A buy-sell agreement provides for the orderly transition of a business when unforeseen events occur.
Imagine a scenario in which there are two women who co-own a business. One of the owners unexpectedly passes away. A few months after the co-owner’s passing, the husband of the deceased owner approaches the surviving owner and tells her that his wife’s interest in the business has passed to him and he asks why he hasn’t received his deceased wife’s share of the profits since she passed away.
He then asks for copies of the financials of the business and suggests that perhaps the surviving owner is taking too much in compensation. If the surviving owner and the husband are unable to reach an accommodation, it is very likely that this situation will need to be resolved in court.
If the co-owners had a buy-sell agreement in place, the surviving owner would have been able to avoid such a costly problem. A buy-sell agreement can be a stand-alone agreement or buy-sell provisions can be incorporated into an LLC operating agreement or a shareholders agreement. Buy-sell agreements can address many scenarios in addition to the death of a partner, such as a partner’s disability, retirement, a business partner who fails or refuses to meet his or her obligations or a business partner who becomes addicted to drugs or alcohol. Any of these issues can be the “trigger events” that require one owner to sell to the other owner.
Once the trigger events are defined in the agreement, the next step is to lay out a mechanism for determining the price of the interest being acquired. There are several options. The price can be set by a formula agreed upon by the owners.
Alternatively, the owners could meet on an annual basis (or more frequently, if they prefer) and, usually in consultation with their CPA, agree upon the value of the business. That value would then be memorialized in a “Certificate of Agreed Value,” which would be binding on the owners for an agreed period of time, usually one year. If any trigger event occurs in the ensuing year, the value set forth in the certificate would be set the purchase price of the seller’s interest in the company.
The buy-sell agreement could also provide that, upon the occurrence of a trigger event, the company will hire a business appraiser to determine the value of the departing owner’s interest.
Usually, the buy-sell agreement also addresses the payment of the purchase price. It would probably be an extreme burden on the company and the remaining owner to require the purchase price to be paid all at once at the closing of the purchase and sale. Rather, the buy-sell agreement will provide payment terms that are designed not to be too much of a burden.
For example, perhaps 10 percent of the purchase price would be paid at the closing and the remainder would be paid by a promissory note bearing a reasonable rate of interest. This would allow the surviving owner to avoid a large one-time payment (money which the business may not be able to access easily) or to avoid having to find financing to pay for the departing (or deceased) owner’s interest.
Buy-sell agreements can be used to establish the fair value for shares of the business, develop exit plans for business partners, keep business interests with the surviving owners, and create a business continuity plan. Buy-sell agreement are valuable tools to provide orderly transitions for small- and medium-sized businesses; and it is important that the businesses have these agreements in place at the time of formation.
Without an agreement in place, the owner will have to resort to the courts to resolve these issues. A lawsuit over the ownership of a business or the value of an owner’s business interest can be a long and expensive process and could lead to a decision by a judge that may not be in the best interests of the remaining owner or the business itself. Taking the time to put in place a comprehensive buy-sell agreement at the formation of the business is well worth the legal fees to avoid future problems and the much higher costs that come with them.