A properly drafted buy/sell agreement for privately held businesses with multiple owners avoids the risk of costly litigation that can occur when a co-owner departs from the business. The following scenario is an example of the financial risk in not having a buy/sell agreement in place:
A business owner (“Buyer”) needs representation in the buyout of her business partner (“Seller”). Seller wants out of their business because he does not want to do that kind of work anymore. The business is profitable; the parties get along. Seller simply has decided he wants something else out of life. Though not in writing, Buyer and Seller have agreed to the terms of the buyout as regards purchase price and financing terms. Fair enough. Simple transaction.
Partway through the drafting and negotiating of the documents the parties hit a roadblock. Apparently the agreed upon terms were not exactly agreed upon as the parties were not in agreement as to the terms of the financing. Was the agreement for interest free payments on Seller’s ownership interest, or a five-year interest-bearing note with a balloon payment? Obviously, such a disagreement over financing terms affects the total purchase price, which in turn jeopardizes the entire deal. It is also now apparent the parties really do not have agreement on the value of the business. With no agreement as to terms, and no appraisal or other objective valuation of the business, the parties are now at a standstill. If they can’t agree the only path forward is litigation.
Thankfully, the parties eventually agree and the deal closes. But only after much tension, delay, and, of course, attorneys’ fees. The better approach – the wiser approach – is to contract around this problem at the outset of the business’s creation with a buy/sell agreement.
Buy/Sell Agreement – Basics
A buy/sell agreement is an agreement between the owners of a closely held business that governs if, when, how, and for how much a co-owner’s interest in the company is to be purchased by the company or co-owners of the company. Two provisions within the buy/sell agreement are of chief importance: the triggering event, the event that causes the buyout, and the purchase price, the price of the shares/membership interests based on some valuation method agreed upon by the parties.
The buy/sell agreement will typically “trigger” upon the occurrence of any of the following events: retirement, death, disability, termination/firing, bankruptcy, or the election of the shareholder/member (as was the case in the scenario above).
Once the triggering event occurs, the buy/sell agreement will determine how those shares/membership interests will be valued for purposes of determining the purchase price. Valuation methods can run the gamut from very basic (a predetermined fixed price) to more complicated (formulas driven by specific financial statement information). However it is done the goal is the same: identify when the buyout must occur and for how much, such that the transfer can be done as quickly and seamlessly as possible without any need for costly litigation.
Buy/Sell Agreement – Timing of Creation
The buy/sell agreement is typically a provision within the operating agreement (for a multi-member LLC or partnership) or the shareholders agreement (for a closely held corporation), which agreements are typically drafted at the outset of the creation of the business. Discussions on how to value a buyout (what method to use) are easier discussions to have at the outset as no owner is yet thinking about leaving and the business’s success (or failure) is not yet known so negotiating positions are equitable.
Buy/sell agreements can always be made after a business is up and operating (and should be if no agreement exists). The challenge is to find the appropriate valuation when parties’ interests are well defined and company financials are established making the parties’ negotiations more adversarial than at the outset. Still, putting a buy/sell agreement in place after the creation of the business is much less problematic than not having one at all.
If you are a business owner, or starting a business, with other co-owners, a buy/sell agreement is vital to a seamless transition of ownership. Please give SJJ a call if you’d like us to review an existing agreement or need counsel in creating a new agreement.