Attorney Laura J. Hansen is our author today, and she has written the following article about buy-sell agreements. In a previous article, Ms. Hansen discussed the importance of succession planning for business owners. For a business to withstand the test of time and become a ‘legacy’ business, the succession of ownership from one owner to the next owner or group of owners must be smooth and effective. A well-drafted buy-sell agreement is an important part of business succession.
Running a business can be difficult with anyone whether your spouse, family member, or best friend. So, most business owners do not want to end up owning a business with some third party who they did not choose or do not know. The terms of a buy-sell agreement address ‘what happens when something happens’. In other words, if one business owner dies, becomes incapacitated, puts the business at risk, or simply wants out, the buy-sell terms set forth the process by which the remaining owners may buy out the affected owner.
Buy-sell agreements are used for all types of business entities whether a partnership, limited liability company (LLC) or corporation, and thus have various names, such as a Share Restriction Agreement, Member Control Agreement, Operating Agreement, or simply a Buy-Sell Agreement. Buy-sell agreements are entered into by owners of a business and may be completed when the entity is first formed, when a new owner comes on board, or simply when the existing owners make time for it. There are several main components of a buy-sell agreement. First, there’s a restriction on the sale of an owner’s interest in the business. Second, there’s a list of events that trigger the process of the buy-sell to begin. Third, there’s a valuation method described to establish a price for the ownership interest, and lastly, terms of the purchase are set forth which may include a down payment and installment payments over a period of time.
So, what are these triggering events? Death, incapacity, divorce, bankruptcy, judgments, and attachments are triggering events. Termination of employment from a business or competing with the business are also triggering events. An owners desire to exit a business, retire, or otherwise move on should also be addressed. In many cases, these events can be anticipated even though they may happen unexpectedly, and while they may seem negative or pessimistic, wise business owners plan for these events.
What happen when one of these triggering events takes place? The buy-sell agreement should describe this process, and there are many options. Under the terms of the buy-sell agreement, the company may have the obligation to buy in or redeem the owner’s shares or membership interest. This is often the case when the triggering event is the death of one of the owners. For other triggering events, the company may have the option to redeem, and if it chooses not to, then the remaining owners have the option to buy the shares or membership interest. This structure gives the remaining owners ways to evaluate tax implications, control, dilution, and other considerations and figure out the best way to proceed.
Of course, placing a value on the shares or membership interests in a business is very important and can be difficult. Valuation methods include using a stipulated value, formula, appraisal process, accountant’s determination, or an outside valuation such as the assessed value. It’s wise to agree to one type of valuation such as setting a stipulated value on a regular basis and then to have a fallback valuation method if the first has not been done.
Payment terms are important, too, and often the buy-sell agreement will set forth a down payment, interest rates, and number of years of payments. In some cases, the company will pay for the departing owner’s shares or interest in full, perhaps using proceeds of life insurance. In other cases, the terms will be agreed to in a promissory note or other security agreement.
One of the most important benefits of putting in place a buy-sell agreement is for owners to come to an agreement before ‘something’ happens and when they are in a neutral and equal position. Before a triggering event takes place, owners do not know whether they will be a buyer or a seller, so that’s the best time to put in place buy-sell terms that are the most fair and equitable to all the owners.
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