Trusted Business Lawyer Assisting with Business Purchases or Sales in Santa Clara County, San Jose and the San Fransisco Bay Areas of California
Buy-sell agreements go by many names, starting, of course, with buy-sell agreement! They also have such monikers as stock (or share) repurchase agreement or redemption agreement. Sometimes they are called cross-purchase agreement, purchase and sale agreement, blind buy-sell, or shotgun agreement. For simplicity, I’ll stick with “buy-sell agreement.”
Although I’m using one only term, there are really two kinds of buy-sell agreements: the kind that is drawn up before there is a need to use it, and the other that is drawn up after.
The one that is drawn up before you need it is usually much less expensive. Why is that? Unfortunately, most often, when a buy-sell agreement is drawn up after you need one, some dramatic event has taken place that is usually accompanied by heightened emotions: a deadlock between owners, death of an owner, exclusion of an owner from the business, and the like. All these events result in great stress for the parties, and transactions are often motivated by threats of litigation. When litigation between owners in fact erupts, more often than not, it is settled by a buy-sell agreement. The expense of litigation is almost always many multiples the cost of an agreement that is drawn up when the parties are amicable. So business owners are well advised to skip the expense, anguish, and uncertainty and have a buy-sell agreement in place before it is needed.
Best Form of Buy-Sell Agreement
What is the best buy-sell agreement to have? That’s an easy question to answer. There is no best form of agreement; there is only what’s best for you. And that requires a careful consideration of the circumstances of the business and the owners.
For example, if there are two equal owners of a business, one type of agreement might be better than one for a business with several owners, not all of whom are equal. Different owners may have different abilities to run the business after a buy-out, and different owners may have different abilities to pay for a buy-out. When the co-owners are family members, it is quite common for the owners to be primarily concerned about setting a value for estate tax purposes or are concerned about treating various family members equitably. And, of course, a buy-sell agreement that is entered into to settle litigation will address different needs than one that is entered into before any dispute.
The first consideration is what event (or events) will trigger the buy-sell. Quite naturally, lawyers experienced in drafting buy-sell agreements call these events “triggers.”
One of the most common triggers is death, and for many buy-sell agreements, this is the only trigger. The obvious reason for this is that death is certain. Even if one is not sure of his own mortality, a business owner knows for sure that some day his partner will die, and if that happens while they are still co-owners, a prudent business owner would want protection from the issues that arise from having a widow or children or an estate as a co-owner of the business.
Less obvious is the fact that many buy-sell agreements are driven by the sale of insurance. An insurance agent sells a customer on the idea of having insurance to buy out his partner or fellow shareholder, and a buy-sell agreement is an ancillary part of the sale. All too often, however, a buy-sell agreement that is put into place in this circumstance focuses only on death, and a valuable opportunity is missed to address other trigger events.
When people think of death in this context, disability often comes to mind. Both can be the result of accident or illness, and both result in an owner not being able to participate in the business. But one critical distinction between the two is that insurance to fund a buy-out is readily available for death but not for disability. So death as a trigger event should be considered to be one category and disability and all other trigger events in another.
Disability is actually one form of withdrawal from running the business. There are others, such as retirement, just plain quitting, or loss of a license required for the business (or profession).
Perhaps the most important trigger that is often overlooked is a falling out between co-owners. One partner thinks the other is not pulling his share of the load, that he is taking out more money than he deserves, and the complaining partner sets out to fix that problem by demanding that an adjustment be made. Friction frequently ensues, worse follows worse, and at some point, the partners are at each other’s throats. This is when you really, really need a buy-sell agreement, but if you don’t have one or it doesn’t address one partner hating the other partner’s guts and desperately needing to get him out of the business, things can get expensive fast.
There is an old saying: If there is one lawyer in a town, he starves. If there are two lawyers, both prosper. Your business is like a small town. If the business or the owners hire a lawyer to draw up a buy-sell agreement before it is needed, often one lawyer can do the job, and the fees will be reasonable. If the owners wait until there is a dispute, there will be two lawyers, sometimes more, and they will all prosper.
Who Pulls the Trigger?
The next consideration is who can pull the trigger. Is it the business? Is it an owner? Any owner? It may depend on what the triggering event is.
A significant issue is who the buyer will be. If the business is purchasing the interest of the departing owner, that is often referred to as a redemption. If a co-owner is buying that is sometimes referred to as a buy-sell or as a cross-purchase. There are often critical tax, legal, financial, and regulatory considerations in choosing between a redemption and a cross-purchase.
For example, if there are more than two shareholders, and one of the shareholders purchases the stock of a departing shareholder, the buying shareholder ends up with a proportionately greater share of the business than if the company purchased the stock.
The $64 million question: what is the business worth? If the parties are negotiating a buy-out of an owner that will take place immediately upon signing the agreement, they can bring to bear their business judgment on what the business is worth at that time, based on all the facts and circumstances, and if they don’t like the value, they don’t sign the agreement.
But for buy-sell agreements written in advance, there has to be a method for fixing the value. Most buy-sell agreements therefore have a method of fixing the value, and most of these methods are defective! For example, one method is to have the owners agree on a value when the agreement is signed and then to have the value updated every year. This is terrible because business owners almost never update the agreement. Then the parties are stuck with an out-dated value. Or are they? If the would-be seller thinks the value is far too low, he won’t sell and there will be litigation to see if the agreement is valid and binding. Furthermore, even if the agreement is update every year, there can be subsequent events that make the value unfair to one of the parties.
Another technique is to have the business appraised at the time of the trigger event. Frequently, lawyers provide for the buyer and the seller each to appoint an appraiser and for the two appraisers to value the business. If they don’t agree, then the two appraisers appoint a third appraiser. Obviously, these clauses are not written by the people who actually have to pay the fees of the appraiser. Multiple appraisers do not assure better results, particularly when the clauses (as they frequently do), call for disregarding one the appraisals.
But the most important issue is often overlooked: what is the standard to be used for valuing the interest to be purchased. It can make a dramatic difference whether the standard is the one for valuing a partial interest in a business vs. the amount that would be distributed if the business were sold as a going concern, the bills paid, and the cash distributed pro rata to the owners.
Financing the Buy-Out
A critical consideration is funding the buy-out. In other words, how will the buyer (whether it is the business or one or more co-owners) pay for the stock? In the case of death, insurance is an obvious answer, but it might be too expensive, or an owner might be uninsurable. And what if the trigger is something other than death?
The business might have the cash needed to pay for the purchase, but there may be loan covenants that interfere with the business’s ability to but out an owner. But often the cash position of the business does not allow it to pay in full for the purchase of an owner’s interest.
The principal asset of many business owners is their interest in the business. The plain fact is that most businesses and most business owners don’t have enough cash on hand to pay for the purchase of another owner’s interest in the business. This means that the payment for the stock or partnership interest or LLC interest must be made over time, and this introduces the risk of non-payment.
A well-crafted buy-sell agreement will address the issue of not crippling the buyer with a payment schedule that can’t be met as well as security for the seller.
Something that should not be overlooked is the possible need for additional agreements to go with the buy-sell agreement. For example, the parties might need employment agreements, a security agreement, or an escrow agreement.
Hiring the Right Lawyer For the Purchase or Sale of Your Business
An entire book could be written about buy-sell agreement (and many have been). The best buy-sell agreement for you is the one that takes into account your circumstances and addresses your objectives. The best way to accomplish that is to hire a lawyer who is knowledgeable and experienced in drafting buy-sell agreements. Richard Burt is such a lawyer. Contact us today by calling (408) 286-7333 for a free telephone consultation or to set up an appointment to discuss your particular circumstances. Or send an email using the form on the contact page.