Buy-Sell Agreements, sometimes referred to as Shareholder Agreements in corporations or Members’ Agreements in LLCs, serve as a valuable tool in small businesses, especially in the area of transition planning. Generally, Buy-Sell Agreements are entered among equity holders and the business and dictate when and how an equity interest can or must be purchased or sold, and by whom. Some attorneys refer to them as “prenups for business owners,” because they generally govern how business owners can or must separate from one another, and what will become of the respective ownership interests upon such separation. The primary functions of these types of agreements are to protect the value of the various stakeholders’ interest in the business and ensure smooth and workable transitions in ownership of the business by preventing disagreements and potential lawsuits from undercutting the efficient operation of a business. Every business lawyer has stories of disputes, costs and expenses, time and even businesses that could have been saved had the lawyer advised and the client or clients agreed that a properly drafted Buy-Sell Agreement should be negotiated and entered. This article will discuss some of the key concepts Buy-Sell Agreements typically cover.
General Structure
Most Buy-Sell Agreements are intended to allow the equity holders in a business one or more mechanisms to divest themselves of their interest in the business, and/or protect their interest in the business in the event another equity holder elects to divest. This means, most often, that one stakeholder or another has either (1) a right or an obligation to purchase another stakeholder’s interest in certain events; or (2) a right or an obligation to sell such stakeholder’s interest in certain events. These mechanisms take many forms and should be specifically designed and drafted to meet the needs and goals of the applicable small business and its equity holders. In the most typical agreements, they prevent a party from divesting without meeting certain requirements.
For example, in some small businesses, the most important goal is to achieve some stability and consistency and a clear process and power structure in the event of a transition. In others, the primary objective is to protect one party’s investment in the company, or the value derived therefrom, either for that equity holder or that equity holder’s family and loved ones. In other businesses, the primary objective is to allow an equity holder to avoid being locked into a company controlled by others. All of these are potential interests that can be balanced in negotiating and implementing a Buy-Sell Agreement.
Triggering Events
One of the core features of a typical Buy-Sell Agreement is that certain events or circumstances trigger a right or obligation to sell or purchase an interest in the business. The most commonly agreed upon triggering events include those over which the relevant member has little or no control, such as death, disability or termination; those over which the relevant member may have some measure of control, such as divorce or bankruptcy; and those over which the member likely has control, such as an election to transfer or sell such member’s interest in the business, retirement, or other voluntary separation from the business. There may be others, depending on the specific circumstances of the business and its stakeholders. Depending on the surrounding circumstances, and the exact interests the stakeholders intend to protect, different triggering events may trigger different rights and obligations. For example, the operators of a business may wish to treat a retirement more favorably than a voluntary resignation prior to retirement age, or may wish to treat a termination for cause differently from an election to leave the business for health or other reasons. A Buy-Sell Agreement is flexible enough to allow for these variations in treatment in order to conform to the needs and desires of the stakeholders.
The Purchaser
Another important concept to build into a Buy-Sell Agreement is the appropriate purchasing party – who specifically has the right or obligation to purchase the equity interest? The most common potential purchasers are 1) the company or 2) the other equity holder(s). This portion of a Buy-Sell Agreement allows for some creativity. The Agreement can be structured so that, upon a triggering event, the remaining equity holders have the option to purchase the interest and if they decline, the company then has the option (or obligation) to purchase the interest. The roles can be flipped, with the company having the first option and the equity holders the second. There is flexibility in determining who will purchase the interest and whether they have the option or obligation. This is an important conversation topic for equity holders and gives them some flexibility to achieve a good result for all interested parties from a variety of perspectives, including tax treatment, operations, cash flow, and others.
Valuation
Another important element of a Buy-Sell Agreement is how the purchase price or other consideration to be paid in connection with a transaction will be determined. In most scenarios, this starts with a methodology for valuing the interest to be sold and determining what value the parties seek to protect. This valuation can take many different forms, including an agreement among the equity holders (annual or otherwise), a third-party appraisal, or implementation of a predetermined formula for calculating value. It can also account for certain discounts or other adjustments at the parties’ discretions, such as marketability and lack of majority control. These valuation methods and potential adjustments should dovetail with the agenda of the parties in making the agreement, including possible variation for precise circumstances, as contemplated previously in discussing triggering events. In considering and fleshing out these issues in advance, parties can take full advantage of a Buy-Sell Agreement in preventing uncertainty and attendant disputes down the road.
Transaction Terms
Another key element to consider is how the sale and purchase of the equity interest will play out. This includes determining when, where, and how the payment will be made. The process is dependent on the facts and circumstances surrounding the company, such as whether the company or other buyer has sufficient cash available at any given time to pay in full or if financing will be required. The stakeholders have to weigh and balance the potentially competing interests of a departing equity holder receiving value, the remaining equity holders’ access to and available resources, the company’s cash flow and other operational considerations. A Buy-Sell Agreement can be negotiated and structured to protect any or all of those interests to the extent the stakeholders deem it necessary or appropriate.
Specific Provisions
Buy-Sell Agreements often address other potential transaction scenarios, providing stakeholders with certain rights or obligations on account thereof. For example, drag-along rights generally allow a majority stakeholder to force a minority stakeholder to participate in a transaction the majority stakeholder has elected to consummate. Conversely, tag-along rights generally allow a minority stakeholder a right to force its way into such a transaction. Shootout provisions generally allow one stakeholder to elect to trigger a mechanism for a buyout and another stakeholder to elect who will purchase and who will sell, or some other material aspects of the transaction. Buy-Sell Agreements can contain preferential rights for certain buyers or other acquirers, or provisions intended to benefit certain groups of stakeholders to the exclusion of others. All of these provisions depend, again, on the particular circumstances surrounding the business and the parties’ balancing of potentially competing interests in the business.
Conclusion
Buy-Sell Agreements, “pre-nups for business owners,” are an adaptable tool that stakeholders can use to manage transition in a business to properly balance the potentially competing interests among various stakeholders and the business itself. As discussed, they can be negotiated and implemented to fit a wide variety of circumstances and address a wide variety of needs or interests. Business owners should consider implementing a Buy-Sell Agreement or similar arrangement in some form at the earliest opportunity, as they allow business owners to achieve a degree of certainty in the business environment, which is rarely, if ever, a negative. Lawyers should raise the possibility as early as possible and do what they can to educate business owner clients about the advantages a solid Buy-Sell Arrangement can provide.