A buy-sell agreement is one of the most-important – and often most-overlooked – types of business contract. Any company that has more than one equity partner should have a buy-sell agreement in place. Far too many businesses are running either without an agreement or with one that’s outdated and ineffective. Unfortunately, the importance of these agreements usually isn’t realized until a triggering event occurs, bringing the lack of direction to light and causing significant problems.
First off, it’s important to know exactly what a buy-sell agreement is. Cornell University Law School defines it as “a binding agreement used by sole proprietorships, partnerships and close corporations that governs what happens to an individual’s ownership interest when that individual withdraws from the business, dies or becomes disabled.” The buy-sell agreement outlines how and when a partner exits from the business.
I’ve found that many business owners use the term when referring to the more-encompassing shareholder agreement. Cornell defines a shareholder agreement as “a binding agreement between the shareholders of a corporation defining shareholders’ rights, privileges, protections and obligations. The shareholders’ agreement usually includes the corporation’s articles of incorporation and bylaws.” In many cases, a buy-sell agreement is incorporated into a shareholder agreement.
Triggering Events
When considering a buy-sell agreement, it’s good to know the potential situations for which it helps provide guidance – referred to as triggering events. For example, the death of a shareholder is the simplest, as there is no gray area. If a partner dies, there needs to be a plan that outlines how his or her shares are handled, and how the finances are handled for the shares and/or the family.
An equity partner becoming disabled and unable to work is another trigger. This is a little trickier, as it requires a good definition of disability and must outline what happens with the partner’s shares and how value is transferred.
The next three examples are related, yet each has different terms and conditions. These are resignation, termination and retirement, and the agreement must outline what is done in each case.
I once encountered a situation in which a minority partner in a business resigned and took a job with a competitor. Because of a poorly worded buy-sell agreement, the business not only lost a key employee, but also had to come up with a lump sum payment to buy out his shares upon his departure.
Termination can also be sticky. First you need to delineate between termination for cause and termination without cause. They are usually handled very differently in the buy-sell agreement.
The next two triggering events – divorce and bankruptcy – can be easily overlooked. The divorce of a partner from a spouse could have implications on the shares that partner owns. The agreement needs to address how this would be handled. The same holds true for a personal bankruptcy of a partner – though this isn’t something that happens very often, you should have a plan for it.
Finally, there’s the partner dispute. For the sake of the partners and the business, the shareholder and buy-sell agreements need to address what happens if you reach a point in the partnership during which you simply cannot agree and/or can no longer work together.
Goals of Buy-Sell Agreements
These agreements accomplish more than simply outlining how to handle triggering events. They provide a market for illiquid shares in a closely held private company, which is especially important to minority shareholders. Most agreements restrict the ability of shareholders to sell their shares, providing a level of control for the remaining equity partners to determine who their future partner(s) will be. Without such restrictions, a minority owner of a business could theoretically sell his or her shares to anyone, whether the others want this new partner or not.
It’s important to note that the likelihood of selling a minority interest in a closely held private company is not very high. Investors do not like to buy minority shares, as they have no control. This is what makes the equity illiquid; there really is no market for these shares. The buy-sell agreement should provide a process for minority partners to sell their shares back either to the other partners or to an agreeable third party.
This leads us to the second key goal of a buy-sell agreement – providing an exit strategy for partners. It’s not uncommon for partners to move in different directions in life and end up on different pages when it comes to the business. I’ve seen many instances in which this has caused considerable angst. When the aspirations of the partners are no longer aligned, one or more partners may feel trapped.
The buy-sell agreement (and the shareholder agreement) can provide a path to an amicable exit of one or more partners. Without an agreement in place, a partner may either have to stay on board, extending an already uncomfortable situation, or choose to leave the company without receiving a buyout of his or her equity. In this case, the partner would still be an equity shareholder, but would not be an employee, which is not an ideal situation.
Preparing for the Unknown
To this point, I’ve focused on voluntary exits. But some of the biggest disruptions in business happen when there are unplanned events that result in the exit of a partner. A well-written buy-sell agreement provides for continuity in a business when there has been a sudden exit of a partner. It will cover what happens to the shares should a partner die or become disabled.
I worked through one situation in which the remaining partners of a business “inherited” the widow of a partner who passed away. Upon her husband’s death, she became the majority shareholder. She decided to make changes that ended up hurting the business. Unfortunately, the other partners were along for the ride, as they had no agreement to govern what happened after the shareholder’s death.
This story highlights another goal accomplished with a good buy-sell agreement, as it can provide for the families of shareholders in the event of death, disability or other triggering event.
Very often, equity partners in a business are counting on the equity they’ve built to provide for them in retirement. However, not everyone thinks about providing for their family should something happen to them. A good agreement outlines how the value of the equity will be transferred to family members. It allows the family to receive much-needed income while preserving the cash flow of the business. In these cases, there can be a combination of insurance and stock buy-back to provide financial support for the shareholder’s family.
Exploring Valuations
The valuation process is another important element of the buy-sell agreement, and there are three ways to approach it. First, you may have a fixed value, in which a dollar amount is set in the agreement. This is not usually the most-effective strategy as the value of a business is dynamic and can change quite a bit from year to year.
The second method is a valuation formula. This is better than a fixed value, but can have challenges as well, many of which come from changes to the business model over time, which the formula does not address.
For example, I’ve seen agreements in which the formula ignored company debt. When the agreement was drafted, there was no debt, but when a triggering event eventually occurred, there was a line of credit and a bank note. The formula didn’t take these into account and as a result, the final value was not as fair to all parties. Additionally, the formula method can lead to problems when the business evolves into a very different form over time.
The third and most-reliable method calls for a valuation to be done as needed. In this model, a formal valuation is done for triggering events. It’s also good practice to have a valuation done every year or two, as this helps partners understand and drive the value throughout the life of the business while providing guidance for insurance levels.
Crafting a Buy-Sell Agreement
These agreements have wide-reaching impact, so it is important to get help from qualified advisors. For one thing, you’ll need a business attorney to draft the agreement. Attorneys are not a one-size-fits-all resource, so be sure the one you work with has experience in writing buy-sell agreements and familiarity with your specific situation. It may also be helpful to have the assistance of a tax attorney, as there can be significant tax implications any time shares of a business change hands.
Your accountant should be involved, as he or she has a good understanding of the financial history of the business and can help plan for the future. A valuation advisor should also be part of the process (1) at the beginning to establish the value of the business and (2) at regular intervals to update the value and (3) again at triggering events.
The last two advisors I recommend engaging are your insurance agent and financial planner. Shareholder and buy-sell agreements will often call for life, disability, key man and other insurance. Your insurance agent can help you secure the coverage required to achieve your goals. Your financial planner can help plan for your long-term goals; the equity from your business is just one asset, and part of the big picture for your long-term plan.
In working with hundreds of business partnerships, I’ve come to realize that far too many do not have a shareholder or buy-sell agreement. For those that do, many have not looked at it in years. It can be uncomfortable thinking about and planning for things like death, disability or partner disputes. However, planning for these and other future events is much easier to confront when you’re not faced with the reality of the situation. Doing it now will pay huge emotional and financial dividends down the road when you’re faced with the inevitable curveballs that life and business throw your way.
