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.

It is common for private company owners to wonder what price they would receive if their company was offered for sale.  When a business owner wants to formally determine the company’s actual value in the marketplace, however, the typical approach is for the owner to  retain an experienced, independent business valuation expert who will analyze the company’s financials, consider the state of the market and provide a valuation report.  This valuation report will provide an important data point for the owner to consider, but it should not be the final verdict regarding the actual value that could be realized in a transaction.

This blog post discusses some of the methods used by business valuation experts to determine a company’s value and also reviews additional factors business owners will want to evaluate when considering a potential sale of their company.  These additional items should be considered when a business owner asks the question —what is my company truly worth?

What Goes Into A Valuation Report

When the company’s value has not yet been determined, it is important to understand what goes into the analysis that is conducted by a business valuation expert.  To provide an objective analysis, valuation experts will consider several different measures of value. These generally include: (i) a liquidation value (the net cash that the company would receive if all its assets were liquidated), (ii) a book value (the difference between the company’s total assets and its total liabilities reflected on its balance sheet), (iii) a comparable value (what similar companies are selling for during this period in the same industry), and (iv) a discounted cash flow value.  This last measure of value calls for the expert to determine the company’s anticipated future earnings and then discount those to present day – a common valuation methodology.  This last model also takes inflation into account.

 When the valuation report comes in, it may be advisable to compare it to a “back of the envelope type of valuation” – simply multiplying the amount of the company’s annual earnings by an industry multiple.  This multiple will likely be included in the expert’s valuation report and then applied to the company’s earnings generated over some period of time, usually three to five years.  As noted, the valuation expert’s report will provide a good indication of the value of the business.  But as stated, it is not the end of the story for the reasons discussed below.

Expected Future Earnings Increases 

A valuation report is based on the company’s value as a snapshot – a specific moment in time.  The report may therefore not account for expected positive future earnings increases.  For example, if the company made a large capital investment in its infrastructure, technology, or personnel in the 12 months before the valuation report was issued, the new investment and the expected boost in earnings that follows such a capital investment may not be captured in the report.  Further, until the anticipated increase in earnings is actually realized, the expected addition to the company’s value may not be accepted (and paid) by a potential buyer. 

Jerry McGuire’s famous phrase is applicable here – “show me the money.” A potential buyer may be unwilling to pay more for the company based on an expectation of its earnings increasing, and instead, will require these enhanced earnings to be realized before paying for the additional value.  One way to change this dynamic may be to look to the past.  If the majority owner can show the potential buyer that similar investments made in the past by the company resulted in substantial earnings increases, the buyer may be more willing to accept the validity of the projection.  Under these circumstances, the buyer may agree to pay at least somewhat more for the business even before the increase in earnings has actually been achieved. 

The Importance of Locating A Strategic Buyer

Not all buyers created equal for each and every company. When a company owner is ready to consider selling the business, it is helpful to conduct a market analysis to determine all  potential strategic buyers who may be interested in purchasing the company.  Securing a sale to a strategic buyer is the best way to maximize the value of the company when the business is sold.  As stated in Investopedia:

A strategic buyer is a company that acquires another company in the same industry to capture synergies. The strategic buyer believes that the two companies combined will be greater than the sum of their separate individual parts and aims to integrate the purchased entity for long-term value creation.

A strategic buyer is thus one that is willing to pay a premium to acquire the company.  The strategic buyer will typically be an existing, usually larger, business that is buying the company for a number of strategic reasons, including: (1) to capture or expand a market, (2) to bring an existing  group of employees into the fold to help with growth, (3) to capture the benefit of a patent or some other proprietary information or technology that the target company possesses, and/or (4) to fully integrate the company with theirs with a focus on longer term objectives..  Value is therefore relative and there are some buyers with have specific objectives who will be willing to pay more to achieve synergies that result from the purchase of the target business. 

Value Not Reflected on the Balance Sheet

The last items to cover are potential value enhancements that may not be apparent on the company’s balance sheet.  One example is a patent or other technology that has not been fully exploited by the company.  There are potential license fees that could be obtained from enforcing these patents, developing new products, or otherwise building on existing patents.  These are the kinds of opportunities that may be pursued by a deep-pocketed company that is well-positioned to unlock this additional value.

 Depending on the type of business, such as a franchise or distributor, the majority owner may have secured exclusive territories in which the company has the right to operate or significant contracts with third parties.  But due to the lack of capital or insufficient management personnel, the company may not have been able to exploit these opportunities.  When these exclusive rights and opportunities are disclosed to the acquiring company, the purchaser may be willing to pay more for the business to secure and control these exclusive rights. 

 Another example concerns the key managers of the company.  If these key employees are subject to well-drafted, multi-year non-competition agreements, the acquiring company will be assured of  management continuity and stability after the sale.  Again, when these types of non-compete agreements are fully disclosed and explained to the potential purchaser, they may lead to an enhanced value the purchaser is willing to pay to acquire the business. 

 Finally, depending on the nature of the business and the desires of the majority owner, the potential may exist for the acquiring company to pay the owner a lucrative amount to serve as a consultant for some period after the sale.  These fees, however, are typically not included in the stated purchase price.  Accordingly, all future consulting fees will normally be fully taxed as compensation.  Along these same lines, some purchasers may also agree to provide the former owner with a bonus if the business can achieve certain revenue milestones (or other targets) within a specific period of time after the purchase has been completed.


 What is a company worth?  Value can be measured, but the ultimate answer can involve an array of factors to consider, some of which may not be readily apparent. 

There are basic financial performance measures involved in valuing any business, and normally, potential purchasers will not pay premium dollars to buy a company when its current financial reports show that it is only marginally profitable. This will be disappointing to hear for the majority owners of a successful business who are seeking to secure a top dollar sales price for their company.  To obtain this best price requires a due diligence process that should include an assessment of many factors, including, but not limited to: (i) who are the best  buyers for the business, (ii) what recent investments have been made by the business that may generate increased future earnings, (iii) what factors exist that would enhance the value of the company (including patents, trademarks, restrictive employment agreements, and exclusive contracts), and (iv) what additional value will the purchaser agree to pay the former owner to assist with the transition if the owner is interested in a consulting arrangement. 

Putting in the work to identify the optimal buyers for the company and to demonstrate all of the value that the purchaser will be acquiring in the transaction is critical for majority owners who want to achieve the best purchase price for their company. 

In the private company context, high-performers, senior executives and other vital employees are a company’s lifeblood. It is therefore critically important to retain these top performers, which often requires that the company’s majority owners provide these key employees with significant financial rewards. Simply paying top performers additional cash compensation or issuing them shares of an illiquid ownership interest may not be the best approach. But issuing units or shares to employees will dilute the company’s ownership and could also expose the company’s majority owners to future claims for breach of their fiduciary duties. 

An alternative means of compensating top performers may be providing them with stock appreciation rights or what is known as phantom stock. This post reviews some of the pluses or minuses involved when majority owners are considering whether to issue these types of non-equity awards to the company’s highly valued employees.

Issuing Equity Grants to Key Employees Can Create Problems

The desire for an alternative to providing key employees with stock or units in the company is spurred by several factors. First, many companies are closely held and/or have elected Subchapter S tax treatment, which restricts the number of owners the company may have. Second, in closely held companies, the existing owners may be reluctant to have their ownership interest diluted by granting stock options to employees or issuing shares of stock or membership units to them. Third, granting equity to employees provides these new owners of the business with significant new rights, which may include, but are not limited to: (a) calling an owners’ meeting and including items on the agenda for discussion, (b) demanding access to the company’s financial books and records, (c) filing claims against the majority owners on a derivative basis for breach of fiduciary duties, and (d) receiving payment for their ownership stake in the event of a sale or IPO.

In short, once employees are issued equity in the company, they become co-owners of the business, and the majority owners need to be prepared to share ownership of the company and other rights of company governance with these new partners. Therefore, the majority owners need to be aware that their new minority partners will be authorized to assert a number of rights and/or claims against the company and its majority owner(s) that may result in conflicts that can disrupt the business. These concerns must be juxtaposed against the need for the majority owner to provide employees with some kind of “skin in the game” to incentivize them to remain top performers.

