Monday, September 21, 2009

Buy/Sell Agreements 101 - Understanding the Basics

By Thomas L. McLain

Whether your small company is a corporation or a limited liability company, most legal advisors recommend that buy-sell provisions be a part of your company documentation. Buy-sell provisions accomplish at least two purposes. First, by specifying the terms pursuant to which an equity owner may sell or transfer an equity interest in the company, the buy-sell provisions provide continuity of ownership and control. Second, buy-sell provisions provide liquidity in the event of the death or disability of an equity owner. By spelling out up front the terms pursuant to which these and other goals are accomplished, the owners should eliminate anxiety, pain, and real controversy later. However there is a lot to consider and this outline of the basics of buy-sell provisions will prime the business owner for an effective consultation with their company attorney.

Types of Buy-Sell Structures. In the case of a corporation, the buy-sell agreement is a stand-alone agreement. In contrast, in the case of a limited liability company, the buy-sell provisions are typically incorporated into the operating agreement. In either case, there are two types of buy-sell structures based upon how the payments are actually made.

· Redemption structures. This type of structure contemplates that the company purchase the equity interest of the selling equity owner.
· Cross-purchase structures. This type of structure contemplates that the remaining owners purchase the equity interest of the selling equity owner.

Triggering events. When an event occurs that causes the buy-sell provisions to be applied, it is said to be a triggering event. There are a variety if triggering events and some of the most common are summarized below.

· Death. The death of an equity owner is usually a triggering event, either based on the theory that the estate of the deceased owner will need liquidity, or based on the theory that the remaining owners do not want to be forced to deal with a representative of the estate. Sometimes the death of an equity owner gives the representative of the estate the right to force the purchase of the equity interest; other times, the death of an equity owner gives the company or the remaining equity owners the right to force the sale of the equity interest.
· Disability. Permanent disability is a triggering event for most of the same reasons that death is a triggering event. If the company has disability insurance, then the terms of the buy-sell provisions need to be coordinated with the terms of the disability insurance policy.
· Bankruptcy. The bankruptcy of an equity owner is almost always a triggering event because having a pre-determined method for the valuation and sale of an equity interest reduces the involvement of the company in the bankruptcy process and provides liquidity.
· Voluntary or Involuntary Departure. Some buy-sell provisions allow the company to force the sale of the equity interest of an equity owner who is no longer involved in the company as a result of a resignation or termination.
· Divorce. Some buy-sell provisions allow the company to force the sale of the equity interest of an equity owner who becomes a part of a divorce proceeding. There are pros and cons to divorce as a triggering event and these need to be considered.
· Proposed Transfer. The most common triggering event occurs when an equity owner decides to sell or transfer their equity interest to a third party. If it’s a sale, there is typically an opportunity to match the terms of the sale. If it’s a transfer, there is typically an opportunity to approve or disapprove the transferee.

Valuation. One of the key reasons for adopting buy-sell agreement is to provide a rational approach to business valuation in the case of a departing equity owner. Some buy-out provisions use different valuation techniques depending on the nature of the departure: For example, the valuation for a departing owner who has been terminated for cause by the company may be less favorable that then valuation used for a payment to the estate of a deceased equity owner. Some of the mechanisms used for valuations include:

· Book Value. Usually the least favorable to the departing equity owner.
· Market value. This method is implicitly used when a departing equity owner has a bona fide third party offer and that offer must be matched by the company or remaining equity owners.
· Appraised Value. Appraisals may or may not give full value to the business due to the variety of methodologies that can be used and discounts applied.
· Agreed Value. Many buy-sell agreements use this method. All equity holders agree to a value of the business on an annual basis.
· Insured Value. In the case of a cross-purchase agreement funded by insurance, the amount of insurance will often be used as the measure of the value of the company. Key man life insurance can also provide a value.

Terms of Sale. In instances where the buy-sell provisions have been triggered as a result of a bona fide offer from a third party, then the terms of the sale are usually dictated by the terms of that third party offer. In other instances, there are several different considerations. For example:

· Should the departing equity owner be able to force the purchase of the equity interest? The answer to this may depend on the circumstances; for example, it may be appropriate to allow a representative of an estate to force the purchase of the equity interest.
· Should the company be able to force the sale of the equity interest? The answer to this may depend on the circumstances; for example, it may be appropriate to allow the company to force a sale of the equity interest in the event of a divorce.
· Should the company or the remaining equity owners be required to borrow the purchase price from third parties? If not and the buyers may use notes, the interest, term and payment schedule of such obligation will need to be determined.
· Should any debt obligations be secured by the equity interest being sold or other security?

Other. There are many other things that can be considered in connection with a buy-sell agreement

· Non-compete. Although not common, buy-sell provisions may include non-competes and other restrictive covenants.
· Exceptions. There are often exceptions to the buy-sell agreement, particularly in the area of transfers. An equity owner may be allowed to transfer all or a portion of an equity interest to a close relative without there being a triggering event.
· Business Continuity. Particularly in the case of buy-sells structured as a redemption that are funded by insurance, additional life insurance may be purchased to make sure that the company receives funds to recover from the loss of a key owner. If so, this needs to be coordinated with the buy-sell provisions.

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