You and your friend wish to start new business based on a novel idea that you both are sure will succeed. You know there are no obstacles that can prevent this business from growing and thriving. You are sure this new business will bring you and your family the security and prosperity you have always desired. Your business plan is infallible. Your excitement is palpable. Your thoughts are singularly focused doing what it takes to make this happen. So focused, in fact, that you never stopped to consider: What happens if I unexpectedly die? How can my business interest be used to benefit my family if that happens? What if you and your friend are not compatible business partners? What happens if your friend sells his interest to a person you think incapable? Or your “friend” starts a competing business? What if you get an offer to purchase your business, and you and your friend disagree on whether to sell? All of these questions and others should be answered now, at the business’s inception, in your cloud of optimism, by executing a buy-sell agreement.
An Introduction to Buy-Sell Agreements
A buy-sell agreement is a contract between the owners of a business, and/or the business itself, that provides for the transfer of business interests upon the occurrence of certain events, known as triggering events. Types of buy-sell agreements include: (1) redemption agreements, (2) cross-purchase agreements, and (3) hybrid agreements. Redemption agreements provide for the business itself purchasing the owner’s shares, while cross-purchase agreements provide for the purchase of the owner’s shares by the other owners of the business. As the name implies, hybrid agreements provide for a combination of redemption and cross-purchase elements. Every business should have some form of a buy-sell agreement.
Triggering Events
Triggering events enumerate in the buy-sell agreement the occurrences which will force or allow an owner, or his or her estate, to offer his or her business interests for sale to the other parties of the agreement. Triggering events include those that are faultless and some inevitable, such as death, disability, and retirement; as well as those when one owner acts to the detriment of the business, such as voluntary or involuntary transfer to a third-party, walk-out, operation of a competing business, bankruptcy, a serious felony conviction, loss of a license, and others.
Death
A buy-sell agreement can provide for different responses depending on the nature of the triggering event. For example, the agreement can provide that upon the death of an owner, the deceased owner’s estate is required to sell, and the business required to purchase, the entirety of the deceased owner’s interest in the business. In most instances, this is beneficial to both the business and the deceased owner’s heirs, as the heirs will receive cash without any of the added burden that accompanies business ownership, and the business and its remaining owners can move forward without fear of unwanted business partners.
Disability
Disability of an owner is an often-overlooked triggering event excluded from many buy-sell agreement. This can prove detrimental to all parties, as the disabled owner, unable to work, could lack a much-needed income stream and liquidity, and the remaining owners, now growing the company without the disabled owner, would have to share appreciation with a non-contributing owner. Disability should never be overlooked as a triggering event to include in a buy-sell agreement. A difficult issue with disability triggers is how the business partners agree to define disability for purposes of establishing a right or obligation to force a purchase or sale of interests in the business.
Retirement
A buy-sell agreement contemplating an owner’s retirement benefits both the retiring and remaining owners of the business. Without such agreement, the retiring owner faces uncertainty regarding the value he or she will receive for his or her share of the business, and the other owners may be unprepared to raise sufficient capital to purchase the retiring owner’s interest. A buy-sell agreement addressing an owner’s retirement solves these problems by addressing how much notice the retiring owner must give, setting valuation of the retiring owner’s interest, and establishing a procedure for the company and/or the remaining owners to purchase the retiring owner’s interest. Defining retirement for purposes of triggering a right or obligation to purchase or sale business interests is important. Is it anytime you wish to leave the business, or after your voluntarily cease employment after reaching a certain age? Owners should contemplate exactly what they wish to define as “retirement” and include such in the agreement.
“Bad” Triggering Events and Transfers of Interests
The aforementioned triggering events are often faultless, and incorporating them, and the reactions thereto, into your buy-sell agreement should benefit both parties. Buy-sell agreements also protect owners and the business when one owner acts to the detriment of the business, such as walking out on the business, losing his or her license, filing for bankruptcy, being terminated for cause, and others. A properly drafted buy-sell agreement can help dissuade these actions by including less favorable terms to the offending owner, such as the offending owner being forced to sell his or her interests at a fixed price less than fair market value.
Buy-sell agreements should also contemplate when one owner wishes, or may be forced, to sell or otherwise transfer his or her interests to a third-party. One option to restrict certain transfers is a right of first refusal providing that the other owners must first be given the option to purchase the transferring owner’s interest before he or she transfers to a third party. Buy-sell agreements are particularly useful in protecting minority owners’ business interest. For example, if the majority owner wishes to sell his or her interests, a tag-along provision in the buy-sell agreement will allow the minority owners to “tag-along,” and sell their interests on the same terms as the majority owner. Conversely, a “drag-along” provision forces minority owners to sell on the same terms and conditions as the majority owner.
Valuation[1]
When executing a buy-sell agreement, it is important the owners specify the appropriate standard of value at which the company and/or its owners may purchase interests upon the occurrence of a triggering event. Generally, the goal of the buy-sell agreement should be to establish purchase price based on fair market value. Valuation can be provided by an agreed stated value, formula, or appraisal. Stated value and formula are often problematic, as stated value can be far from fair market value, particularly if the agreement is not periodically updated, and formulas can be manipulated. Ideally, an independent appraiser should be retained to establish fair market value at the time of the buy-out. Additionally, different triggering events can have different valuation terms. For example, if triggered by death, the agreement can provide that valuation will be not less than the death benefits from life insurance, but if triggered by a walk-out of an owner, the valuation can be punitive and less favorable. It is also important for owners to consider the payment terms to fund a buy-out on the occurrence of a triggering event, whether that be by cash, debt financing, or a combination of both.
Life Insurance
Using life insurance to fund buy-outs is very common in buy-sell agreements. In a redemption agreement, the business will own a life insurance policy on the owner’s life. When that owner passes away, the business will use the life insurance proceeds to redeem that owner’s interest from his or her estate. Life insurance is similarly used in cross-purchase agreements, although it becomes more complex as the number of owners increases.
Conclusion
Many people like to defer thoughts and conversations of their estate plan, as thinking and planning for your own death is not a particularly fun thing to do. Similarly, planning for the future worst-case scenarios in a new and growing business is equally unpleasant. After all, your attention is focused on growing the business, not planning on putting out fires that don’t yet exist, especially when doing so costs money that could be put into other startup costs. However unpleasant, it is extremely important to plan for these future events, many of which are absolutely certain to occur at some point, when you are starting a business. Executing a buy-sell agreement mitigates many problems that may arise in the future and is a necessary and essential part of starting a new business. Doing so will help protect yourself, your business, your family, and your business partners against these unneeded and unwanted problems in the future. The costs of not planning for these outcomes can be much more than the costs of planning before the problems arise.
[1] https://esapllc.com/connelly-2021-buy-sell-valuation/
