The Role Of Buy-Sell Agreements
Buy-sell agreements are important tools for preventing unwanted persons from becoming members of the ownership group, ensuring continuity of ownership, and providing a ready market for closely held business interests when an owner dies or withdraws from the business. Buy-sell agreements can also provide appropriate procedures for transferring business interests if an owner dispute arises.
A buy-sell agreement should be considered for every closely held business with multiple owners because there is usually no ready market for selling an ownership interest in such a business. This lack of a ready market places a party that needs to sell at a bargaining disadvantage. Without a buy-sell agreement, the remaining owners may attempt to increase their ownership stake at a bargain price, especially when dealing with the heirs of a deceased owner. A buy-sell agreement establishes a purchase price for the owner’s interest.
WHAT IS A BUY-SELL AGREEMENT?
A buy-sell agreement is a contract that restricts business owners from freely transferring their ownership interests. Typically, the agreement provides that an owner’s interest in the business will be sold at a specified price to the other owners and/or to the business entity itself upon the occurrence of specified 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 include an owner’s death, disability, retirement, or desire to withdraw from the business before retirement. However, triggering events can encompass any circumstances that might cause an owner to dispose of an ownership interest.
The owners should also specify the method for determining the purchase price in the buy-sell agreement. Common methods for determining the price under a buy-sell agreement include (a) establishing a fixed per share price, (b) using an appraisal to establish a fair market value (FMV) price, or (c) using a formula approach such as an earnings multiple or percentage of book value.
Common Buy-sell Agreement Provisions
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 (such as death, disability, divorce, or retirement) occur.
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.
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.
The most common types of buy-sell agreements are:
In a redemption agreement, the owner and the entity (whether it is a corporation, a partnership, or an LLC) enter into a contract. The owner agrees to sell his interest to the entity according to the price, terms, and conditions specified in the contract. Redemption agreements often grant the entity a right to purchase at the price and terms specified in the agreement if there is a third party offer to purchase the interest. If the entity chooses not to exercise its right, the owner is usually free to sell to the third party. In addition, redemption agreements may obligate the entity to buy the owner’s interest in the event of certain circumstances. The tax consequences of a redemption vary depending on the type of entity involved.
A cross-purchase agreement is a contract between the owners of a corporation, partnership, or LLC. Under this arrangement, the owners agree to offer their ownership interests for sale to the other owners at the price and terms specified in the contract. In the event of an owner’s death, the estate normally must offer the decedent’s ownership interest for sale to the other owners at the specified price and terms. If there is no third-party buyer, the other owners are generally obligated to buy the interest in the event of certain circumstances.
Under a hybrid agreement, the owners contract with the entity and the other owners. Hybrid agreements are typically used when there is no insurance to fund the purchase of ownership, such as when an owner is uninsurable. This provides the various parties with flexibility to decide who will purchase the ownership interest when a triggering event occurs. Upon certain events, the owners agree to offer their ownership interests for sale to the entity and/or the other owners at the price and terms specified in the contract.
Some hybrid agreements provide that the ownership interest will be offered first to the entity and then to the other owners if the entity does not buy the interest. In other agreements, the owners may have the first option to purchase the interest with the entity required to redeem it if the other owners decline to exercise their option. Still other hybrid agreements provide that part of the ownership interest first be offered to the entity and the remainder to the other owners.
A third-party buyout agreement involves a contract between the owners and one or more parties outside the current ownership group. For example, there may be two existing owners of a corporation and a key employee who is well regarded by both owners. A buy-sell agreement could provide the employee with the right of first refusal to acquire the shares of either owner, with the other owner and/or the entity obligated to purchase the shares if the employee does not.
Because they have economic, tax, and legal ramifications, there are many variables to consider when deciding whether to use a cross-purchase, redemption, or hybrid-type of agreement.
In general, the income tax consequences of redemption agreements are more complicated than the income tax consequences of cross-purchase agreements. This is true for C and S corporations, partnerships, and LLCs alike. Also, a redemption agreement can have the unintended consequence of increasing the older generation’s ownership percentage in the entity when a younger-generation owner dies or withdraws from the business. This thwarts the older generation individual’s estate planning goal of reducing ownership. Finally, redemption agreements can have negative financial accounting consequences. Therefore, in practice, cross-purchase agreements tend to be used more often than redemption agreements.
Events That Trigger a Buy-sell Agreement
The provisions of a buy-sell agreement can be triggered by any number of events. The owners must decide which events will trigger the purchase obligations under their buy-sell agreement. To ensure there are no misunderstandings, the buy-sell agreement should clearly define the designated events. The following discussion covers some of the more common triggering events.
Owner’s Death An owner’s death can be extremely disruptive to a closely held business. Often, the owner’s heirs become unwanted participants in the business. Even worse, the heirs can be forced to sell their interest to an outsider to raise cash to pay estate taxes or other expenses. To minimize these risks, most buy-sell agreements provide for the mandatory purchase of an owner’s interest in the business at death. In limited circumstances, the entity or remaining owners are given the option to purchase the deceased owner’s interest.
Owner’s Disability An owner’s disability is another event that commonly triggers the provisions of a buy-sell agreement. However, the triggering event should be well-defined since a disability may be physical or mental, as well as a permanent or temporary condition. Insurance may be available to fund or partially fund the disability buy-sell agreement.
Owner’s Retirement Some buy-sell agreements are triggered at an owner’s retirement or other lifetime separation from the business. However, it is generally not advisable to provide for a mandatory purchase of a departing owner’s interest. Instead, the agreement is used to protect the remaining owners by restricting the departing owner’s ability to transfer his interest. If the entity or remaining owners are obligated to buy a retiring owner’s interest, an installment payout is advisable.
Other Triggering Events may include an: