Buy-Sell Agreement
Entrepreneurship has become an established
trend in American business today. New businesses are being
organized at an ever accelerating rate, but many fail or falter
because of the lack of sound business planning. If the business
is owned by two or more shareholders, partners, or members,
an essential element of its business plan is a buy-sell agreement.
The buy-sell agreement may be part of a shareholder agreement
in the case of a corporation, an operating agreement in the
case of a limit-ed liability company, or a partnership agreement
in the case of a partnership. While these forms of agreements
typically address issues such as governance and control of
the business, resolution of deadlocks and distribution of
income, the buy-sell provisions will generally address
the following issues:
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Do the business owners wish to restrict their ability
to sell, gift or otherwise transfer their interests in
the business to third parties or even to family members?
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Do the business owners wish to impose obligations
upon or grant options to themselves to purchase the interest
of a business owner who dies, becomes disabled, retires
or terminates his employment or who has his interest involuntarily
transferred through bankruptcy or divorce?
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In the event of a proposed sale of the business,
may a dissenting business owner holding a minority interest
be forced to sell his interest?
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How is the business interest to be valued?
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On what terms will the purchase price for the business
interest be paid?
Generally, business owners wish to
limit owner-ship to active participants in the business. The
unexpected death, bankruptcy or divorce of a business owner
may result in a transfer of that owner’s business interest
to an heir, bankruptcy trustee or ex-spouse who has no interest
in participating in the business or who is unacceptable to
the other business owners. The business owners must decide
whether the business entity or the business owners will purchase
the business interest. That decision may have important tax
consequences. The buy-sell agreement will define those events
which will trigger an obligation or option to buy the interest
of a business owner at an established price within a specific
time frame.
Valuation Methods
The buy-sell agreement must establish
the price at which a business interest is to be purchased
or a specific method by which the purchase price will be determined
based upon the value of the business.
The purchase price will typically reflect
the earnings of the business and the book and net asset values,
including goodwill and other intangible assets of the business.
The most common valuation methods include the following:
Predetermined Price Subject to Periodic
Review.
This approach requires all of the business
owners to agree upon a predetermined fixed price, at a stated
dollar amount, as the value of the restricted business interest.
The advantage of this valuation method is that it is simple
and is based upon the collective opinion of the business owners.
However, unless the predetermined price is reevaluated periodically,
it may not truly reflect the value of the business at all
times.
Price determined by Formula.
The most commonly accepted valuation
formulae are based in whole or in part upon the gross revenues
or net earnings of a business. Earnings are particularly relevant
with respect to businesses that sell products or services
to the public. The formula based upon gross revenues has some
appeal because gross revenues are less subject to manipulation
than are net earnings, since business expenses and overhead
are not relevant factors. However, earnings or profitability
must also be an important determinant in establishing the
value of a business. The valuation of a business based upon
a book value or net asset value is simple because these figures
are readily available from existing financial statements.
Since book value or net asset value will reflect neither goodwill
nor the earning capacity of the business, they are typically
used in combination with a formula based upon capitalization
of earnings.
Price determined by Appraisal or Arbitration.
If the owners are unwilling or unable
to agree upon a current formula or a fixed dollar amount to
establish the price for their interests, the determination
of the price by an independent appraiser or arbitrator might
be appropriate. The agreement should provide a mechanism for
selecting the appraiser and should require that the appraiser
or arbitrator selected have appropriate appraisal credentials.
Funding
Methods
Funding the buy-out is always a major
issue which should be addressed in the buy-sell agreement.
Insurance is the most effective way to
fund a buy-out due to death or disability, but the business
interest offered for sale may be available for reasons other
than death or disability. In such instances, an installment
payment arrangement may be an absolute necessity. In an installment
payment arrangement, the purchaser of the business interest
will often provide the selling business owner or his estate
a promissory note or similar instrument rep-resenting his
obligation to make a series of payments which may or may not
be secured by the business interest to be purchased.
Other Considerations
All buy-sell agreements
should contain provisions addressing the following:
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Identification of the parties whose rights and
obligations will be established by the agreement.
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Restrictive language precluding the sale, transfer
or encumbrance of the business interest absent compliance
with the provisions of the agreement.
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Definition of the events which would trigger an
obligation or an option to purchase the business interest.
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Description of the effect of an exercise or non-exercise
of an option granted under the agreement.
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Valuation of the shares and determination of the
purchase price.
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Terms of payment and the funding or financing of
the purchase price.
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Provision for guarantees or security of payment
of any deferred portion of the purchase price.
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Description of circumstances under which the agreement
will be terminated.
The buy-sell agreement,
if properly drafted, will remove a substantial element of
uncertainty among business owners in the event of death, disability,
divorce, bankruptcy, retirement or termination of employment
in the valuation of the deceased share-holder’s estate. No
business of two or more owners should be without one.
