The Top 5 Reasons a Buy-Sell Agreement is Essential for Your Business
by James E. Robinson, Esq.
Starting a closely-held business is an exciting event brimming with promise. Crucial to the formation is selection of the founding “owners” who usually are well-known to each other. Forming a business with people who know each other and collectively agree to be in business together at the outset is what each member relies on when deciding to get involved in the first place.
Among the most important considerations for business owners is controlling the transfer of an ownership interest in the business. One aspect of this issue is whether an owner (a shareholder in a corporation, a member of a limited liability company (“LLC”) or a partner in a partnership) should have the right to transfer his interest, with or without restrictions. Owners should also consider what happens in the event of their death, disability or retirement. It is important to address these matters in a written shareholders’ agreement, LLC operating agreement or partnership agreement when the business is being formed and the parties are on good terms. This will help reduce the possibility of misunderstandings and ensure that owners’ expectations are met. The agreement provides a plan for the future.
Should there be Restrictions on an Owner’s Right to Transfer Her Interest?
It is common for an owner to want the right to transfer her interest to another person. The other “person” may be one of the remaining owners or an “outsider” such as a spouse, relative, friend or some other third party. When a transfer of ownership is proposed, a red flag immediately goes up for the remaining owners, who may find themselves in a business with someone who is not of their choosing. Problems with unrestricted transfers are legendary and a potential minefield for the smooth continuation of the business.
Even if the other “person” is an existing owner, problems can arise. For example, if the proposed transfer is to one or more of the other owners, it could affect the balance of control among them. Suppose one of three equal owners had the right to transfer her entire interest to one of the other owners, that transfer would result in ownership (and in most cases, voting rights) being divided between the two remaining owners 66.7% / 33.3%. To prevent that from happening, owners usually agree that in the event of a transfer among the owners the remaining owners will each acquire their proportionate share of the transferred interest so that the ownership percentages remain unchanged after the transfer.
The sale to an outsider raises a host of other issues. There is a natural tendency for the remaining owners to resist what they will perceive as forced sharing of ownership with someone they did not choose and who may not have the qualities to conduct the business in a cooperative manner. For that reason, it is not uncommon for owners to limit the ability of an individual owner to transfer her interest in the company to an outsider. The types of limitations which can be put in place include an outright ban on transfers and a requirement that an owner wishing to transfer her interest first offer to sell it to the company or the other owners. The owners may also agree upon a list of people or classes of people (e.g. spouses, children, etc.) to whom an owner may transfer her ownership interest. Another approach involves allowing an owner to transfer some or most of her ownership interest while prohibiting the transfer of any management rights. For example, in a corporation this can be done by creating two classes of stock, one with voting rights and one without. Owners are then permitted to transfer only their non-voting shares. This approach can be useful for estate planning purposes if an owner wants to begin transferring her ownership interest to her children without relinquishing control of the business.
What Happens if an Owner Dies?
The remaining owners will often want to control ownership of the company and prevent inheritance of the deceased owner’s interest by her heirs or a sale to outsiders by the deceased owner’s estate. At the same time, each owner will naturally want to provide for the financial security of her family in the event of her death. A common approach is to agree that the company or the other owners will buy out the interest of a deceased owner. This keeps ownership in the same hands and also provides the family or estate of the deceased owner with a ready source of funds without requiring them to become involved in the business or sell the deceased owner’s interest. The purchase of an owner’s interest by the company is known as a “redemption” and a purchase by the other owners is known as a “cross-purchase.” Which alternative is appropriate will depend on the circumstances and the choice will often involve consultation with the parties’ accountant and/or tax advisor. An important question to ask yourself is where the money to fund the buy-out of an owner’s interest will come from. As a business grows and becomes more successful, the value of an owner’s interest may grow into the hundreds of thousands or millions of dollars – a sum which might be difficult for the company or other owners to raise on short notice. Fortunately, life insurance is often available at a reasonable cost and can provide a complete or partial source of funding for the buy-out. Another important question is how the value of an owner’s interest will be calculated. This is addressed in a separate section below.
What Happens if an Owner Becomes Disabled?
