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Family members who enter into a private business together are taking on double risk. They face the same types of challenges that all owners and investors face in operating/investing in a business, but they are also exposed to the risk their personal relationships may suffer if the company does not fare well. For this reason, the decision to adopt a buy-sell agreement (BSA) – a type of corporate prenup – may be even more important for owners of family businesses. The BSA provides a clearly defined path governing how a partner exit will take place when the co-owners are in conflict about their roles in the business or the direction of the company. Family business owners are hardly immune to disagreements that can arise among business partners, and this post discusses some of the significant benefits that owners/investors in family businesses can secure by entering into a carefully drafted BSA. 

What Are the Advantages of a Buy-Sell Agreement?

According to Forbes, as of in 2021 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 BSA entered into by the owners. These sobering statistics may be even more applicable to family businesses, because in our experience, most family business owners do not take the steps required to evaluate and adopt a BSA before forming their companies or taking in family members as investors in the business. 

We view the BSA as a critical step in careful business planning. Family members, like other business partners, may enter into a business venture together with the best of intentions, but people and their financial needs can change over time. We are all subject to the four Big Ds: divorce, disability, dysfunction and death. And any of these may lead to a fifth D – departure from the business. A business divorce between partners may become a necessity if any one of these four Big Ds takes place, which can impact family members just as they do other partners. When a separation becomes necessary, having a defined partner exit plan in place – a form of BSA – will limit the conflicts that arise as the partners go through the business divorce process.  

For majority owners, the BSA provides owners with a contract right and mechanism to remove minority investors from the business who have become too difficult or demanding. For minority investors, the BSA provides them with the right to secure a buyout that enables them to monetize their ownership interest in the business if they become dissatisfied with the actions of the majority owner or of the management team. Thus, the BSA limits conflicts when a business divorce becomes necessary, because it provides for the orderly removal of partners and governs the specific terms on which the exit of a business partner takes place.

When business partners have not adopted a BSA, the likelihood of conflicts between them leading to litigation increases dramatically. And litigation among business partners is often bitter and prolonged, which may severely damage, if not end, close relationships among family members. Internal disputes and litigation between business partners will also likely cause major disruption to the company. Thus, having a well-drafted BSA in place almost always outweighs any possible disadvantages that may result. The following discussion reviews some of the most important benefits that can be achieved when partners make the decision to enter into a BSA:

  • BSA provides a clear path forward – The BSA provides for the departure of partners in a manner that limits conflicts between them. When no BSA exists, minority investors may become disgruntled because they have no path to an exit, and they may engage in disruptive actions that create problems for the business in efforts to force a buyout of their interest. Similarly, the majority partner may become frustrated no means exists to secure the removal of a minority partner, who is causing problems for the business and the other partners.
  • BSA sets forth a transition plan – In addition to providing co-owners with a clear exit path, the BSA also assures continuity of the business for its customers, creditors, and employees. A BSA 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 BSA provides a clear set of rules that govern when a partner retires, dies, becomes disabled, is subject to a divorce, or is terminated. The BSA also applies when a voluntary sale of the business takes place, and in all of these instances, the BSA limits disagreements between the partners.
  • BSA establishes price point and exit process – A well drafted BSA sets forth the payment terms for the minority interest after the value is determined, along with the method for funding the payment. Valuation is often a hotly contested issue, but the BSA will specify in detail how the interest of the departing partner will be valued to avoid these conflicts as much as possible.
  • BSA creates an effective dispute resolution mechanism – To the extent that disputes arise between co-owners, the BSA sets forth a clear method for resolution, which is generally through a fast-track arbitration process. Thus, a comprehensive BSA helps partners to address disputes in a way that either avoids or reduces the time, stress and substantial cost that would otherwise result from becoming involved in litigation.   

Key Elements of a Buy/Sell Agreement

There are four chief elements of a BSA, which are discussed below. These are not cookie-cutter documents. Terms need to be considered by the co-owners with input provided by counsel who are experienced with these agreements, so they are able to reach an agreement that meets their specific needs. Each of the parties is advised to have separate counsel to provide them with guidance that helps meet their business objectives.

Determine how the BSA may be triggered

The first key provision of a BSA is the trigger point, i.e., the point at which the BSA can be exercised by either party to the agreement. Generally, majority owners will have the right to buy the minority owner’s interest when he or she (i) files bankruptcy, (ii) gets divorced, (iii) dies or (iv) leaves the company. These are private companies, and the majority owner does not want to be forced to accept strangers injected into the business, as these situations could lead to that possibility. But majority owners also want to have the right to pull the trigger and buy out the minority investor at their option so they can remove any disgruntled/difficult minority partner.

