In any business there should be an agreement among the owners of the business, whether it be a shareholders' agreement for shareholders of a corporation, an operating agreement for members of a limited liability company, or a partnership agreement for partners of a limited or general partnership. For ease of reference, the business itself is called the "Company" and the agreement, regardless of its format, the "Buy-Sell Agreement".
Buy-Sell Agreements are some of the most difficult documents to put in place. Not only are there many disciplines involved and many moving parts, but the business owner and his advisors all need to engage in addressing the issues at the same time. This can be a challenge, as the business owner may not be motivated to take the time, and the lawyer or the accountant may not be motivated to really think through the various issues, especially if they don't have the experience and expertise. Often a boiler plate document that is pulled off the computer is ineffective and can cause more harm than good.
Let's look at what the Buy-Sell Agreement is trying to accomplish. The business owner seeks to restrict the transfer of ownership interests by other owners of the business so the business owner does not end up as a partner with a spouse, a child who may or may not be working in the business, or another partner not of his or her choosing. Even a transfer from one owner to another owner may have to be restricted as such a transfer could upset the balance of power causing one owner to have majority or super majority control. On the other hand, the business owners may wish to permit transfer to children or trusts for a spouse or children for estate planning purposes, particularly if the Company is recapitalized to provide for non-voting interests. For various tax planning purposes and because most state law does not permit a complete prohibition on transferability of interest, a Buy-Sell Agreement should include a right of first refusal so that a business owner may transfer interests if the Company and remaining owners do not exercise the right of first refusal to purchase the interest. As a practical matter, the right of first refusal severely affects the marketability of the business interests because an outside purchaser may be unwilling to evaluate and place an offer where the likelihood is that the Company or remaining owners will buy out the interest from under him.
A properly drafted restriction on the transfer of interests with an appropriate exception for permitted transferees and a skillful right of first refusal make it clear for the identified successor owner(s) of the business that the successor will ultimately have the opportunity for control of the business, whether alone or together with the other business owners.
Note that the Buy-Sell Agreement normally governs the ownership of interests in the Company and not a potential sale of the business assets. Accordingly, the controlling owners of the Company could sell the business assets without the consent of the minority successor owners thereby potentially defeating the purpose of the Buy-Sell Agreement. The minority owner in this situation will want either a right of first refusal for the purchase of the business assets or at a minimum, "tag along" rights. Tag along rights provide the minority owner with assurance that if the controlling owners sell their interests in the Company, that the minority owners will share on a proportional basis. The Buy-Sell Agreement can also include "drag along" rights to provide assurance to the controlling business owners that the minority owners will sell their interests on the same basis.
Another scenario that should be considered relating to restriction on transferability of ownership is a potential involuntary transfer of a business owner's interest who is insolvent or has a judgment against him or who may seek to dissolve the Company to force obtaining value for his or her ownership interest. In such event, we provide the Company and the remaining owners with the option to acquire the interest possibly on an installment basis. Here the business entity itself also has objectives to provide for the continuity of the business, allowing for smooth transition of ownership and control and to avoid disputes and potential litigation among the owners that would otherwise drain the business of resources and the energy of the owners.
Another objective of the business owner accomplished through a Buy-Sell Agreement is to provide a market for his or her business interest at retirement, death or other triggering event. This may be part of the business owner's retirement plan or exit strategy. The identified successor or remaining owners also seek to establish trigger events for the timely acquisition of the business. For instance, they will wish to ensure that upon the death of another owner, they will have control of the business. They may wish to establish a fixed retirement date at which time they know they will acquire the interest. If business ownership is tied to continued employment in the business, then termination of employment by a business owner can be a key triggering event.
Once all the trigger events are identified, the issue will be whether the Company or remaining owners will have an option or a mandatory obligation to purchase the interest. In addition, the business owner whose ownership interest is at stake could have a "put" or an option to require either the Company or the remaining owners to purchase his interest. There is no formula for any of these possibilities and no substitute for actively thinking through various scenarios. For instance, if there are two equal owners on a peer level, and one of them dies, the likelihood is that there will be a mandatory buyout between them, possibly funded by life insurance to ease the transition. On the other hand, if the business owner who dies is a part of the senior generation and is in the process of gifting ownership to his or her children in the business and if the proceeds of a buyout are not required to provide support for the spouse or to equalize inheritance among the non-business owner children, then the younger generation should have an option to purchase the interest, rather than be mandated to purchase. The younger generation should have the option to purchase just in case the business owner changes his mind as to the succession of the business. Another objective of the Buy-Sell Agreement is to establish a favorable price for the business interest which may not be marketable for fair value after the death, disability or retirement of the key business owner. Establishing an appropriate value is critical where there are peer business owners relying upon obtaining fair value for his or her business interest. Establishing an appropriate purchase price methodology together with the terms of payment and source of financing is also important to the successor or remaining owners to ensure financial feasibility of the purchase.
The determination of the purchase price can be accomplished by various methods, including by agreed value set forth in a certificate of value attached to the agreement which should be updated periodically. It can be established by formula or by professional appraisal. The parties will also need to determine whether the value of the interest to be purchased should be based on a fractional share of full enterprise value of the business or the value of the fractional interest itself. The latter could involve significant discounts for minority and fractional interests and lack of marketability. It is also important to determine whether the price will be discounted for certain events, such as voluntary termination of employment prior to retirement. The agreement should outline the terms of payment, whether on an installment basis or cash, whether any installment obligation will be collateralized and, often missing from Buy-Sell Agreements is that any installment obligation be subordinate to any indebtedness to the Company's primary lender. Failure to include this provision could jeopardize ongoing operations of the business.
Other provisions to consider for inclusion in the Buy-Sell Agreement are special provisions to protect minority shareholders, S election provisions if the Company has made an S election, deadlock clauses such as a "Texas shoot out," voting agreements and covenants not to compete (the remaining owners may not be pleased if they are buying out an owner who competes with them).
A well thought through Buy-Sell Agreement developed in conjunction with the business succession plan and the estate planning for the owners will ensure that the business owners and the business itself are all protected, accomplishing their respective objectives and avoiding costly litigation if something goes wrong.
Karen Schaefer is a partner at Lacy Katzen LLP who concentrates her practice in business and estate planning law.