Have You Considered Every Aspect?
A buy-sell agreement is a legally binding contract that stipulates what happens to a partner’s share of the business when that partner leaves the business. In other words, the agreement clarifies how ownership in a closely held company will be transferred under different circumstances. A buy-sell agreement is part of succession planning.
The lack of a buy-sell agreement in your business will cause headaches down the road because eventually every partner will exit the business. It’s better to think through all possible ways a partner might leave and spell out how his or her shares will be transferred in each scenario.
Before signing the buy-sell agreement every shareholder should understand every clause. Misunderstandings can cause unpleasant surprises down the road.
Here are three key things to consider when planning a buy-sell agreement.
1. Trigger Events
What types of events would cause a partner to exit the business? Is the partner retiring? Was he or she fired? Did the partner die? What happens to the partner’s shares if they quit? Get divorced?
If your buy-sell agreement doesn’t stipulate what happens with each trigger event, you may end up in situations that harm the long-term health of your business.
For example, if a partner dies unexpectedly, the partner’s spouse may end up becoming your partner. Or if the exiting partner chooses to sell shares on his or her own, people with no knowledge of your industry can suddenly become part of your management team.
2. Who Buys the Shares?
Will the business entity buy the shares back from the exiting partner? Or will the remaining partners have the opportunity to buy the exiting partner’s shares?
Each of these options can affect your business taxes and/or relationships with the remaining partners.
3. Method of Valuation
How will the value of the exiting partner’s shares in the company be calculated? This is critically important in companies in which “shares” aren’t bought and sold in the open market.
Will the value of the shares be fixed or based on a fair market evaluation, going rate, or other method of appraisal? Will the valuation of the shares differ, based on the role the partner played in operating the business?
4. Words on the Page Matter
Periodically updating the buy-sell agreement can prevent legal disputes that may arise long after the original buy-sell agreement was created. Over time, the value of each partner’s share may have risen even if the partner didn’t help create the rise in value.
The Indiana Supreme Court recently ruled on a case in which a company director was involuntarily terminated 12 years after the buy-sell agreement was signed. The fired employee sued over how much money he was owed for his shares in the privately held company.
At the time of the termination (2018), the company had hired a valuation advisor to appraise the value of the fired employee’s shares. The valuation advisor used the fair market value standard to appraise the value of the former employee’s shares, then discounted that value due to lack of marketability of the shares and the individual’s lack of control.
The terminated employee sued, arguing that valuation discounts should not apply in the case of forced buy-outs.
In 2021, the Indiana Supreme Court sided with the terminated partner, emphasizing that when a valuation method is stipulated in a buy-sell agreement, a court will not rewrite that explicit agreement.
So in this case, a “legally binding agreement” proved to be just that – legally binding.
Hire an Experienced Attorney
A lawyer experienced in succession planning or business law can help you prepare the buy-sell agreement. The lawyer can act as a neutral third-party in explaining the clauses to each of the shareholders.
An experienced lawyer can also help you update the agreement as your business grows and changes. How you structure the buy-sell agreement today might be substantially different than how you set it up 10 or 15 years ago.
Call me and I would be happy to recommend a few experts qualified in creating buy-and-sell agreements. Or, I could suggest some good questions to ask the attorney to gauge his or her qualifications.
For more information about succession planning, download my free guide: Succession Planning Simplified.
RECOMMEND READING
Chris Mercer: Indiana Supreme Court Affirms the Words on the Page of a Mandatory Buyout Provision