive and will not be covered by James’ existing health plan. James’ only valuable asset is his share of the business and someone has offered him a substantial sum for it. What if Mike wants to buy James’ share but cannot match the other offer? What do these owners do in this crisis situation?

These situations can all be avoided by putting a carefully drafted buy-sell agreement into place before such circumstances arise. Typically, a buy-sell agreement will list all of the events that trigger the buy-out of an ownership interest; as well as any restrictions on voluntary transfers. It will also lay out who may purchase the shares, the price, and the terms of the purchase.

We don’t want to think about death or disability

While death and disability are not topics most people want to discuss, business owners should consider buy-sell provisions that are triggered by an owner’s death or disability. The agreement can include either an option or an obligation on the part of the company, the other owners, or both the company and the other owners to purchase a deceased or disabled owner’s interests. For example, an agreement could provide that upon the death or disability of an owner: 1) the company has the first option (or is required) to purchase that owner’s interest; and 2) if the company does not purchase the interest, the remaining owners have the option (or are required) to purchase that interest. There are differing tax consequences depending on whether the company or other owners purchase the interest and whether the company is a C corporation, an S corporation or another form of entity.

In addition, whether the company itself or any or all of the other owners purchase the interest can affect the respective ownership of the remaining owners. For example, assume a company with three shareholders as follows:

X owns 40 shares or 40%
Y owns 40 shares or 40%
Z owns 20 shares or 20%

Y dies. If X buys Y’s shares, X now owns 80 shares or 80% and Z owns 20 shares or 20%. If the company had purchased Y’s shares, X would still own 40 shares or 66-2/3% and Z would own 20 shares or 33-1/3% of the outstanding stock.

Providing for the purchase of an interest upon the death of an owner confers other benefits as well. Pre-determining a method for the fast and easy liquidation of an asset that might otherwise be unmarketable allows the heirs of the deceased to generate quick cash. Such purchase plans can also assure surviving owners that they will not have to suddenly share the company with strangers.

What if an owner wants to retire early ...or compete?

Business owners may also want to consider provisions that restrict stock ownership to those persons actively involved in the company. A buy-sell agreement can provide that upon termination of the employment of an owner for any reason, the company and/or the other owners have the right or obligation to purchase the withdrawing owner’s interest. The reason for termination can be a factor in determining the purchase price. For example, if someone is leaving to work for a competitor, the departing person may be paid less for their ownership interest than if that person left due to retirement.

Restricting the transfer of ownership interests

Most buy-sell agreements also include restrictions on voluntary transfers of ownership interests. As noted above, transfers may be restricted to the company itself, other owners, or a combination of the company and the other owners. In a slightly different vein, terms of the buy-sell agreement may provide that if a bona fide offer is made by a third party, the selling owner must first offer their interest to the company and/or other owners on the same terms as the third-party offer. If the company or other owners do not purchase the interest within a specified period of time, the selling owner is then free to sell their ownership interest to the outside party.

Triggering events can be as varied as the businesses and the owners themselves

Almost any event could be a trigger depending on the needs of the parties. The parties themselves decide what events will trigger certain actions. Owners may want to consider including triggers such as divorce, insolvency, or bankruptcy. Another common trigger occurs upon the company’s success in reaching a certain level of profit and terms of the agreement may provide that all or part of the interests of passive investors may be bought out at that point. Such a plan may be desirable where the person with the idea initially needed investors to get the business off the ground but the owners wanted to avoid giving the investors the lion’s share of the profit when the idea succeeds. An arrangement like this may be especially appealing to companies where the real asset of the company is the know-how and ideas of a person or small group of people who merely need working capital to get the idea off of the ground.

Whatever the triggering event is, a well-crafted agreement will dictate who may purchase the shares, at what price, and upon what terms.

Setting the purchase price -- or a way to calculate it -- in advance

A buy-sell agreement should provide a way to determine the price to be paid for the ownership interest if a triggering event occurs. At times, this can be a difficult task. Remember that a buy-sell agreement may be in place many years before becoming operative. In companies where there is a potential for rapid growth, setting a price for future use can be particularly problematic. The parties should therefore carefully look at economic factors that may change between the time of the agreement’s execution and the time of its activation.

There are several price setting methods available for consideration. One option is for the parties to agree to a price once a year and include it in the agreement itself. Another option is to have a formula that is used to determine the price upon a triggering event. Or the parties may choose to have an appraisal done. Parties may even agree to let a specific arbitrator make the decision when the time comes. Some agreements also utilize the “Gauntlet” method, whereby one party names a price and the other either sells his shares at that price or purchases the other’s shares at the named price. Where there is a third party offering to buy an owner’s interest, the agreement may provide that the purchase price is the price being offered by the third party. Finally, the agreement may use combinations of the above pricing methods for different triggering events. The underlying considerations are: how much is the company worth at any point in time for the one who wants to sell? Would that price still be reasonable if, instead of selling, that party wanted to buy out the others? What if the buyer were a third party? Setting the price can be an arduous task -- but coming up with a fair price or method of calculation in advance so that everyone knows where they stand can ease tensions and avoid added expense.

Laying out the payment terms

The agreement should specify whether the purchase price will be paid in cash or in installments. If the purchase is to be made in installments, a promissory note should be used and the terms of the note set out in the agreement. Also, the company or the other owners may want to consider purchasing life and/or disability insurance for the owners. These insurance proceeds can then be used to purchase the shares of a disabled or deceased owner.

Saving time, energy, money and headaches!

The decisions involved in creating a buy-sell agreement that works both for the buyer and the seller can be numerous and sometimes complicated. However, business owners who fail to plan for the types of circumstances noted risk personal and business discord, perhaps even court battles and the loss of the business. Careful planning resulting in a comprehensive buy-sell agreement can save business owners a great deal of time, energy, money -- and headaches!

For more information, contact Sherri Ulland, at Lommen, Nelson, Cole & Stageberg, P.A. Sherri works with businesses on buy-sell agreements, non-compete agreements, mergers and acquisitions, other commercial transactions, and securities. She can be reached at 612-336-9337, 800-752-4297, or sherri@lommen.com.

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¹Buy-sell agreements are also often referred to as stock restriction agreements, shareholders' agreements or stock purchase agreements.