This post identifies key issues to be considered when planning or reviewing a buy sell agreement.
The term “buy sell agreement” is catchall phrase that refers to agreements affecting transfers of shares or interests in closely held businesses. For corporations, the buy sell agreement is usually a separate document, and not part of an employment agreement, for example. In the context of an LLC or partnership, however, buy sell provisions and compensation (i.e., distributions and guaranteed payments) are usually covered in a single agreement, which is known as an “operating agreement” for LLCs or “partnership agreement” for partnerships. In this article, “shares” includes LLC interests, partnership interests and shares of corporate stock. References to “buy sell provisions” are to the paragraphs in a buy sell agreement, operating agreement or partnership agreement that regulate transfers of shares.
In general, buy sell provisions have two key objectives. First and foremost, they prevent owners from transferring shares to outsiders. Second, they provide avenues for disentangling owners upon the occurrence of divisive events.
Transfer Restrictions. Absent restrictions on transfers of shares, an owner might unexpectedly learn that his business partners include spouses, children or creditors of other owners, or even a business competitor. Such restrictions also prevent disgruntled owners from selling S corporation shares to an ineligible shareholder. Transfer restrictions usually treat prohibited transfers as a nullity, which avoids these disruptive or disastrous consequences.
Rights of First Refusal. It is common to include a provision that allows an owner to transfer shares to outsiders, provided the other owners or the entity are given the prior right to purchase the shares for the same price and on the same terms. Rights of first refusal are seldom exercised. Shares of closely held entities are difficult to sell at any price, since potential purchasers seldom have the right to liquidate the business, receive compensation or compel cash distributions. Further, potential purchasers are reluctant to perform due diligence and negotiate a price if it is likely the process will be a futile exercise. Thus, one might characterize a right of first refusal as an illusory opportunity to sell shares to outsiders.
Options Triggered by Certain Events. A myriad of options ripen upon the occurrence of events commonly known as “triggering events,” such as death, disability, termination of employment and involuntary transfers. A fundamental assumption is that a triggering event permanently changes the objectives of the affected owner. For example, the heirs of a deceased owner typically want cash, whereas the continuing owners want to continue the business without the financial drain of financing a buyout. The same is typically true upon disability or termination of employment. Buy sell provisions are intended to disentangle parties with differing objectives.
The remaining owners or the entity will typically have an option (“call option”) or a mandatory obligation to purchase the shares of the owner affected by the triggering event. Or, the affected owner may have the right (“put right”) to compel the other owners or the entity to purchase his shares.
Death. At a minimum, most buy sell provisions give the remaining owners or the entity a call option to purchase the shares of a deceased owner. Occasionally, the remaining owners or the entity have a mandatory obligation to purchase the decedent’s shares. Another alternative is to give the executor of the deceased owner a put option to compel the other owners or the entity to purchase the decedent’s shares. In general, buy sell provisions triggered by death are liberal in favor of the decedent. For example, minority interests are seldom discounted and the time frame for payment is shorter than for other triggering events.
It is common for the entity to purchase life insurance on key owners to provide funding for redemption of their shares at death. An alternative is a “cross purchase” in which each owner purchases life insurance on the other owner(s). (This is most common if there are only two owners.) Although beyond the scope of this article, a cross purchase may be preferable when the entity is a corporation, since the purchaser will receive a stepped up basis in the purchased shares. (Having said that, if an S corporation receives life insurance proceeds, the adjusted basis of its shares will be increased pro rata.) The life insurance transfer for value rules of IRC §101(a)(2) and the basis adjustment rules of IRC §754 and IRC §1368 should be carefully considered when choosing the most suitable options triggered by death.
Disability. Especially when an owner is actively working in the business (e.g., services, manufacturing or sales, as compared to holding rental properties), a permanent disability is often a triggering event. A disability is usually deemed a triggering event if it permanently prevents the owner from performing his regular duties on a full time basis. If the entity has a disability insurance policy on the owner, the triggering event is usually the same as the definition of disability in the policy, so as to coordinate the entity’s redemption obligations with the proceeds from the policy. More often than not, however, there is no disability insurance or its proceeds are inadequate to fund the redemption. Due to the financial hardship on the remaining owners, disability frequently triggers only a call option available to the remaining owners. Disability provisions are necessary but often problematic. The permanence or severity of the disability may be in dispute. There is also the issue of who makes the determination.
Termination of Employment. Termination of employment of an employee owner ignites acrimony and a need to disentangle like no other triggering event. The terminated owner-employee may use his access to financial records to harass the entity. And he will inevitably want cash, either for living expenses or to start a competing business. If the business is increasing in value, the remaining owners will be annoyed that their efforts (and perhaps dividends) are inuring to an inactive owner. Accordingly, it is common to give the entity or remaining owners a call option to purchase the terminated employee’s shares. Frequently, the agreement will allocate a portion of the price to a non compete agreement preventing the terminated owner from starting a competing business. Options may be harsher if the owner is terminated for “cause,” which usually captures conduct such as fraud, criminal acts, drug or alcohol abuse, etc. Buy sell provisions triggered by retirement or termination without cause tend to be more liberal toward the former employee-owner.
Involuntary Transfers. A transfer of shares may be involuntary, such as by reason of bankruptcy or divorce. Most buy sell agreements provide call options to the entity or remaining owners as a mechanism to prevent shares from falling into the hands of former spouses or creditors. As covered in more detail below, the price and terms are usually favorable to the purchasers.
Price. Except for disfavored triggering events such as termination of employment for cause or involuntary transfers, the price is usually equal to a pro rata share of the value of the entity. In other words, there is no minority interest discount. Some agreements peg the price at an amount agreed to by the owners at the annual meeting preceding the triggering event. This is a very practical approach, except that meetings are frequently neglected and the value may be stale. For this reason, the agreed value is usually discarded if it more than one or two years old. As a backup, the value may be based on a formula. For example, an active business might be valued using a multiple of annual sales or cash flow. The final alternative is to determine the value of the entity by appraisal. Appraisals can be expensive, so the drafter should specify who bears the cost. If the triggering event is an involuntary transfer or termination for cause, it is common to apply a discount to the price or get to the same result by valuing the actual block of shares using the “willing buyer willing seller” approach.
Terms. If the triggering event is death, a portion of the price equal to any life insurance proceeds is usually payable in cash, either by the entity or the remaining owners, depending on whether the structure is an entity purchase or cross purchase. For other triggering events, the price is usually payable over a term ranging from 5 to 15 years and a down payment of 10% or 20% of the price. The term will tend to be longer and the interest rate will tend to be lower in the case of a disfavored triggering event. Occasionally, and especially for real estate holding companies, the deferred balance of the purchase price may be secured by a mortgage.
Summary. Buy sell provisions are analogous to a prenuptial agreement. A structure for disentangling is agreed to in advance, which reduces the fears and uncertainties otherwise associated with a triggering event. Buy sell provisions can be relatively simple or overwhelmingly complex, depending on the number of triggering events and the differences in options, prices and terms for each event. A buy sell agreement should be in place before it is “needed.” Ideally, this is at the commencement of the business. That may not be practicable, however, if the parties have limited funds and the business has nominal value. As the value of the business increases, and the parties get older, the value of a buy sell agreement is more evident. But it also more likely that circumstances of certain owners will have changed or a triggering event is imminent. In all events, if a practitioner can distill the buy sell provisions to a few key objectives, the process of getting an agreement in place will be manageable.