Buy-Sell Agreements should be found in every private company with multiple owners. They are invaluable in any number of situations as a tool to avoid deadlock, discord, receivership, or winding up and termination of a company. Buy-sell agreements may be separate stand alone documents, they may be part of the entity’s governing documents, or they may be part of other agreements between the entity’s owners.
Buy-sell agreements require a certain degree of foresight and prediction about where the company will be a number of years in the future. These expectations change over time so the owners should periodically review their buy-sell agreement to confirm that it still meets their needs and expectations.
So what are the key issues that a buy-sell agreement needs to address?
Triggers in Buy-Sell Agreements.
Triggers go to the heart of the buy-sell agreement as they dictate the type of events that will cause the terms of the buy-sell agreement to come into effect. Common triggers are retirement, deadlock, and death. Other triggers include the voluntary or involuntary transfer of an ownership interest, resignation, or the termination of employment of an owner-employee.
When it comes to determining what triggers a party chooses to include in a buy-sell I find that it is often best for the party to consider what situations he or she wants protection from. Some common situations to consider include:
- Protection from the risk of a divorcing owner’s spouse gaining an interest in the business (Texas is after all a community property state).
- Protection from the risk of other owner’s combining their interests to the detriment of an individual owner. The “bully” scenario.
- Protection from another owner with greater resources buying additional control. Should owner’s have equal opportunity to increase their share of ownership interests?
- Protection from the risk of bankruptcy of an owner. Bankruptcy courts wield a lot of power with regard to disposing of debtor’s property.
- Protection from disagreement among the owners on whether to accept a purchase offer from a third party. Should the majority be able to force a sale?
- Protection from termination of an employee-owner’s employment. How would the former employee feel if his or her salary is terminated and distributions are not made?
- Protection from a failure to make distributions.
- Protection from (or requirement for) the application of a minority or lack of marketability discount to any redemption or cross-purchase. The application of minority or lack of marketability discounts is a hotly contested issue when not specifically addressed with prior planning.
Valuation Methods for Buy-Sell Agreements.
There are a number of valuation methods for a buy-sell agreement. In some agreements the valuation is set with objective and specific standards such as multiples of earnings, capitalization rate, or book value. Other agreements might favor a subjective standard or establishing a methodology over objective numbers. Subjective standards typically require the use of third party professionals to establish the valuation. In this scenario, the buy-sell agreement should outline the factors that a valuation professional may or may not consider in the valuation as well as the process for selecting that professional.
Which method is best depends upon the nature of the business and often times may vary within the buy-sell agreement based upon the trigger event. For example, a valuation for purposes of redeeming the interest of a deceased owner could be very different from the valuation method used when one owner is opting out or threatening the sale of his interest to a third party. In the former scenario it might be more appropriate to allow for a valuation that considers future profits and opportunities, while the latter scenario might warrant application of a discount for lack of marketability or minority status.
Funding of Buy-Sell Agreements.
The best drafted buy-sell agreement can be rendered worthless because of inadequate planning for how the parties will fund the required purchase under that agreement. One of the most common funding mechanisms is insurance but this funding method is typically only available in limited circumstances such as death of an owner. So what are the other options? Borrowing, installment sales, and personal resources are the most common alternatives though each has certain benefits and risks associated with them.
Borrowing the funds to implement a purchase pursuant to a buy-sell agreement necessarily assumes that the borrower (whether another owner or the entity) will be able to secure a loan. Prudent planning may necessitate clauses in a buy-sell agreement that require sufficient reserves, whether in cash or assets, to increase the likelihood that the purchaser will be able to secure funding necessary to effect the purchase.
Installment sales are another alternative that usually come with the benefit of avoiding the need to qualify for a loan. This is a significant benefit that can allow for less hassle and an efficient implementation process when the buy-sell agreement is triggered. However, this structure can carry significant risk for the seller as the payment structure relies heavily on future income. What happens if revenues decline? Will the seller be compensated for the additional risk with a higher interest rate on the payments? If so, what is the appropriate rate? Will the buyout payments receive priority? Is the seller going to take a security interest in business property or possibly the personal property of the other owners?
Additional Matters to Address with a Buy-Sell Agreement.
A significant consideration is determining how the purchase and sale will be structured. There are usually two options: a cross-purchase or a redemption. In the cross-purchase scenario, the interest is purchased by all or some of the other owners of the entity. Under the redemption scenario, the interest is purchased by the entity itself. Each has its own benefits, impacts, and risks to the other owners and prudence dictates carefully considering each scenario to determine how the purchase and sale should be structured. This is another area where the structure of the transaction may differ based upon the triggering event.
A buy-sell agreement carries with it certain additional requirements to be effective. For example, a buy-sell agreement that imposes restrictions on the transferability of corporate stock carries with it certain notice and record keeping requirements that must be met for those restrictions to be enforceable.
In addition, effective implementation of a buy-sell agreement may require amending the entity’s governing documents, shareholder or partnership agreements, or other documents related to the entity.