Businesses usually start with best intentions and under the best of circumstances. However, down the road many life events and business challenges occur that change business owners, their relationships, and goals. It’s essential, therefore, for most new businesses to begin with a discussion of a buy-sell agreement.
A typical buy-sell agreement functions in the same way as a “prenuptial” agreement in marriages. They save businesses from dissolutions (or bankruptcies), facilitate the transition of ownership, and help parties to avoid conflicts before they even start. For the same reasons, all existing businesses with two or more owners (partners, shareholders, or members) must have buy-sell agreements. This will protect all involved in the future.
A typical buy-sell agreement is written to allow businesses and their owners (i.e. shareholders, members, and partners) to mandate certain terms and conditions of future ownership transfer or business sale upon the occurrence of specified triggering events. If you are forming a new business and are unfamiliar with buy-sell agreements, consider the following issues:
- Buyer choices. It’s important to designate who may or may not buy out the partner or shareholder. In a closely-held business, it is important who has the voting rights and controls the business entity. If the departing partner or shareholder provided services to the business, it is important to set forth the criteria that help to determine who is qualified to take over the duties of the leaving partner or shareholder. The criteria for the potential buyers and acceptance process of the new voting members or shareholders should be specified in any buy-sell agreement.
- Define a triggering event. Triggering events can be a death, divorce, retirement, disability or whatever is specified in the buy-sell agreement. They can also include a breach of contract, unethical or criminal misconduct.
- Purchase price. For many business owners who are just starting their new business, this can be a difficult negotiation point. It’s often difficult to properly value a new business entity, especially in the pre-revenue/planning phase. So, buy-sell agreements would typically provide a formula for the determination of the business’s value or describe a process for selection of qualified professional(s) who would provide business evaluation services for the business owners. The buy-sell agreement should also set forth specific steps describing the dispute resolution process, whether through a mediation or a binding arbitration, to resolve any disagreement with respect to the purchase price. Some agreements mandate an annual re-evaluation of a purchase price following certain guidelines while others allow for a specified third party to set a purchase price.
- Tax considerations. We all know when it comes to taxes there can be unexpected and costly surprises. Be certain that your buy-sell agreement outlines the most efficient way to transfer the ownership. You need to be certain that you do not overlook important tax considerations.
- Financing of the buyout. Making terms of the financial transaction part of the buy-sell agreement is vital to ensure timely payments are made. For this part of the agreement consider life insurance funding, extending terms of repayment, security, down payments, accrued and default interest rates, missed payments and allowances for tough economic conditions or downturns in business profits.
- Typical buy-sell agreement clauses. As with many contracts, there are standard terms used. The following are a few examples of clauses you’ll find in buy-sell agreements that you’ll want to understand:
- Shotgun clause – allows a shareholder to offer specific price per unit/share for the other shareholder(s)’s units/shares. The other shareholder(s) must either accept that offer and sell his or her units/shares for said price or buy the offering shareholder’s units/shares at that price per unit/share.
- Tag-along clause-provides the right to the minority shareholders to “tag” or force the minority shareholder to include the minority shareholders’ stake in the contemplated sale on the same terms as the majority shareholder.
- Drag along clause– provides the right to the majority shareholder to “drag” or force the minority shareholders to sell their stake on the same terms as the majority shareholder.
Taking the time to prepare a buy-sell agreement, just like a prenuptial agreement in a marriage, is essential to not only avoid potential conflicts, if a triggering event occurs, but also to ensure that all business partners have the same goals and objectives in mind for both the short and long-term.
This article is intended to serve as a general summary of the issues outlined therein. While this article may include general guidance, it is not intended as, nor is it a substitute for, a qualified legal advice. Your receipt of this article from Lexern Law Group, Ltd. (the “LLG”) or any of its attorneys does not create an attorney-client relationship between you and the LLG. The opinions expressed in this articles are those of the authors of the article and does not reflect the opinion of the LLG.