All closely held businesses should consider a Buy-Sell Agreement (sometimes referred to as a Shareholders Agreement). If the business is conducted as an LLC instead of a corporation, then the buy-sell agreement provisions can be included as part of the LLC’s Operating Agreement (all of the references to shareholders become “members” and shares become “LLC interests”). The purpose of a buy-sell agreement is to provide for an orderly transition of ownership interests on the occurrence of specified events. A buy-sell agreement controls: (1) the circumstances under which a shareholder may sell his or her shares; (2) who is a permitted buyer; and (3) how the price for the shares will be determined and paid.
The benefits of a buy-sell agreement include: (1) allowing the remaining shareholders to determine with whom they will work and share control of the company; (2) ensuring continuity of management and control by the remaining shareholders; and (3) providing for the orderly liquidation of the shareholders’ interests in the event of death, disability, retirement, or other forced or voluntary withdrawal from the company.
Here are some topics for discussion among the shareholders of a closely held business who are considering a buy-sell agreement:
1. Restriction or Prohibition of Transfer of Shares.
a. A buy-sell agreement addresses the restrictions on transfer of a company’s shares. The buy-sell agreement can restrict transfers or even completely prevent the shareholders from transferring any shares to an outsider (third party).
b. Buy-sell agreements typically permit transfers among shareholders or to a shareholder’s trust or other estate planning tool for the benefit of the shareholder.
2. Examples of Transfer Restrictions.
a. Right of First Refusal. If a shareholder gets an offer to sell his or her shares, then that shareholder must offer his shares to the other shareholders at the same price, and can only sell shares if the other shareholders refuse to purchase his or her shares.
b. Tag Along Rights. Assuming shareholders are willing to let a shareholder sell shares to a third party, then the shareholders may want to participate in that sale under “tag along rights.” For example, assume that there are 3 shareholders with each owning 1/3 of the company’s shares. A buyer presents an offer to one shareholder for his 1/3 interest. Under tag along rights, each of the 3 shareholders would sell 1/9 of the shares to the third party (total 1/3 of the company). Under this scenario, the buyer gets 1/3 of the shares and all of the shareholders participate in the sale to the third party.
c. Drag Along Rights. Drag along rights cover the situation where an outside buyer wants to buy 100% of the company. A problem can arise if one or more minority shareholders do not want to sell or are holding out for a higher price (tail wagging the dog). Drag along rights provide that if a majority of the shareholders (e.g., 51%) want to sell, then the minority shareholders must agree to sell their shares so that the buyer can buy 100%.
3. Mandatory Buy Out of Shares.
a. Certain events may trigger a mandatory buy-out of a shareholder’s shares. Each of the following is a customary triggering event:
(i) death of a shareholder;
(ii) disability or incapacity of a shareholder, especially if the shareholder works in the business;
(iii) termination of employment – an employee/shareholder is fired or quits;
(iv) disassociation – a shareholder just wants to leave the company and “cash out;”
(v) divorce of a shareholder - a shareholder's ex-spouse stands to receive part of a shareholder's shares. The shareholders usually do not want the ex-spouse as a new shareholder;
(vi) foreclosure of a debt secured by a shareholder's stock – a shareholder uses company stock as collateral and then cannot pay the debt. The creditor forecloses on the shares and could become a new shareholder; and
(vii) personal bankruptcy of a shareholder – there is the potential that the bankruptcy trustee will become involved in the business.
b. The company and shareholders may encounter extraordinary events such as a disagreement between shareholders that deadlocks the company or personality conflicts that make it difficult to continue business. The shareholders may want to consider a version of a “showdown clause” to address such an extraordinary situation. One version of a “showdown clause” provides that one shareholder presents an offer to the other shareholder with a specific purchase price and payment terms. The other shareholder has the choice to be either a buyer or seller at the specified price and payment terms. Other potential methods to break a deadlock may include the appointment of an independent provisional director or the submission of the dispute to mediation or arbitration.
4. Buy Out Price.
What is the buy-out price for a shareholder’s shares after a triggering event and should the same valuation method apply for all triggers?
a. Potential Valuation Methods:
(i) fixed price – the shareholders agree on a fixed price, usually annually. The shareholders focus on the valuation issue each year under calm circumstances. If the shareholders cannot agree on a fixed price, then they can elect to use another valuation method as a default position;
(ii) book value – most simple; looks at the company’s balance sheet, but does not take into account going concern and goodwill value of the business;
(iii) formula – formula can be based on recent or average revenues, profits, EBITDA or other basis. This approach focuses on the earning capacity of the business and takes into account going concern and goodwill value. The drawback is that it is based on historical earnings and may not reflect recent changes, good or bad, that can affect the business’ future; and
(iv) appraisal – appraisals are expensive and can vary widely in valuation ranges; consider appraisal only as a default valuation if the parties cannot agree.
b. Different valuation methods can be used for differing triggering events. For example, the company may buy a deceased shareholder’s shares for an agreed upon price or formula (higher price) and value the shares of an employee/shareholder whose employment is terminated for cause at a lower price, such as book value.
c. How should a buy-out payment be structured?
(i) lump sum; or
(ii) installment payments; e.g., 5 years. The payments will be made from cash flow and will not be as disruptive to a business as a large lump sum would be. The shareholders will have to determine an appropriate interest rate.
d. The shareholders should consult with a life/disability insurance agent to discuss funding a buy-out with insurance proceeds.
4. Consult an Accounting/Tax Professional.
The transactions contemplated by a buy-sell agreement can have significant financial and tax consequences that are different based upon, among other things, the form of the company e.g., C or S corporations or LLC. The California Corporations Code also has a balance sheet test for corporations that may affect to what extent a corporation can repurchase its shares. The financial and tax consequences can vary significantly based upon the financial/tax circumstances of individual shareholders. Shareholders are urged to seek, in addition to legal counsel, the advice of an accounting and tax professional as part of their evaluation whether to enter into a buy-sell agreement.
