A “buy-sell” agreement is perhaps the most important document in outlining the relative roles and rights of business ‘partners”, insuring smooth relations over a long period of time and attempting to maximize long term personal and business planning strategies. A buy-sell agreement is a contracted agreement between the owners of the business, intended to protect the business, which outlines the measures to be taken in the event that one of them dies or there are other changes or desired changes in ownership of the business.

Buy-sell agreements are frequently discussed in the context of a corporation. However, they are equally applicable to other forms of business enterprises such as limited liability companies and limited partnerships. In this article we will refer to these as “entity” and refer to the shares or partnership interest as the “ownership interest”. This article provides an overview of buy-sell agreements. It is not intended to be exhaustive, but only provide the basic purposes and provisions of such agreements.

A buy-sell agreement is an agreement between the owners of a business for purchase of each other's interest in the business, the purchase of which is triggered in the event of the owner’s death, disability, retirement, withdrawal from the business or other events.

Purposes of Buy-Sell Agreement

There are several purposes for a well drafted buy-sell agreement. Some factors will be more important than others depending on the type of business situation and individuals involved.

• Predictability and Continuity of Ownership. A well drafted buy-sell agreement provides a clear and predictable continuation of a business when such issues are faced at the worst possible time, i.e., the death or other departure of key personnel.

• Orderly Transfer of Ownership. Restrictions on transferability or ownership can minimize the chances that a business could be disrupted by a change of ownership, in some cases to an unwanted “partner”.

• Establish a Fair Price for the Ownership Interest. A well drafted buy-sell agreement can provide a known, objective and definable means of valuing ownership interest in a closely held business.

• Tax Considerations. These include preserving S corporation status, assisting in setting values for estate tax purposes and providing for the amount and timing of distributions. In order to keep this article to limited space, tax issues will not be extensively discussed.

• Protection of Majority and Minority Owners. A well drafted buy-sell agreement may also provide for the purchase of minority’s interests and limit the amount of involvement and information to which a minority interest would otherwise be entitled. The agreement can also include provisions limiting some classic devices majority owners utilize against minority owners.

Types of Buy-Sell Agreements

Restricting transferability of an ownership interest in the entity is a central feature of a buy-sell agreement. Buy-sell agreements come in three basic forms:

• First, the purchase of a selling owner’s interest by the entity itself
• Second, the purchase can be made by the other owners, and
• third, is a hybrid combination or the first two.

Redemption of a departing owner’s interest by the entity is straightforward and easy. There is one buyer and one seller. Redemption, however has a number of shortfalls. First, state law restrictions may prevent the entity from purchasing the ownership interest. Second, an installment purchase would create liabilities on the purchasing entity’s balance sheet. Third, the entity’s purchase does not provide any increase in the basis of the other owner’s interest. There may also be tax issues that are raised by the purchase.

Cross-purchase provisions require each owner to purchase the selling owner’s interest. The purchasing owner receives a step-up in basis of his or her ownership interest. Cross-purchase type agreements may be cumbersome and difficult to enforce when a large number of owners are involved.

The hybrid approach combines the two other methods. The entity is first given the right to purchase the ownership interest. If the entity can not or does not exercise this right, the other interest owners then have the right to purchase the interest. This approach provides the maximum flexibility to address the variables on a case-by-case basis.

A buy-sell agreement plans for the desire of an owner to sell his or her ownership interest. A buy-sell agreement may also require the sale of an ownership interest in certain circumstances. These may include bankruptcy of an owner, pledges, departures, both voluntary and otherwise, of an employee-owner. Different provisions may be adopted depending upon the reason for the departure.

Determination of Purchase Price

Establishing the purchase price for the ownership interest may be the most difficult part of the buy-sell agreement. Among the methods used are: fair market value, cost, or some method utilizing earnings or other financial statement information.

Buy-sell agreements will attempt to define fair market value in one of several ways. First, the owners may agree upon a value at a specific time each year. Other buy-sell agreements provide that the value will be equal to the amount of insurance that has been purchased on the life of the owner.

Another common valuation method is the use of independent appraisers. These provisions may include one, two or three appraisers. It may also include averaging the amounts from the appraisers, choosing a third “tie-breaker” appraiser who may choose one of the values, in a “baseball arbitration approach” or provide a third value that is then averaged with the others. There are multiple methods that may be used.

The other “typical” approach is to provide for some type of financial formula. The interest being sold may be valued on a multiple of net income or operating cash flow or a multiple of net book value. The price to be paid may be structured differently depending upon the event that triggers the purchase.

Payment Terms

Many buy-sell agreements will provide for the installment payment to the survivors of a deceased owner. Some will provide for insurance proceeds to be paid to the survivors. The agreement can also provide for any offset of amounts due by the selling or deceased owner.

As can be seen from the above, the terms of a buy-sell agreement can be tailored to meet the needs of the particular entity and the owners involved. Owners should consult with competent advisors in order to provide for the best possible agreement under the circumstances.
For more information visit www.successdna.com and www.sutlaw.com.

This document is distributed for informational use only; it does not constitute legal advice and should not be used as such.

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