Thought should also be given to the possibility that an owner will become disabled due to illness or injury and that the disability will be permanent or continue for an extended period of time. A disabled owner might want to be bought out so that he can have money to pay medical bills or address other personal and family needs. On the other hand, a disabled owner might prefer to retain his ownership interest in the business, especially if the business is growing or generates investment income (such as dividends or other payments to owners apart from any salaries or similar compensation paid to owners who are actively working for the company). Rather than selecting one approach or the other, it can also be agreed that an owner who becomes disabled will have the option to decide whether he wishes to be bought out or to retain his interest in the company. There are policies of insurance designed for the specific purpose of providing money for the purchase of a disabled owner’s interest, however such policies (known as “disability buy-out” policies) are often quite expensive and other means of funding the buy-out payments may need to be considered. These can include borrowing money or paying the purchase price for the disabled owner’s interest over time.
A related question is what happens in the short term if an owner becomes disabled. The disabled owner will generally need a continuing source of income and it’s not uncommon for business owners to agree to provide each other with protection in the form of continued salary payments – often for a period of 6 to 18 months and often on a decreasing basis. For example, it might be agreed that a disabled owner will be entitled to receive her full salary during the first four months of disability, two thirds salary during the fifth through eighth months of disability, one third salary during the ninth through twelfth months of disability and nothing further if the owner continues to be disabled after the expiration of one year. If it’s been agreed that a disabled owner will be bought out, then the buy-out usually takes place at the same time the salary payments stop. This way the disabled owner won’t be left without a source of funds. Disability income insurance (as opposed to disability buy-out insurance) can often be purchased to fund the company’s obligation to make continuing salary payments to a disabled owner.
What if an Owner Decides to Retire?
An owner will often wish to have an agreement for a buy-out in place so that there’ll be a source of funds for his individual and family needs upon retirement. While the other owners might not have any objection to providing a buy-out upon retirement, they will usually want to specify retirement terms. One of the reasons for this is that there’s no insurance or other outside source of funding (except, perhaps, for loans) available to cover the event of retirement. Accordingly, the obligation to buy out the interest of a retiring owner can place a severe financial burden on the company and/or the other owners. Owners may wish to limit early or near-term retirement due to a belief that the know-how and skills of all the owners are necessary to ensure the success of the business and that everyone should be willing to make a commitment to continue to work for the company for some minimum period of time. These types of concerns can be addressed by establishing a minimum retirement age and/or a minimum service time (for example, it might be agreed that an owner will not have the right to be bought out if he voluntarily leaves the company within ten years). As an alternative to a cut-off date or age, it can be provided that if an owner retires before his 65th birthday (or some other set date) the value of his ownership interest will be discounted by a specified amount. For example, if the discount were set at 5% per year, then an owner who elected to retire five years early at age 60 would receive only 75% of what he would otherwise receive in payment for his ownership interest at age 65.
How will Your Company be Valued?
As noted above, one of the critical aspects of the planning process is determining how the company will be valued. The simplest and least expensive method is by means of the parties’ agreeing upon a current value and further agreeing that they’ll update that value every year (or on some other periodic basis). The problem with this approach is that it’s human nature for the parties to treat their agreement as complete, file it away and neglect to update the company’s value. It’s not uncommon for the need for a buy-out to arise and for the parties to consult their agreement only to find that no value was ever agreed upon or that the agreed-upon value is out of date and doesn’t fairly reflect the current value of the business. At the other end of the spectrum, owners can agree to hire a certified business appraiser to prepare a business valuation report with respect to the company when circumstances requiring a buy-out arise. This is probably the most accurate method, but may also be the most expensive and time-consuming. Between these extremes there are any number of other approaches which may be used – including agreement upon the use of an industry standard formula or rule-of-thumb (e.g. a multiple of annual earnings) – each with its own advantages and disadvantages. In the end, the best approach will depend on the needs and circumstances of the particular company and its owners.
Determining how and when an ownership interest in a business may be transferred is of critical importance to individual owners seeking to do their own personal and financial planning. A written agreement between the owners creates certainty and reduces the potential for future disputes. Feel free to contact us to discuss a plan tailored to your particular needs and those of your co-owners.
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Please note that this article is intended only as a general discussion of issues which may be confronted by the owners of closely-held corporations, LLC’s and partnerships and that it should not be taken as creating an attorney-client relationship or as legal advice with respect to any particular person, business or situation. Circumstances and the applicable legal principles vary and you should consult with an attorney before entering into any contract or agreement.