Importance of Buy-Sell Agreements

Whenever a company, corporation, or a limited liability has more than one owner (unless the owners are married), a buy-sell agreement can be of critical importance.

When a person goes into business with another person, typically they do not want the risk of being in business in the future with some unknown person. Without a buy-sell agreement, things can occur which cause a business owner’s interest in a company to go to another person. This can happen by a voluntary sale or gift, death, divorce, or an involuntary transfer to creditors or a bankruptcy trustee.

For example, without a buy-sell agreement: (1) If a co-owner dies, the deceased co-owner’s estate or family members will then own the deceased co-owner’s interest in the business (unless the deceased co-owner’s valid Will states otherwise); (2) If a co-owner becomes involved in a divorce, then his or her spouse can potentially make a claim to his or her interest in the business; (3) If a co-owner has creditors (whether by contract or in tort, such as a bad car accident), and a creditor obtains a judgment against the co-owner or his or her estate, then the judgment attaches to the co-owner’s interest in the business, and the creditor can levy on it and become a co-owner of the business (and hold it hostage); (4) If a co-owner files bankruptcy, then without a buy-sell agreement a bankruptcy trustee may make a claim to the bankrupt co-owner’s interest in the business and sell it to a third person (or hold it hostage). In all of these situations, without the presence of a buy-sell agreement, then a co-owner may find himself or herself in business with a total stranger.

In the event of death by a co-owner, without a buy-sell agreement the other co-owners do not know what to do as to the deceased co-owner’s estate or family, and the deceased co-owner’s estate or family does not know what to do as to the business. Depending on the deceased co-owner’s percentage interest in the business, this can adversely (and disastrously) affect the continued operation of the business, and, regardless of the percentage interest of the deceased co-owner, can result in time-consuming and costly litigation among the surviving co-owners and the deceased co-owner’s estate or family. A buy-sell agreement can avoid these situations and provide a road map for the surviving co-owner to have an option to buy out a deceased co-owner’s interest in the business from the deceased owner’s estate or family.

Typical provisions in a buy-sell agreement provide that a co-owner may not sell his or her interest in the company, without first giving a right of first refusal to the company and the other co-owners. This prevents a co-owner from selling or giving his or her interest in the business to a third person. A typical buy-sell agreement also provides what happens in the event of death of a co-owner. A buy-sell agreement can provide that the other co-owners or the company may have a discretionary option (or it can be a requirement) to purchase the deceased co-owner’s interest in the business from the deceased co-owner’s estate. A buy-sell agreement can provide that the purchase price of the deceased co-owner’s interest in the company is to be at “fair value,” leaving the determination of “fair value” for a later date should it become necessary. Alternatively, a buy-sell agreement can provide a mechanism, such as an appraisal process or formula, for determination of fair value, arbitration, or provide a set dollar amount (an issue with a set dollar amount is that the fair value of the business will undoubtedly change over time).

A buy-sell agreement can provide that if the surviving co-owner exercises his or her discretionary option to buy out the deceased co-owner’s interest from the deceased co-owner’s estate, then the purchase price of the deceased co-owner’s interest in the company is paid by, for example, 20% cash down, and the balance financed, for example, at the Wall Street Journal’s prime rate plus 2%, amortized over a period of 3 years and payable in equal, successive monthly or quarterly installments (the terms can be adjusted in the buy-sell agreement to whatever terms work for the co-owners). This payment obligation is documented by a Promissory Note and secured against the deceased co-owner’s interest in the company, so that if the business fails to make the required payments, the deceased co-owner’s estate can get back the deceased co-owner’s interest in the business back. This same arrangement in a buy-sell agreement can be made applicable in the event of divorce, involuntary transfer (creditors), or bankruptcy of a co-owner.

Even with a buy-sell agreement, often a surviving co-owner and a deceased co-owner’s family will mutually agree to some other arrangement for the surviving co-owner to buy out the deceased co-owner’s interest in the company, with the buy-sell agreement serving as a general road map for the parties to follow and expressing the intention of the co-owners of a company of what is to happen if one of the co-owners dies.

Ideally, a buy-sell agreement will be backed up by life insurance so that the surviving co-owner or the company has the funds to pay to a deceased co-owner’s estate or family in order for the surviving co-owner or the company to buy out the deceased co-owner’s interest in the company (negating the necessity of a promissory note and security). However, many business owners, especially at start-up, find that life insurance is prohibitively expensive.

With or without life insurance, a buy-sell agreement is critical in situations where there is more than one owner of a company.

Other provisions which can be included in a buy-sell agreement are tag along rights (allowing a minority owner to tag along with the majority owners if the majority owners decide to sell their interest in the company to a third party buyer), come along rights (allowing the majority owners to require minority owners to also sell their interest in the company to a bona fide third-party buyer, if the majority owners are also selling their interest to the third-party buyer), put and call provisions, a company option to buy-out a co-owner’s interest in the company if the co-owner is terminated from employment by the company or becomes disabled, voting agreements, and the like. The terms of a buy-sell agreement can be tailored to whatever terms fit the needs and situation of the co-owners.

In setting up a company, many multiple owners do not know whether the company will survive and make it past the first year, and are often cashed-strapped and therefore avoid the expense of a buy-sell agreement. Buy-Sell provisions can usually fairly easily be incorporated into a limited liability company’s operating agreement. If a corporation, buy-sell provisions are included in a separate shareholders’ agreement. Once a company gets off the ground, a buy-sell agreement is of vital importance.

© 2014 Walling Law Firm, P.C.

  1. Leave a comment

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: