Buy/Sell Agreements in Closely Held Businesses

Buy/Sell Agreements are agreements between owners of a business that determine how and when owners may sell or be bought out of a business entity. In the case of partnership or a limited liability company, buy/sell provisions are typically embedded into, respectively, the partnership agreement or the company’s operating agreement. In the case of a corporation, those provisions are generally the subject of a separate document known as a “shareholders agreement.”

Although these agreements vary widely, they generally attempt to accomplish three things: (1) they provide that each of an entity’s co-owners cannot sell or transfer his or her interest except as provided for in the agreement, (2) they provide a mechanism for protecting the remaining owners as against a co-owner who has decided to sell his ownership share to an outsider, and (3) they provide for certain buy-out rights under which the entity itself or the remaining owners may buy-out an owner who has died, become disabled, wishes to retire, etc.

There are many considerations in drafting such an agreement, including determining the triggering event that sets the buy/sell provisions in motion, the method of valuing the interest to be bought out, and the terms and time periods of such a buy-out.

Certain triggering events are easy to determine. For example, in the case of an owner who voluntarily determines to simply sell his interest, the event that starts the process is either that owner approaching the company regarding his wish to sell his interest (in which case, the entity’s “right of first purchase” may be triggered) or the owner might already have an offer from a third party (at which time the company and remaining stock holders may have a “right of first refusal.”). Other buy-out events are compulsory rather than voluntary. They include death and disability. Death as an event is very straight-forward to determine; however consider “disability”. Who determines when a shareholder is “disabled,” a company physician, the co-owner’s physician, or both? And how long should an individual have to be disabled before his co-owners or the business entity are legally entitled to buy him out. Finally, consider retirement; the triggering event in a retirement is a one-sided and voluntary decision to retire, but how much notice must the retiring owner give to the company?

Looming large on the list of considerations is valuation of the business interest to be bought out. This is frequently the object of contention; buy/sell provisions that spell out a method or even a formula for valuation may eliminate or at least focus such a dispute. A valuation method may employ one or more appraisers, or the agreement may specify a simple arrangement such as use of the “book value” of the company as determined by the company’s regularly retained accountant. The value may not be the same in all situations. For example, a buy-out resulting from an owner’s voluntary resignation or withdrawal may not be as high as a buy-out for an event such as death. Moreover, in the early years of a venture the buy-out for a voluntarily retiring or withdrawing owner might be set prohibitively low to offer a disincentive for leaving a venture that was relying on that owner’s services.

Along with valuation comes related issues such as terms of payment (over time, in a lump sum, or some combination of the two), whether the company keeps insurance in place to fund the buy-out, and the basic consideration of whether the enterprise is buying the owner’s shares (a redemption) or whether one or more of the other owners are buying the withdrawing owner’s shares (a cross-purchase). On this last issue, a typical approach is to first give the entity the opportunity to buy-out the departing co-owner or its estate and if the entity does not so buy-out that owner then, the right to buy-out that owner falls to the other owners individually.

Buy/Sell provisions often must be considered in connection with tax consequences of the buy-out, bank issues that might arise when a co-owner departs, and business issues that vary according to how important the departing co-owner is to the business operation. A detailed discussion of each of these is beyond the scope of this article, however, future issues of this newsletter will take up each of these subjects in turn in a more detailed way.

If you are a co-owner of a business the time to plan is now. It is often the case that it is easier to negotiate fair provisions early in a business enterprise’s life rather than waiting until later when one of the co-owners has become disgruntled or ill or ready to retire. At such a time it is often more difficult to agree to terms.

— Rod Fluck

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