Buy-sell deals are crucial when a firm is young

After all, the corporate or LLC statute under which you have organized your business includes many rules for operating a company and governing the relationship among the owners. So, why would you need a separate agreement?

Despite the common notion that you can defer a buy-sell agreement until you have the resources to devote to the process, you should not put it off. Many good businesses have been disrupted or even failed because owners did not properly define their relationships.

Think of it this way: You’ve put a lot of thought and effort into putting together a plan to operate a successful business, and you should exert a similar amount of effort to define the relationship among the owners of the business.

Consider the following when putting together a
buy-sell agreement to help ensure success of your business:

1. Transfer restrictions.

A buy-sell agreement (sometimes called a shareholder agreement, member control agreement, or something else) has the primary purpose of ensuring continuity of ownership. When a business is started, partners agree to do business with each other and not with others for specific reasons. Each owner likely brings certain expertise and experience that is not easily replaced. Also, personalities of owners are critically important for business success.

Therefore, one of the most important functions of a buy-sell agreement is to restrict transfers of ownership in a company to third parties. Transfer restriction can be either absolute (for example, no transfers are permitted ever without the consent of the other owners), or transfers may be limited by right of first refusal or other similar restriction.

Transfer restrictions for “sub-S” shares are critically important. If a business is an S-corporation, a transfer by a shareholder to a non-eligible shareholder could result in the loss of beneficial tax status. All S-corporations should consider an absolute prohibition on transfers of shares to non-eligible shareholders and a “clawback” right of the corporation and the other shareholders in the event an unpermitted transfer is attempted.

Also, it is important to limit owners’ ability to use their ownership in the company to secure personal obligations such as bank loans (such as by granting a lien on shares or LLC membership interests). If no restriction exists and an owner defaults on the loan, a banker or other lender may become a business partner. Similarly, permitting the company and its owners the right to “buy back” ownership that is subject to an involuntary transfer, such as in a bankruptcy or divorce, should be considered.

2. Purchase options.

Most often when a business is started, everyone is in perfect alignment regarding the business and its direction. However, feelings change over time, and life events could also affect an owner’s ability to continue with the business. A buy-sell agreement frequently includes the option (or obligation) to buy out an owner upon the occurrence of certain events, including: death, disability, retirement, termination of employment or termination of active engagement with the business, insolvency or bankruptcy, and when transfers of ownership are attempted in violation of any transfer restrictions.

It often surprises people when they learn that the law does not require a business owner to be actively engaged in day-to-day operations of a business. The issue usually arises when an owner ceases or slows down his or her involvement with the business despite expectations of fellow owners. Without a purchase option in a buy-sell agreement, an uninvolved owner retains his or her rights to participate in any owner votes and share in the profits of the company.

Including such a buy-out right ensures that all owners will be active and also provides a means to fairly liquidate the equity of an owner who is no longer interested in involvement in the business.

3. Valuation.

In order for a purchase option to be effective, there needs to be a way to value the ownership interest being purchased. There is no one right answer on how to do this, although common methods include a stipulated value, a formula for determining value, and an outside appraisal. Each of these methods has its own good and bad qualities, and it is important to work with an attorney and accountant to determine which is most appropriate.

4. Operation and management.

An often overlooked topic for a buy-sell agreement is the operation and management of a company. The statutes under which a company is created gives one some default rules for how the company will be governed; however, those rules may be modified by agreement, and it may be appropriate to modify those rules to meet owner expectations.

For example, you may want to define different rules for how a board of directors or governors is elected, or require supermajority consent of the owners for certain actions (such as bringing in new owners, changing the business activities of the company, borrowing money or selling assets).

5. Owner compensation.

Compensation in the form of salary or wages should be considered separately from an owner’s share of profits. For example, one owner may be involved with the business only part-time, but brings a particularly valuable type of expertise, while another owner works full-time in the business. In this case, it may be appropriate for the full-time owner to receive a higher amount of compensation than the part-time owner, while the owners split any remaining profits equally. Also, the mechanism for determining or changing compensation of the owners should be clearly defined in the buy-sell agreement.

A buy-sell agreement is one of the most complicated parts of starting a new business, and this article only touches generally on some of the larger topics. Business owners would be advised to discuss their expectations about the relationship among owners before starting the business, and work closely with advisers to best structure their agreement.