On the other side of the coin, the minority investor does not want to be required to exit the business before the company appreciates in value. The investor may therefore insist that the BSA prevents the majority owner from triggering a buyout of the minority interest less than three to five years after the investment is made. In addition, and importantly, the minority investor will also want to insist that a look-back provision be part of the BSA, which ensures that the minority investor will not receive a below market value if the majority owner buys the investor’s interest and then promptly sells the company (or a share of the company) for a higher value than used to pay the investor for its interest. If the majority owner redeems/purchases the investor’s interest and then sells the business (or a substantial stake in it) in a fairly short period of time for a higher value, the look-back provision will require the majority owner to make a “true up” payment to the investor based on the increase in value. The length of the look-back provision is negotiable, but it is often in place for a full year after the majority owner buys the investor’s interest.

Finally, while the minority investor may want to be able to demand a buyout whenever the investor desires to exit the business, the majority owner is unlikely to agree to permit the investor to pull the plug shortly after investing in the company. The majority owner may therefore insist that the minority investor cannot exercise a redemption right for at least three to four years (or longer) after the investment is made. This gives the majority owner a set period of time before the investor can withdraw its investment. The majority owner may also require that all of the investor’s stake in the company be redeemed at one time to preclude multiple exercises of buyout rights. 

Determine How to Value the Redeemed Interest

There are guidelines for valuing a private company, yet highly regarded valuation experts frequently reach different opinions about the value of the business and the value of the investor’s interest in the company. Given the importance of the purchase price to be paid to the departing partner, the co-owners should focus on how they want to determine the value of the company and purchase price when a business divorce takes place. It is often helpful to retain a business valuation expert to help draft the valuation provision and how the process will take place.

The major elements that the parties will need to consider in determining the value of the redeemed interest include:

  • What is the valuation date (should it be the date the buyout is triggered, or a specific day of the year, e.g., December 31, regardless of the trigger date)?
  • Should the value be based on a single date/point in time, or should it reflect a composite/average of the company’s value over the past two to three years?
  • After the value of the business has been determined, should minority discounts be applied in calculating the value of the interest held by the minority investor, which are discounts based on the lack of marketability and the lack of control that are often applied when valuing minority held interests in a private company?
  • Should the value of the company be based on a specific formula applied to the company’s financial performance (e.g., a multiple of the company’s revenues or earnings), or should the value be determined by business valuation experts who will rely on several different valuation methods? If so, how is the expert selected, and how are disagreements with the expert’s opinion resolved?

Further, agreeing to retain a business valuation expert to determine the value of the redeemed interest will not suffice to address all questions about the valuation process. The expert needs to be instructed by the parties whether or not to apply minority discounts to the company’s value, what the date of valuation is, whether a single valuation date is being used or whether the value determination should be based on an average of the company’s performance over a set period of years, and finally, whether the company’s value should include or omit retained earnings and/or working capital. All these issues need to be spelled out in the BSA.

The BSA will also provide the payment terms after the value of the redeemed interest has been determined. In most cases, the purchase price will be paid over a period of years after an initial payment is made. Therefore, the partners will need to document in the BSA (1) the rate of interest to be paid on the balance of the purchase price; (2) whether the majority owner will provide any collateral in the event of a default in payment; and (3) what rights/remedies the minority investor will have in the event of a default in payment by the majority owner.

Select a Prompt, Efficient Conflict Resolution Process

The final element of the BSA is the dispute resolution mechanism. It is not uncommon for partners to have conflicts over the value of the redemption price even when the BSA details how the value will be determined. Rather than allowing these conflicts to become the subject of protracted, expensive litigation that is carried out publicly in the courts, the parties can agree to make their disputes subject to a mandatory arbitration provision.

Arbitration is a matter of contract, and the parties can structure the arbitration to meet their needs by limiting scope, duration and timing of the arbitration proceeding. For example, in the BSA’s arbitration provision the parties can choose just one arbitrator or a panel of three; they can limit the scope of discovery permitted before the final hearing; they can require the final hearing to take place in just 60-90 days after the arbitrator (or panel) is appointed; and they can eliminate any potential award for lost profits or punitive damages by the arbitrator(s). This type of a fast-track arbitration allows the parties to agree to conduct a prompt, cost-effective and private resolution of their disputes without a public airing of grievances, which may hold significant appeal to family members who are in business together. 

Conclusion

Family dysfunction is the subject of countless books and movies, and those conflicts exist in family businesses, as well. One way to avoid or at least narrow the scope of the conflicts when family members enter into business together, however, is for them to adopt a BSA at the outset.  The BSA provides for a defined partner exit, which the parties can carefully negotiate to protect their interests as majority owners or minority investors if a business divorce becomes necessary. While no agreement can eliminate all conflicts, spending time on the BSA to pre-plan how a future business divorce will take place will help limit the issues that may be disputed in the future. Further, including a fast-track arbitration provision in the BSA will enable the parties to reach a prompt and cost-effective resolution of any future conflicts that do arise.

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.

Conclusion

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.

Disagreements are common between business partners in private companies, but most do not lead to a partner exit. When partner conflicts become severe enough to warrant a business divorce, however, majority owners and minority investors will both be well served if they have taken the time to negotiate and implement a “corporate prenup.” If partners have not adopted a partner exit plan, the disputes between them may be both costly and prolonged when a partner departs. While there is no perfect Buy-Sell Agreement (BSA), a well-crafted contract will enable a business divorce to take place in a manner that limits disputes between the partners, which saves time and money.

Why a Buy-Sell Agreement Is Necessary

The chief reason that a BSA is necessary is that it gives both sides something they need when serious disputes arise between the co-owners. Majority owners do not want to be saddled forever with a minority partner who is causing problems for them in the business. For their part, minority investors who have strong objections to the actions of the majority owner do not want to be stuck holding an ownership interest in the company that they cannot monetize. The BSA therefore allows the majority owner to redeem (buy out) the minority investor’s interest. It also allows the minority partner to secure a redemption (sale) of his or her stake in the business. Thus, both sides are able to secure a business divorce when they decide it is necessary.     

The Key Elements of a Buy-Sell Agreement

There are four chief elements of a BSA, which are discussed below. These are not cookie cutter documents, and each of these terms will need to be discussed at some length by the co-owners to reach an agreement that meets their specific needs.  

1. The Trigger

The first element is the trigger, which is the point in time at which the BSA can be exercised. It is fairly standard for majority owners to have the right to purchase the minority owner’s interest when he or she (i) files bankruptcy, (ii) gets divorced, (iii) dies or (iv) leaves the company. These are closely held companies, and the majority owners do not want strangers to be injected into the business.

Majority owners also want the right to be able to pull the trigger and buy out the minority owner whenever they desire so that, at the first hint of problems, they can remove any disgruntled/difficult minority partner. But the minority partner who is making an investment in the company may resist an early exit and require that the investment be given sufficient time to appreciate in value so that the investment will have been worthwhile. The minority owner may therefore insist that no buyout right can take place within the first three to four years after the investment. The minority owner should also require that any buyout take place pursuant to a look-back provision. This provision provides that if any sale or other transaction takes place that places a higher value on the company within a year (or longer) after the minority interest has been redeemed, the minority owner will receive a supplement payment that provides the minority owner with the benefit of the increase in value. 

The minority owner will want the right to demand that his or her interest be purchased whenever the minority owner desires to exit the business. The majority owner is unlikely to want to permit the investor to be able to pull the plug shortly after an investment is made in the company. The majority owner may therefore require that the minority investor has no right to request a redemption for at least three to four years (or longer) after the investment has been made. Similarly, the majority owner may require that all of the minority investor’s stake in the company be redeemed at one time so that the majority owner is not required to deal with multiple exercises of a redemption by the minority investor. 

2. The Value of the Redeemed Interest

Private company valuation is no easy task, and highly regarded valuation experts may reach very different opinions about the value of the ownership interest that is being redeemed. As a result, the co-owners should spend time considering how they want to go about determining the value of the business and the interest being redeemed when a buyout is triggered. In this regard, it is often helpful to retain a business valuation expert to help draft the valuation provision and how the process will take place.

Some of the components that the parties need to consider in valuing the redeemed interest include:

  • What is the date of valuation (should it be the date the buyout is triggered, or should it be a specific date of the year, e.g., December 31, regardless of the trigger date)?
  • Should the value be based on a single date or should it be a composite/average of the company’s value over the past two to three years?
  • Do minority discounts apply to a minority interest based on lack of marketability and the lack of control or should the value not include any minority discounts?
  • Should the value be based on a specific formula based on the company’s financial documents or should value be determined by business valuation experts and, if so, which one(s)?

Merely agreeing to retain a business valuation expert is not sufficient. The expert needs to be instructed whether minority discounts apply to the value, whether a single valuation date is being used or whether the value should be based on an average value based on a period of years, as well as whether the value should include or omit retained earnings and/or working capital.

3. The Payment Terms

In addition to setting forth how the value of the interest to be redeemed will be determined, the BSA also needs to define how the price will be paid. The payment of a shareholder redemption often takes place over three to five years, although some BSAs provide for an even longer payout. Given the length of time for the payout to be completed, the BSA may provide for some type of collateral in the event there is a default in payment. The BSA must also specify whether the redeemed interest is transferred at the time the transaction takes place, or whether the transfer takes place over time as payments are made. While it is more common for the redeemed interest to be fully transferred at the same time as the redemption, that is not always the case.  

4. Dispute Resolution Process

The final element of the BSA is the method selected for resolving any disputes between the partners that take place during their business divorce. Given the desire of all parties for the process to be completed promptly, they may choose to arbitrate these conflicts rather than engage in litigation. If arbitration is their choice, they have the option to require that the final arbitration hearing take place on a fairly rapid timetable, perhaps in 90-120 days. This ensures that they will have a prompt final separation of their joint ownership interest in the business.

Conclusion

Even when parties going into business together are family members or longtime friends who trust each other, they are wise to plan ahead. By putting a BSA in place, they are preparing for possible outcomes that make a partner exit necessary. It is certainly possible that death, divorce or significant changes in their business goals may cause them to seek a business divorce, and they will appreciate their foresight in having taken the time to carefully negotiate and implement a corporate prenup.