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Defining Buy-Sell Agreements
When an owner of a business dies, becomes disabled or leaves the business, a market is created for the owner's interest in the business entity. A buy-sell agreement is a contract among the owners which provides terms and conditions for the purchase of a withdrawing owner's interest in the business. Buy-sell agreements are important tools for maximizing the odds of a smooth transfer of ownership interest in the event of death, disability or departure of one of the owners.
Typical Buy-Sell Provisions
A typical buy-sell agreement may provide that the surviving owners of the business will purchase the deceased or withdrawing owner's share of the business entity. In its most basic form, a buy-sell agreement controls when owners can sell their interests, who can buy an owner's interest, and what price will be paid. More specifically, a buy-sell agreement will often: list the events that cause a mandatory or optional buyout (such as disability, death or withdrawal), provide a formula for determining the purchase price, including a determination of the appropriate valuation dates, state the payment terms of the buy-sell obligation, address the requirement of non-competition agreements between the parties, and designate the types of transfers of an owner's interests which are either permitted or prohibited by the agreement.
Perhaps most importantly, the agreement must have a mechanism for providing the funds needed to make the purchase. Often, in the case of the death of an owner, the chosen mechanism is a life insurance policy purchased by the business entity. The insurance proceeds are used to buy the deceased owner's interest from the deceased owner's estate. The business interest is then retired or allocated to the other owners.
Advantages of Buy-Sell Agreements
There are many goals that a well-drafted buy-sell agreement achieves. The business situation will dictate the importance of the various factors.
- Predictability and Continuity of Ownership. While a buy-sell agreement cannot remove the issue of replacing departed key people, it can at least minimize the risk of uncertainty over how and under what conditions the business interest will be disposed of or retained. Such planning may preserve relationships with customers, creditors, and employees and reassure such parties of business continuity in the event one of the owners dies, becomes disabled or withdraws.
- Create a Market for Business Interest. As most buy-sell agreements are employed in privately held businesses, the ability to resell business interests may be impractical. Buy-sell agreements allow for liquidity by providing business owners a way to sell in particular circumstances.
- Establishing a Definite Price for Ownership Interest. A buy-sell agreement should provide a known, objective, and definable means of valuing the seller's shares. The price can be either a specific number agreed upon by the owners periodically (for example, at the annual meeting), or a formula that is designed to account for changes over time in the value of the business (for example, a multiple of the company's average EBITDA over a period of time). The valuation formula may vary based on the triggering event (whether death, disability or withdrawal) and other factors.
- Allows Active Owners to Retain Business Control. A buy-sell agreement can define the scope of appropriate purchasers of the business interest, thus preserving active owners' business control.
Conclusion
Buy-sell agreements create the ground rules for transfer of interests between business owners in the event one of them dies, becomes disabled or withdraws from the company. They can provide certainty during difficult times and should not be overlooked at the outset of any private business venture with more than one owner.
For more information about this topic, please contact Robert Gonzales (rjg@mglaw.net) or one of our other Business Planning attorneys. |
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