But the reality is there’s no better time than when relationships are strong and positive to develop an agreement that protects the partnership against unforeseen changes down the road.
If a shareholder decides to leave the partnership, a buy/sell agreement can provide liquidity, establish a value for the stock, and offer restriction on stock transfer in a closely held company (a company with a small group of controlling shareholders).
It requires thought and discussion, but can be a lifesaver for a company if done properly.
These agreements have three main components:
1. trigger events;
2. valuation methodology;
3. noncompetition agreement.
A buy/sell agreement identifies certain trigger events that, depending on the type of situation, will provide the company or remaining shareholders with a mandatory or optional purchase requirement for the stock of the departing shareholder.
Trigger events usually include such things as: disability, retirement, resignation, divorce, insolvency, deadlock, sale to a third party and death.
If there is a disability, retirement or resignation, and the shareholder is actively working in the business and needs to be replaced, the company and other shareholders will need to consider whether the shareholder should continue as a passive shareholder or have his or her shares redeemed.
The buy/sell agreement usually defines what is meant by disability and often the company or the other shareholders will purchase disability insurance to fund a redemption. There is no type of insurance to fund a redemption for retirement or resignation, so terms satisfactory to all will need to be specified.
If divorce or insolvency should occur, the buy/sell agreement gives the company and the other shareholders an option to redeem the divorcing or insolvent shareholders’ interests. Without such an option, a divorcing spouse or a creditor of an insolvent shareholder could become a partner-not a result bargained for by the initial partner group.
If shareholder discord arises causing deadlock, a previously negotiated “shotgun” provision is very helpful, particularly in a business with two 50/50 shareholders. The party who wants to leave the company has the right to make a proposal as to what he or she believes his or her stock is worth. The second party then decides if he or she wants to be the buyer or seller. Thus, one party “cuts the pie” and the other party chooses which piece he or she wants.
If a shareholder has an offer from a third party to buy his or her stock, generally the other shareholders will have a right of first refusal to purchase the stock of the selling shareholder at the offered price. A right of first refusal is triggered when the selling shareholder produces a good-faith offer from a third party.
Sometimes, the buy/sell agreement provides that, with a good- faith third-party offer, the non-selling shareholders have the right to buy the selling shareholder’s shares at a price based on a valuation or formula. Proper planning ensures that the company and/or other shareholders don’t end up with partners they don’t know, didn’t count on or worse, don’t want.
In the case of death, the purchase requirement is usually mandatory. Often the requirement to purchase the stock of a deceased shareholder is funded through the purchase of life insurance, ensuring that the company or the other shareholders have the funds available to make the payment upon death.
If the company doesn’t require mandatory purchase on death, the stock devolves through an estate plan to a spouse, children or others if designated by the deceased.
The buy/sell agreement also provides terms on which a sale will occur, the amount of a down payment, the term over which the remaining payments are made and any restrictions on the company during the time it is making the payments. For example, sometimes the agreement provides that upon default, the selling shareholder will receive its stock in return.
What’s it worth?
Establishing a value for stock is an important element of the buy/sell agreement. Various valuation techniques include book value, yearly shareholder agreement, pre-determined formula or appraisal.
Book value is often the least effective method of valuation due to increases in the value of fixed and certain other assets and the existence of intangibles, including intellectual property, that will not be recognized.
Shareholders may opt to agree each year on the value of the business. The challenge is that more often than not the shareholders will set the value in the early years of the company and then cease to do so. If a triggering event is solely dependent on a set valuation, shareholders will be in as bad a situation as if they had no buy/sell agreement.
Another option for valuation is formula value or third-party appraisal. A formula approach can be problematic if the formula isn’t updated periodically to take into account business changes.
Either of these methods, formula or appraisal, can be employed as an alternative to a set value. The agreement can provide that if no value has been set within the 15 months prior to the triggering event, then an alternative mechanism is applied.
No competing allowed
A noncompetition agreement is a critical part of any buy-sell agreement. If a shareholder departs the business, but is allowed to take his or her knowledge and set up a competing business, the value of the business he or she has left may decline. In addition, the value the departing shareholder has been paid may be too high if he or she is allowed to compete.
To get started, meet with your business lawyer and CPA, certified public accountant, to discuss your buy/sell agreement. They can help you understand the various nuances to consider for your specific business and their assistance will be critical in document preparation. I have seen too many shareholders try to cobble these agreements together only to realize that the language doesn’t exactly work in the way they had hoped.
Be proactive in your business and negotiate a buy/sell contract when relationships are good, so that all will be protected in the future.
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