Business Buy Sell Agreements - A Primer
We all know people who invest in stock that is publically traded on a stock exchange, like the New York Stock Exchange. In fact, most people with IRA accounts or 401(k) accounts are invested in funds that in turn invest in the stock market. Those investors will periodically sell or trade their shares – perhaps as a result of a death in a family, a change in investment strategy, a change in the investor’s perception of the stock, or simply a need for liquidity.
The stock market makes that kind of transferability facile and routine. With publically held companies there is usually such a large amount of stock outstanding at any point in time that no single shareholder’s transfers affects the control or the value of the corporation.
Consider the very different environment of closely-held, or privately-owned, companies. In the privately owned company, the shareholders typically double as both the people who work at the company and those who serve as its officers. Often those shareholders fill functional and critical roles in the company: a financial resource, an outside sales developer, an IT consultant, and so on.
Because of that allocation of business responsibility, and the “we’re in it together” mentality of many closely held business owners, control over who could end up as their “partner” in the business is critical. Having any outsider – and that includes spouses or other family members of current shareholders -- owning an interest in the business is usually viewed as undesirable since such unintended (and often unwanted) co-owners could alter the dynamics of how the business functions.
In addition, while the lack of a public market oftentimes allows the closely held business the benefit of being able to “write its own rules,” that same lack of a true market is also a significant drawback since a shareholder can’t freely dispose of his or her shares. Having no ready market means the shareholder’s stake is illiquid.
To address these issues, owners of closely-held entities often enter into a form of “buy-sell agreement” which creates an artificial “stock market” for sales of shares. They also can establish certain restrictions on the disposition of company stock when a shareholder exits under selected circumstances. A typical buy-sell agreement mandates the repurchase of a shareholder’s stock on the occurrence of certain agreed “trigger” events, creating a private market for the shares and providing a source of liquidity otherwise missing in the closely-held business environment.
Trigger Events. Here are some of the customary trigger events that most well-crafted buy-sell agreements address:
- Retirement. When an owner decides to retire or withdraw from the business, the buy-sell agreement usually requires that the departing shareholder offer to sell his or her shares back to the remaining shareholders. If the remaining shareholders do not wish to purchase the shares, they are offered to the company. If none of the parties decide to buy the shares, the departing shareholder is normally allowed to sell his shares to a third party. Some agreements require the repurchase of the departing shareholder’s stock.
- Right of First Refusal. If a shareholder receives an offer from an outside party for his or her shares, that shareholder must first offer his stock to the remaining shareholders at the same price being offered by the outside party. If the remaining shareholders do not wish to buy the shares, then they are customarily offered to the company for purchase. While this stipulation is important, in reality the transfer of closely-held securities to an outside party is rare.
- Death/Disability. If a shareholder dies or becomes disabled, the buy-sell agreement normally requires the shareholder’s estate or the disabled shareholder to sell the shares back to the other shareholders or to the company.
- Divorce. Another circumstance often addressed by the buy-sell agreement is the divorce of a shareholder. Again, since the remaining shareholders do not want to deal with unwanted business associates (such as a co-shareholder’s soon-to-be ex-spouse), the divorcing owner may be required to sell his or her interest to the remaining owners or the company.
- Financial Distress Occurrences. Sometimes the financial condition of the business requires additional capital infusion from its shareholders, and one of the shareholders is unable or unwilling to contribute. It could also happen that an owner’s shares are subject to levy or seizure by his personal creditors, or a shareholder decides to seek creditor protection in the bankruptcy courts. In those circumstances, the buy-sell agreement can allow the company to operate unhindered by paying the shareholder for his or her shares.
Purchase Price. A stark difference between the public and private markets is apparent when determining the value of privately-held stock. The value of publicly traded stock is determined by the stock exchange on a daily basis; the value of private-held stock is most frequently determined by the agreement or appraisal. The determination of the value of closely-held business interests is far beyond the scope of this article, but buy-sell agreements usually employ one or more familiar valuation approaches:
- Agreed Price. The parties simply agree upon a fair valuation of shareholders’ stock once a year (or every two or three years). Sometimes agreements include an automatic adjusting mechanism if the parties fail to revisit the price for a number of years.
- Book Value. This represents the amount of value remaining if all the business assets were sold and its liabilities paid. While this has simplicity to commend it, it is an appropriate valuation methodology in only a limited number of cases.
- Multiple of Earnings Valuation. With this model, the earnings of a business over a year (or the average of several years) is multiplied by some factor. There are numerous variations of this approach.
- Appraised Value. Sometimes the parties simply agree to get an appraisal to determine the value of the departing shareholder’s interest. In this case the valuation parameters that the appraiser uses (such whether or not to use valuation discounts) are sometimes defined in the agreement.
Other Buy-Sell Issues. A buy-sell agreement can also address other corporate governance and management issues, such as membership on a board of directors, who can make certain decisions for the company, capital call requirements, and compensation matters.
Form of Buy-Sell Agreements. There are several different styles of buy-sell agreements. Some require that the company itself repurchase a shareholder’s stock upon the occurrence of a trigger event. These are sometimes referred to as “redemption agreements.” These are contrasted with “cross-purchase agreements” in which the other shareholders agree to purchase the shares on the occurrence of a trigger event. Others – called “hybrids” – usually provide that if the company doesn’t purchase the shares, then the obligation rests with the other shareholders. Choosing the right contract style will depend upon a variety of factors such as the number of shareholders, type of business, future income tax implications, and so forth.
“Funding” the Buy-Sell. When a buy-sell agreement requires the re-purchase of a shareholder’s stock at death, it is not uncommon for the purchasing party (the company in a redemption agreement, or the other owners in a cross purchase agreement) to acquire life insurance to provide a pool of money with which to fulfill the purchase obligation. Sometimes owners “put the cart before the horse” by acquiring life insurance without a formal legal agreement that obligates the policy beneficiary to purchase anything.
In the absence of insurance, or upon the happening of a trigger event in which there is no insurance available – like the retirement of a shareholder, the buy-sell agreement usually will provide for the purchase price to be paid to the departing shareholder over time. A payment structure that gives the purchasing party the right to stretch the payments out over, say, three years, or five years, or even ten years, helps assure that the business operations won’t be negatively impacted by the purchase obligations.
Planning Integration. Where the circumstances warrant, we also recommend that the terms of a buy-sell agreement be properly integrated with other business agreements, such as employment agreements, stock option agreements, and so forth. In addition, the benefits and the obligations of a buy-sell agreement should be clearly coordinated with each shareholder’s estate plan.