Most private businesses have bylaws, company agreements or partnership agreements that govern their operations, but these agreements are often silent, or not well thought out, regarding issues that may become critically important to business partners. Specifically, most company governance documents do not include buy-sell provisions, and as a result, there are no terms in place that control how a partner exit will take place in the event of a partner’s retirement, death, disability, divorce, employment termination or a partner’s request for voluntary sale. To put this problem in context, Forbes reported in 2021, that there are nearly 32 million small businesses in the United States. Yet, the Small Business Association estimates that only a fraction of these closely held companies have a Buy-Sell Agreement in place among the owners.
This post reviews issues related to the timing for creating Buy-Sell Agreements, as well as some of the key terms that should be included in these agreements.
When Should Partner’s Work with Counsel to Prepare the Buy-Sell Agreement?
The ideal time for business partners to prepare and enter into a Buy-Sell Agreement is while the company is being formed or when a new business partner is making an investment in an existing business. This timing is appropriate, because at the time the company is formed or when a new investment is made the partners are focused on the future success of the company, and they generally have a positive view of the company and of each other.
Both owners and investors should want to enter into a Buy-Sell Agreement. The benefit to owners is that they secure the power to redeem the interest of a minority partner. No majority partner wants to be stuck with a minority partner who is not making meaningful contributions to the business, or worse, who is interfering with the continued successful operation of the business. For minority investors, they obtain a critically important benefit in a Buy-Sell Agreement, because it provides them with a way to monetize their interest in the business. In the absence of a Buy-Sell Agreement that allows the minority investor to obtain a redemption, the investor may be stuck for years holding an illiquid, unmarketable interest in the company.
What Are the Advantages of a Buy-Sell Agreement?
There also are benefits for the company in having a Buy-Sell Agreement in place, because it provides for the orderly removal and/or exit of a business partner. If no agreement is in place, the likelihood of litigation between the owners increases dramatically, and that litigation can cause a huge disruption of the business. On balance, the advantages of having a well-drafted Buy-Sell Agreement in place outweigh any disadvantages that may result. The list below identifies some of the most important benefits that are achieved when partners enter into a Buy-Sell Agreement:
- Peace of mind in providing a clear path forward – A Buy-Sell Agreement limits the conflicts between business partners that are detrimental to the company. Without a Buy-Sell Agreement in place, minority investors may become disgruntled as they have no path to an exit, and similarly, the majority partner may become extremely frustrated by the inability to remove a minority investor who is engaging in conduct that disrupts the business.
- A defined transition – In addition to offering business owners and partners protections against the actions of other partners or third parties, a Buy-Sell Agreement also assures continuity of the business for its customers, creditors, and employees. A Buy-Sell Agreement clearly defines the manner, method and timing of partner exits, including how the partner’s interest in the business will be valued at the time of exit. Thus, a Buy-Sell Agreement will have a clear set of rules that apply to a partner’s retirement, death, disability, divorce, termination of employment, or a voluntary sale or disagreement.
- Establishes agreed buy-out pricing point and process – A well drafted Buy-Sell Agreement sets forth the method for funding the purchase of the interest held by a partner who is withdrawing or being removed and establishes the terms for the payment of the purchase price. Disagreements commonly arise regarding the value of a partner’s shares in the business at the time of the partner’s exist, but the Buy-Sell Agreement will specify how the business will be valued to limit these conflicts as much as possible.
- Mitigates the likelihood of partner disputes – If a triggering event occurs, each partner understands from the outset his or her rights regarding the interests of the company. Thus, a comprehensive Buy-Sell Agreement will help partners to avoid the substantial costs and expenditure of time and stress involved in business divorce litigation.
What Are the Potential Pitfalls of a Buy-Sell Agreement?
Buy-Sell Agreements are not cookie-cutter types of agreements. They need to reflect the specific concerns and goals of the business partners who are signing them. If the partners do not put in the time up front to make sure that the agreement conforms to their intent, this is likely to cause future problems for the company and the partners. These concerns can include:
- Inflexible pricing provisions – A concrete purchase price set by the Buy-Sell Agreement will likely become unrealistic over time (and at the time of a trigger event) as business cycles fluctuate. Setting a specific dollar amount may result in purchase prices that are not based on current market value. Therefore, business partners should work with their own counsel in coordinating with the company’s counsel to draft a Buy-Sell Agreement that provides a flexible pricing model consistent with the trends of the industry in which the company exists. This includes a valuation process at the time of the triggering event, and partners should carefully select the proper valuation model for the business.
- Partner fails to pay attention to Buy-Sell Agreement – If the company is taking the laboring oar in drafting the Buy-Sell Agreement, the minority investor should work closely with his or her own counsel to ensure that the Buy-Sell Agreement provisions drafted by company counsel are fair and equitable to such partner. Once the rules of engagement are set, it is unlikely that that the Buy-Sell Agreement will be amended by the partners, especially if there is discord among them in connection with a partner exit from the business.
- Inadequately identifying triggering events – A Buy-Sell Agreement must clearly identify when and how the partners can exercise a triggering event, and what specific steps are required by the company and by the partners when one of them triggers the Buy-Sell Agreement. The lack of a clear definition as to how the Buy-Sell Agreement is triggered may result in litigation among the partners.
- Failing to properly establish the financing terms of the Buy-Out Agreement provisions – Similarly, if the Buy-Sell Agreement does not specify the financing terms that apply to the buyout of a departing partner, this may also result in conflict and litigation among the partners. The bottom line is that the buyout of a minority investor will need to be accomplished in a structured buyout that does not cripple the company.
The need for a Buy-Sell Agreement may not be apparent to business partners when they are forming or investing in a growing company. At that point, the partners are not thinking about leaving — they are focused on building or growing their business. But partner exits are common, and failing to plan for partners to depart in the future is a recipe for conflict, significant legal expense and disruption to the business. Partners are therefore well advised to hammer out a Buy-Sell Agreement early on that will stand the test of time and provide them with a reasoned path that governs how partners can or will leave the business if it becomes necessary in the future.