I’ve often said a properly drafted and adequately funded buy-sell agreement may be the best legal document in an owner’s filing cabinet. A buy-sell agreement may help by:
- Preventing unwanted persons from becoming owners.
- Ensuring continuity of ownership through a number of triggering events.
- Providing a ready market for closely held business interests.
- Establishing a fair market value for closely held business interests.
- Resolving disputes among owners.
A buy-sell agreement should be considered for any closely held business with multiple owners because there is usually no ready market for selling a partial ownership interest. This lack of a ready market places a party that may need to sell (due to death, termination of employment, divorce, etc.) at a distinct disadvantage. Without a buy-sell agreement, the remaining owners may attempt to buy additional interests at bargain prices in a distress sale, particularly when dealing with the heirs of a deceased owner. A properly drafted and adequately funded buy-sell agreement establishes a purchase price for the owner’s interest and a means of purchase for the buyers.
However, if the buy-sell is intended to protect the departing owner, their estate or heirs, the obligation on the other parties to purchase must be mandatory. In other words, an option to purchase or right of first refusal to meet any third party offer does not create a market for the departing owner or his successors. Since the method for determining value is negotiated when the agreement is adopted, all owners have a vested interest in establishing a fair and reasonable value for ownership interests.
A buy-sell agreement is a contract that restricts business owners from freely transferring their ownership interests. Most agreements provide that an owner’s interest will be sold or offered for sale at a specified price to the other owners and/or to the business entity upon the occurrence of specific triggering events. This purchase option prevents unwanted individuals from becoming members of the ownership group, and if combined with a mandatory purchase obligation, ensures a ready market for closely held ownership interests.
The owners specify the events that trigger a buy-sell agreement. Common triggering events may include an owner’s death, disability, retirement or desire to withdraw from the business before retirement. However, triggering events can encompass any other circumstances that might cause an owner to dispose of an ownership interest, i.e.: divorce, bankruptcy, inability to practice a profession, etc.
The owners should also specify the method for determining the purchase price in the buy-sell agreement. Common methods for valuation include (a) establishing a fixed per share price, (b) using an appraisal or (c) using a formula approach such as an earnings multiple or percentage of book value.
Buy-sell agreement provisions should be considered carefully because much flexibility exists in their design. For example, each triggering event in the agreement could either create an obligation or option to purchase by the remaining owners or the entity or at a minimum the right to match any third party bids. Also, there are many valuation methods for an ownership interest and several methods for funding buy-sell agreement purchase obligations.
Buy-sell agreements are commonly used to restrict a business owner’s ability to transfer his ownership interest. These restrictions prevent outsiders from obtaining an ownership interest. Buy-sell agreements are also used to create a ready market for an otherwise illiquid asset and to provide appropriate procedures for transferring business interests if an owner dispute arises. Although the agreements may vary substantially, they typically include one or more of the following basic provisions:
- Right of First Refusal. When a potential third-party buyer exists, the agreement grants the entity and/or the other owners a right of first refusal to buy a deceased or withdrawing owner’s interest before it can be sold to an outside party. The price and payment terms under the right of first refusal should be specified in the buy-sell agreement.
- Mandatory Purchase Option. When a third-party buyer is not available, the agreement obligates the entity and/or the other owners to purchase an owner’s interest if specific triggering events, i.e.: death, disability, divorce or retirement.
- Option to Purchase. The other owners or the entity are granted an option to purchase the withdrawing owner’s interest at a triggering event. However, there is no obligation to buy the interest.
- Push-Pull or Russian Roulette Clause. When there is a dispute among owners, the agreement allows any owner to offer to purchase other owners’ interests. However, the offering owner must sell for the same purchase price offered, if the offeree chooses.
- Tag-along. When a controlling owner’s interest is sold, this provision requires the purchaser to buy the minority owners’ interests at the same price. This protects the minority owners from having to sell their interests at less than the controlling owner’s favorably negotiated price. The majority owner also benefits when a purchaser wants 100% ownership because the minority interest owners are required to sell their interests.
Buy-sell agreements also can be used to help fix the value of closely held business ownership interests for estate tax purposes, if certain requirements are met. The underappreciated arbiter of many disputes among co-business owners is the buy-sell agreement.