A well-managed business can exist in perpetuity, but ownership won’t remain the same forever. Eventually, an owner will leave for one of several reasons. The owner may retire; become disabled; die; lose a professional license; want to sell or give away ownership; or lose control of the interest in personal bankruptcy, in a divorce or by defaulting on a loan for which the interest was made collateral.
Continuing owners face the prospect of working with new owners or the caretakers of disabled owners. Outsiders include guardians, estate representatives, heirs, bankruptcy trustees, angry former spouses and creditors. An active owner may become debilitated by substance abuse. Friendly relationships may sour. While new prospective owners may be talented, responsible professionals, there is the risk that they won’t be. Without a buy-sell agreement (also called a business buyout agreement), there is no means of blocking undesirable ownership transfers. This poses a risk to the business and its value.
A buy-sell agreement is a binding contract that provides an orderly succession plan for corporate shareholders, partners or LLC members. It establishes rules about how an interest may be sold and the terms of the transaction.
A “right of first refusal” requires that a transferring owner initially offer the interest to the company and continuing owners at the price offered by a third party. The company and owners can decide to purchase the interest or decline that right. If they decline, the outsider can then buy into the company.
A “right to force a buyout” gives continuing owners the capability of buying another owner’s interest. In a variety of circumstances-including death, disability, divorce or disagreement-the continuing owners can maintain complete control of the company. Departing owners can invoke this right without the need to find an outside buyer. By using disincentives, owners can mitigate the risk that one will be expelled or leave the company early when capital and talent are needed most. Expelling an owner early may cost the company a premium. Early retirement can discount the valuation of the retiree’s interest.
Typically, the company itself has the first option to buy a transferring owner’s interest. If the company chooses not to, continuing owners can purchase the available interest in proportion to their respective ownership stakes at the time of the transaction. Usually, the decision depends on the source of funding and the transaction’s tax consequences. There is a period of time during which the owners can consult with a tax advisor and legal counsel to make an informed decision.
Usually, agreements require the company to purchase life insurance to fund the buyout in the event of death and disability insurance to fund the buyout in event of disability. Other funding will be necessary if a buyout is necessitated by an un-insured circumstance such as personal bankruptcy or divorce. Owners should consider payment terms that balance the departing owner’s desire to receive payment as quickly as possible and the need to maintain the business’ solvency. For example, they might provide for a sizeable downpayment followed by regular installments over a period of years.
One of the most difficult issues to address is the valuation of the company (and interest for sale). The agreement can use of a variety of valuation techniques ranging from simple, such as book value, to complex, such as a multiple of its earnings before accounting adjustments. It can require a professional valuation. The goal is to arrive at a fair valuation.
Every contract can be amended. Companies may begin with a relatively simple agreement and simple valuation methodology. As the business grows more complex and becomes more valuable, owners can amend the document as necessary. It is best to discuss these issues as early as possible-preferably at the formation stage of the business. Because no one knows which owner will be the first to leave, each owner has an incentive to develop provisions that treat everyone like he or she would like to be treated. By thinking about potential problems and planning for them, owners can prepare to preserve their business and wealth.
Editor’s note: This column does not constitute legal advice.