For those in partnerships and closely-held corporations, the incapacitation, death, or retirement of an owner can cause much angst. So to can the possibilities of bankruptcy, divorce, or an attempted sale to a person or entity unknown to the owners. The role of Buy Sell Agreements to address such situations is critical to ensure the business continues without disruption by the business falling into the hands of an unknown third party.
A buy-sell agreement is a legally binding contract, usually found within the operating agreement of a business entity. A buy-sell agreement represent a restriction on ownership; restrictions which are agreed upon or imposed as a condition of ownership. Three basic types of buy-sell agreements exist: (1) a Redemption Agreement, in which the company itself purchases the departing owner’s ownership interest; (2) a Cross-Purchase Agreement, in which the other owners purchase the departing owner’s ownership interest; and (3) a hybrid of the first two approaches, in which the company and the owners each may buy the department owner’s ownership interest, but with one having the first right to buy and the other the second right to buy.
How does the buy-sell agreement work in practice? It typically works as a right of first refusal. For example, if the departing owner receives a bona fide offer to purchase her interest in the company, the departing owner typically must first establish through a written document that the offer is valid and binding. This may require both a written offer and down payment. The buy-sell agreement would then provide that the company has the first right to buy the ownership interest for the same terms, or for other terms as directed in the buy-sell agreement. If the company does not exercise its right of first refusal, the buy-sell agreement may then provide that the other owners have a right of second refusal to buy the ownership interests on the same terms as offered to the departing owner, or for other terms as directed in the buy-sell agreement. Detailed examples of the above are in the linked article — check it out if you are interested in more information.
Another critical concern with buy-sell agreement is the purchase price of the shares. There are three basic approaches to determining price: (1) fixed price method, or an agreement among the owners are to the value of an ownership interest in the company; (2) a formula method, wherein the buy-sell agreement sets forth a formulaic method, such as net book value or capitalization of earnings, for determining the purchase price; or (3) appraisal. Also worth considering when determining how to calculate price is also how the company can fund the re-purchase of shares.
Buy-sell agreements can also address possible tax consequences and allocation of taxes. Again, detailed examples are in the linked article — it is worth reviewing if a buy-sell agreement is of interest to you.
A buy-sell agreement is not the only estate and succession planning tool but it is one worth considering as part of your estate and succession plan. A good buy-sell agreement not only protects the family operation but also the family relationships that are necessary for the family operation to continue.