It can be easy for small business owners to overlook certain unexpected events that can derail a business in no time. What happens when an owner dies, becomes disabled, embezzles a bunch of money from the company, or wants to sell his or her shares or ownership interests to some unknown third party in China? Without a properly structured buy-sell agreement, any one of these events, among others, could have crippling effects on the financial health and the future of the business.
As a general rule, all businesses with more than one owner should have a buy-sell agreement. A buy-sell agreement is essentially an arrangement between the owners of a business under which, upon the occurrence of a specified triggering event (e.g., an owner’s death, disability, divorce, termination of employment, retirement, resignation, insolvency, or sale to a third party), permits either the remaining owners or the entity itself to purchase the shares of the deceased, disabled, selling, or otherwise departing owner. Buy-sell agreements describe the triggering events in detail, specify the parties whose shares are subject to being purchased as a result of the triggering event, specify the parties who are able to purchase the shares, describe the methods used to value the shares, and explain how the purchase is to be funded.
Triggering Events and Purchase Options or Obligations
Owners want certainty and control with regard to who they own the business with, particularly in closely-held companies. It is important to understand that buy-sell agreements are designed to restrict the transfer of owners’ shares. For example, if an owner dies, what are the odds the other owners would want the decedent’s spouse or 19-year-old child to assume an ownership role in the company by default? Generally speaking, the odds are not very high. Instead, the buy-sell will often require either the company or the remaining owners to purchase the shares from the decedent’s estate rather than have the surviving spouse or children take ownership. Often the requirement to purchase the shares of a deceased owner is funded through the purchase of life insurance, ensuring that the company or the other owners have the funds available to make the payment upon death.
If an owner becomes disabled, retires, or resigns, and if such owner is actively working in the business and needs to be replaced, the company and other owners will need to consider whether the owner should continue as a passive owner or have his or her shares purchased. When disability occurs, the buy-sell agreement usually defines disability or how disability is to be determined. Further, the company or the other owners may have disability insurance to fund a purchase in the event of an owner’s disability. There is no type of insurance to fund a purchase for retirement or resignation, so if either of these are listed as triggering events, they should be accompanied by purchase and payment terms that are feasible and satisfactory to all parties.
In the event of an owner’s divorce or insolvency, the buy-sell agreement will often give the company and/or the other owners an option to purchase the divorcing or insolvent owner’s shares. Without such an option, a divorcing spouse or a creditor of an insolvent owner could obtain shares and be entitled to exercise voting rights or other rights of ownership. Again, the other owners and the company will likely want to prevent this scenario because it would be undesirable to have a creditor or owner’s ex-spouse hold an ownership interest in the company.
If an owner has an offer from a third party to buy his or her shares, generally the other owners will have a right of first refusal to purchase the shares of the selling owner at the offered price. A right of first refusal is triggered when the selling owner produces a good-faith offer from a third party. Sometimes the buy-sell agreement provides that, with a good faith third-party offer, the non-selling owners have the right to buy the selling owner’s shares at a price based on a valuation or formula. Proper planning ensures that the company and/or other owners don’t end up with co-owners they don’t know, didn’t count on, or worse, don’t want.
Establishing a value for shares is an important element of the buy-sell agreement. Various valuation techniques include, but are not limited to, an amount agreed upon annually by the owners, book value, pre-determined formula, or appraisal by a third party.
If carried out properly, an annual agreement by the owners as to the value of the business is often the most effective valuation method. The challenge is that more often than not the owners will set the value in the early years of the company and then fail to keep updating it annually as time goes on. When a valuation upon the occurrence of a triggering event is dependent on an annual agreement of the owners, then failure of the owners to keep such agreement current can put them in a worse position than if they didn’t have a buy-sell agreement at all.
Other common options for valuation include a third-party appraisal or setting some kind of formula. Third-party appraisals are typically objective and accurate, but they can be more expensive and time consuming and sometime can require multiple appraisals until the all parties are able to agree. The formula approach is typically quicker and more cost effective; however, this approach can be problematic if the formula isn’t updated periodically to account for changes in the business.
Either of these methods, formula or appraisal, can serve as a fallback alternative to establish value in the event that the owners are not current on their annual agreed-upon valuation. The buy-sell can provide that if no value has been set within a certain number of months (e.g., fifteen months) prior to the triggering event, then the alternative mechanism will be applied.
The buy-sell agreement will also provide terms under which the purchase price will be paid, including but not limited to the amount of a down payment, the term over which the remaining payments are made, applicable interest rates, and security for any deferred payment. Care should be taken to ensure that the terms are reasonable in light of available financial resources. If the company is ever mandatorily obligated to purchase shares, the buy-sell should not require payments that put the company at risk of being over-burdened from a financial standpoint.
Draft Specifically, Know Your Agreement, and Keep It Updated
The provisions of buy-sell agreements must be specifically tailored to the individual business. When entering a buy-sell agreement, it is paramount that business owners know what the agreement says and how its terms will be applied. This concept may seem simple, but a vague or unenforceable buy-sell agreement carries potentially harmful, and even disastrous, consequences for both the owners and the business itself.
Implementing an effective buy-sell agreement and achieving a mutual understanding of its terms will often require business owners to sit down with their legal and accounting professionals, both at the commencement of a business venture and throughout its existence, and discuss difficult issues and scenarios. Periodically revisiting the buy-sell agreement will remind owners not only of the need for clarity, but also of the need to revise and update their agreement in light of any change in circumstances (personal, business or otherwise) that could affect applicability or enforceability. Ultimately, careful drafting of the buy-sell by a knowledgeable business attorney, along with open discussion and prudent monitoring, can help ensure successful buy-sell transactions and protect the company from severe consequences when unexpected events occur.
*** DISCLAIMER: This article should not be deemed legal advice. You should always consult with an attorney about your specific circumstances and legal rights and obligations. ***
Aaron Kolquist is an attorney with Fryberger, Buchanan, Smith & Frederick, P.A., practicing primarily in the business, corporate, and labor & employment areas.