Business Partnership Requires A Buy Sell Agreement-No Exceptions

By: Randall A. Denha, J.D., LL.M.

Do you have a partner or partners in a business? Do your legal documents contemplate what happens in the event of death, disability, divorce, involuntary transfer or retirement of a partner? Do they establish a value for the shares in the event any of the aforementined occurred? What are the payment terms in the event of a buyout?  Do you want to be in business with the spouse or children of a partner? Without a Buy-Sell Agreement (“BSA”) in place, business owners risk facing these scenarios and other situations that can disrupt the business and hurt its value. Having a formal agreement can define a desired exit strategy and ownership succession plans, providing a roadmap in the event any of the triggering events described here occur.

Disagreements are common between business partners in private companies, but most do not lead to a partner exit. When partner conflicts become severe enough to warrant a business divorce, however, majority owners and minority investors will both be well served if they have taken the time to negotiate and implement a “corporate prenup.” If partners have not adopted a partner exit plan, the disputes between them may be both costly and prolonged when a partner departs. While there is no perfect BSA, a well-crafted contract will enable a business divorce to take place in a manner that limits disputes between the partners, which saves time and money.

Why a Buy-Sell Agreement Is Necessary

The time to create a buy-sell agreement is well before it is needed. A properly drafted BSA provides a roadmap for the partners when serious disputes arise. Majority owners do not want to be saddled forever with a minority partner who is causing problems for them in the business. For their part, minority investors who have strong objections to the actions of the majority owner do not want to be stuck holding an ownership interest in the company that they cannot monetize. The BSA therefore allows the majority owner to redeem (buy out) the minority investor’s interest. It also allows the minority partner to secure a redemption (sale) of his or her stake in the business. Thus, both sides are able to secure a business divorce when they decide it is necessary.    

The Important Elements of a Buy-Sell Agreement

There are four chief elements of a BSA, which are discussed below. These are not cookie cutter documents, and each of these terms will need to be discussed at some length by the co-owners to reach an agreement that meets their specific needs. 

1. The Trigger

The first element is the trigger, which is the point in time at which the BSA can be exercised. Common triggers to a BSA are retirement, death, divorce, disability, involuntary transfers, committing an act of fraud or failing to meet a contractual requirement, such as a capital contribution. Make sure to stipulate clearly the consequences of a triggering event and that any potential seller is assured his/her shares will be bought and that a potential buyer will not be forced to buy shares they cannot afford. Moreover, having appropriate triggers will safeguard the business from being interrupted by family members of partners who are no longer living.

However, depending on your business, some of these events might not need to trigger a buy-sell commitment. For example, if a specific owner is not essential for the survival of the business, it might be fine if she or he maintain ownership, or in the case of death, her or his shares simply pass to a spouse or surviving relative.

Majority owners also want the right to be able to pull the trigger and buy out the minority owner whenever they desire so that, at the first hint of problems, they can remove any disgruntled/difficult minority partner. But the minority partner who is making an investment in the company may resist an early exit and require that the investment be given sufficient time to appreciate in value so that the investment will have been worthwhile. The minority owner may therefore insist that no buyout right can take place within the first three to four years after the investment. The minority owner should also require that any buyout take place pursuant to a look-back provision. This provision provides that if any sale or other transaction takes place that places a higher value on the company within a year (or longer) after the minority interest has been redeemed, the minority owner will receive a supplement payment that provides the minority owner with the benefit of the increase in value.

The minority owner will want the right to demand that his or her interest be purchased whenever the minority owner desires to exit the business. The majority owner is unlikely to want to permit the investor to be able to pull the plug shortly after an investment is made in the company. The majority owner may therefore require that the minority investor has no right to request a redemption for at least three to four years (or longer) after the investment has been made. Similarly, the majority owner may require that all of the minority investor’s stake in the company be redeemed at one time so that the majority owner is not required to deal with multiple exercises of a redemption by the minority investor.

2. The Value of the Redeemed Interest

Private company valuation is no easy task, and highly regarded valuation experts may reach very different opinions about the value of the ownership interest that is being redeemed. As a result, the co-owners should spend time considering how they want to go about determining the value of the business and the interest being redeemed when a buyout is triggered. Agreeing to a purchase price is often a contentious process. Thus, make sure you write procedures to settle price disputes quickly. This might be agreeing to purchase prices annually, or agreeing to a price set by an independent third party like an appraiser or arbitrator.

Some of the components that the parties need to consider in valuing the redeemed interest include:

• What is the date of valuation (should it be the date the buyout is triggered, or should it be a specific date of the year, e.g., December 31, regardless of the trigger date)?
• Should the value be based on a single date or should it be a composite/average of the company’s value over the past two to three years?
• Do minority discounts apply to a minority interest based on lack of marketability and the lack of control or should the value not include any minority discounts?
• Should the value be based on a specific formula based on the company’s financial documents or should value be determined by business valuation experts and, if so, which one(s)?

3. The Payment Terms

In addition to setting forth how the value of the interest to be redeemed will be determined, the BSA also needs to define how the price will be paid. The payment of a shareholder redemption often takes place over three to five years, although some BSAs provide for an even longer payout. Given the length of time for the payout to be completed, the BSA may provide for some type of collateral in the event there is a default in payment. The BSA must also specify whether the redeemed interest is transferred at the time the transaction takes place, or whether the transfer takes place over time as payments are made. While it is more common for the redeemed interest to be fully transferred at the same time as the redemption, that is not always the case. 

4. Funding the Purchase and Valuation Issues.

Funding the sale of company interests often plays an important part in these types of transactions. Parties can make arrangements to pay for the shares of stock over a period of time, establish a reserve fund or purchase life insurance to fund the purchase of the interest. If the company’s value is not too great, then the purchase can usually be funded through existing cash or life insurance. For example, if a company is worth $2 million and has two owners that each own one half of the company, the company can buy a $1 million life insurance policy fairly easily on each owner. When one owner dies, the company has $1 million in cash to pay the heirs of the deceased for the value of his or her one-half ownership interest in the company, leaving the company owned 100% by the surviving shareholder.

Problems arise, however, when the company is more valuable and life insurance alone cannot fund a buy-out. For example, if a company that has two owners that own one half of a business worth $10 million, upon the death of one owner, the company or remaining shareholder now has to pay $5 million to fund a buy-out. Since it may be difficult to get life insurance for that amount, there may not be enough cash in the company or in the surviving shareholder’s bank account to pay such a large sum.

Consequently, the buy-sell provision will often allow the purchaser to pay the heirs part of the purchase price as a down payment with the balance paid over a period of time.

5. Dispute Resolution Process

The final element of the BSA is the method selected for resolving any disputes between the partners that take place during their business divorce. Will it be a dissolution action in a court? Third party advisor or team of persons to settle the dispute? Given the desire of all parties for the process to be completed promptly, they may choose to arbitrate these conflicts rather than engage in litigation. This ensures that they will have a prompt final separation of their joint ownership interest in the business.

Conclusion Even when parties going into business together are family members or longtime friends who trust each other, they are wise to plan ahead. Buy-sell provisions are an important part of the documents that govern a company. These types of provisions should be drafted when you start up your company and updated regularly to ensure that they continue to reflect the desires of the owners for the disposition of their ownership interest in the event of an untimely death.