You and your business partner have the greatest business idea since the Post-it note and you’ve decided to form a business to take it to market. A critical early step in the business formation process is the negotiation and execution of a buy-sell agreement. A buy-sell agreement is an agreement between the owners of a business that governs the future transfer of their interests in the business.
The most important reason to execute a buy-sell agreement at the time of business formation is that then no one is seeking to transfer their ownership interest, therefore all parties are more inclined to negotiate an objectively fair agreement. Further, emotions toward the business and each other are generally positive. The risk associated with the owners’ financial investment in the business increases each day that the business grows without a buy-sell agreement in place.
A well drafted buy-sell agreement generally contains three key provisions. First, it will operate to restrict the owners’ ability to transfer their ownership interests in the business. This is generally done by requiring an owner who is interested in selling his/her business interest to give the business itself or the other owners a right of first refusal to purchase the interest at the price and on the terms of a bona fide offer.
This gives the current owners some control over who might become a co-owner of the business, thereby reducing the possibility that unknown or unwanted individuals will step in. This is particularly important when the owners are also the business operators (as is the case in most closely-held businesses) responsible for making the day-to-day management decisions and/or in the case of a family-owned business where the owners desire to keep ownership within the family.
Second, the buy-sell agreement should require the business or the remaining owners to purchase an owner’s interest following a “triggering event” such as the death, disability or retirement of an owner. The purpose of this provision is twofold. Like the transfer restriction discussed above, it will enable the remaining owners to control who can become an owner and participate in management decisions. It will also benefit a retiring owner or deceased owner’s heirs by guaranteeing that the ownership interest, which otherwise might be sold at a deep discount for lack of marketability, will be purchased at a previously agreed upon price and terms (see discussion of valuation below).
This provision can take one of two general forms. A cross-purchase provision requires the remaining owners to agree to purchase the exiting or deceased owner’s interest. A repurchase or redemption provision requires the company to repurchase (or redeem) the exiting or deceased owner’s interest. Each form has certain advantages and disadvantages with respect to the tax consequences to the owners and the business at the time of the cross-purchase or redemption and the cost and ease of administration of the cross-purchase or redemption itself (e.g. a cross-purchase provision can be very costly to administer for multiple shareholders). These advantages and disadvantages must be weighed in light of the size of the business, the owners of the business (e.g. all family members or simply business partners), the business entity type, and the nature of the business. A common addition to this provision will require the purchasing party (i.e. the business owners in a cross-purchase or the business itself in a redemption) to buy life insurance policies on each of the owners so that upon the death of an owner, the purchasing party can use the life insurance proceeds to fund
Third, a buy-sell agreement will identify an agreed upon method for valuing the business as well as a payment structure that is workable for the purchasing party (the business or the remaining owners) and the seller following a “triggering event.” While it can be challenging to determine an accurate valuation method early in the business’s life-cycle, the extra time and expense associated with this task are minimal compared to the time and expense of accurately valuing the business – and having all parties agree to that value – after a “triggering event.”
When applied to closely-held businesses, the old cliché “nothing in life is certain except for death and taxes” can be expanded to include “certainties” such as: ever-changing and expanding government regulation, fluctuating real estate prices, personal family and financial issues, health issues, owner disagreements, sudden lack of available credit, new competition, employee disputes, etc. In the absence of a well drafted buy-sell agreement, the death of an owner (or other “triggering event”) can quickly sink a healthy business as the surviving owners are forced to divert their time, energy and resources – not to mention the business’s resources – away from their expertise (i.e. managing and operating the business) to matters such as how to accurately value the business, who will be an owner and who will have the right to participate in management decisions.
A well drafted buy-sell agreement helps protect the financial investments of the owners in the business and enable them to efficiently and cost-effectively navigate the business through (at least the most common and predictable of) the inevitable “certainties” ahead.
Paul Taylor’s practice focuses on real estate and business transactions including leasing, sales and acquisitions, business formations, and real estate and business financing. Paul serves on the boards for the Kemple Memorial Children’s Dental Clinic and the Bend Metro Park and Recreation Foundation.
Peter Christoff’s practice focuses on real estate and business transactions including leasing, sales and acquisitions, business formations, and real estate and business financing. Peter serves on the Oregon State Bar Association’s Legal Ethics Committee.
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