Multiple Owners? A Buy-Sell Agreement Is a Must

For any type of entity that has multiple owners (LLC, partnership, or closely held corporation), a well-conceived buy-sell agreement can lessen – or avoid altogether – the financial and emotional pain in a variety of common scenarios, cumulatively known as the “killer D’s”: death, default, departure, disability, disagreement and divorce.

As Investopedia explains, a buy-sell agreement among co-owners is a “legally binding contract that stipulates how [an owner]'s share of a business may be reassigned if that [owner] dies or otherwise leaves the business.”

If there are no buy-sell provisions in your operating agreement, partnership agreement or corporate agreements, or if you have no agreements that address these issues, the business is exposed to particularly worrisome issues in the event of death or divorce – i.e., what is to keep a deceased member’s spouse or children, or a divorcing member’s ex-spouse, from taking a seat at the table?

With a buy-sell agreement, the owners can agree, in advance:

• how an owner’s interest is to be held to avoid probate and other complications in ownership transfers;
• under what “triggering events” an owner would be bought out;
• how an ownership interest would be transitioned in case of death, divorce, retirement, default, etc.;
• which party would be the buyer (i.e., the entity or one or more of its owners);
• restrictions on selling or conveying an interest to an outside buyer;
• how the interest of a departing owner would be valued;
• how the entity would fund the buy-out of an owner’s interest;
• what the process would be for removing an owner; and
• how to preserve, in a variety of circumstances, continuity of business operations.

Benefits. A buy-sell agreement offers at least four major benefits, as described in this Wolters Kluwer article:

• Business continuity: In the event of death, retirement, or incapacity, a buy-sell can promote the seamless continuation of the business.
• Compensation: Any survivor or designated successor will be properly compensated for the deceased owner’s interest.
• Assurance: Remaining owners can be sure that the deceased’s business share is not passed onto someone deemed unsuitable.
• Asset protection: If a triggering event occurs, the agreement creates a source of funding and liquidity and mitigates the need to sell assets.

Forms of agreement. A buy-sell usually takes one of three forms:

• A cross-purchase agreement allows the other owners to purchase the interest of an owner who dies, is disabled, or retires.
• An entity-purchase or redemption agreement calls for the business entity itself – not the other owners personally – to purchase an owner’s interest.
• A hybrid of the first two types gives the entity first right of refusal to purchase the departing owner’s interest before that opportunity is presented to the other individual owners.

A fourth option, a “shotgun clause,” is something of a nuclear option, in which owner #1 offers to buy out, at a specified price, the interest of owner #2, who can either accept the offer or buy out owner #1 at that price. This can be particularly useful when two or more owners just do not get along and can no longer effectively work together in the business.

Valuation. A few of the more common methods for arriving at a value include:

• a mutually agreed upon value, either prospectively or at the time of purchase;
• a pre-determined fixed price;
• a formula based on earnings or book value; or
• a third-party valuation performed by a credentialed business valuation professional.

Funding the purchase. After an owner’s interest is valued, the purchase of that interest can proceed. The buy-sell agreement should specify how the purchase is to be funded. Common funding methods, which may vary with the nature of the triggering event, include:

• cash buyout, by the business or by the acquiring owner;
• installment payments;
• percentage-of-earnings payments; and
• insurance (life or disability).
  

We can lead you through the process. Including buy-sell provisions is part of our checklist in drafting clients’ business agreements. While those provisions often contain certain “boilerplate” language, the process of drafting them allows you to tailor the buy-sell to your specific situations and objectives.

We can help you identify those opportunities, so that your buy-sell agreement delivers maximum benefit to you, your co-owners, and the entity itself.

We gratefully acknowledge the contributions of M&A advisor Jim Afinowich (IBG Fox & Fin) to this article.