What Are Phantom Stock and Stock Appreciation Rights?  

Fortunately, the problems for majority owners discussed above that result from the issuance of equity to employees can be avoided through creative business solutions that do not make the employees new business partners. Specifically, the majority owner can issue stock appreciation rights (SARs) or phantom stock units to these key contributors to the business. These rights are sometimes referred to as “synthetic equity” because they provide employees with a contractual “piece of the pie” that does not give them an actual ownership stake in the business. And these synthetic equity grants can be based on actual shares of stock or other units of ownership, such as membership units.

A SAR is a right granted to an employee with respect to one or more shares of stock (or membership units) that entitles the employee to receive a cash payment for each SAR based on the performance of the business. This is akin to a cash bonus that is equal to the excess of the fair market value of a share of stock or unit on the date of exercise over a specified price, usually referred to as the “initial price” or “initial value” of the SAR. In other words, when the price of a share of the company’s stock increases over a set period, the employee receives a cash payment based on a defined formula. SARs are typically subject to a vesting period, often based on the passage of time, but they could be based upon achievement of other metrics.

As a simple example, an employer grants an employee 10,000 SARs with an initial value of $10 per share (which is equal to the fair market value of the company’s stock on the date of the grant). Sometime later the employee “exercises” the SARs, similar to the manner in which an employee would exercise a stock option, the only difference being that the employee is not required to pay any amount up front to acquire the SAR.

At the time the SAR is exercised by the employee, the fair market value of the company’s stock is $20 per share. As a result, upon exercise, the employee receives a cash payment — and thus taxable compensation — in an amount equal to $100,000 (the difference between the current fair market value of $20 per share and the “initial value” of $10 per share, multiplied by the number of SARs granted to the employee, or 10,000). The company will realize a corresponding tax deduction for the payment of this additional compensation. Payment of SARs may be in cash, stock, or both, but they are most often paid in cash, as payment in stock would be dilutive and counter to the notion of “synthetic equity.”

Phantom stock units, like SARs, are also based on the value of underlying stock or membership unit. The difference between phantom stock units and SARs is that rather than receiving a cash payment upon exercise equal to the appreciation in the underlying employer stock, over some “initial value,” the recipient of phantom stock units receives the actual value of the shares of the underlying stock, multiplied by the number of phantom stock units held by the recipient. As with SARs, awards of phantom stock are typically subject to a vesting period.  

As an example, an employee receives 10,000 phantom stock units. The fair market value of the company’s stock at the time the phantom stock units were granted to the employee is generally not as important as it is with respect to SARs, which use an “initial value.” When the phantom stock units are paid, the employee receives the actual fair market value per share of employer stock at that time. Therefore, if the fair market value at the time of payment was $20, the employee would receive $200,000 ($20 per share multiplied by 10,000 phantom stock units).  Unlike SARs, however, the employee received value when the phantom stock units were granted.  In the example above, if the value of the underlying employer stock was $10, the employee has $100,000 of value on the grant date. If this were a SAR with an initial value of $10 per SAR, there is no value of any kind unless and until the value of the underlying stock appreciates above $10.

Federal Income Tax Treatment

There is no tax due when an employee receives a grant of a SAR or phantom stock units; taxes become due only upon exercise and payment. An employee who has vested SARs or phantom stock units is not in “constructive receipt” of income upon vesting, and thus the employee has not received any ordinary income simply by virtue of the vesting and appreciation of the employer’s stock. Rather, the cash payment to which the employee is entitled is included in the employee’s gross income for the year in which the SAR or phantom stock unit is exercised or paid, at which time the employee receives ordinary taxable income that is subject to withholding similar to normal compensation payments. The company also receives a corresponding tax deduction equal to the amount included in the employee’s income when the employee is taxed upon exercise of the SAR or the payment of the phantom stock unit.

Conclusion: Advantages and Disadvantages

The advantage to the employee of receiving a SAR is that it provides him or her with the potential opportunity to receive large payments from the company while avoiding the need to provide any cash outlay that is associated with buying stock options or actual stock in the company. With certain exceptions due to the impact of Code Section 409A, the employee can also control the timing of exercise with respect to a SAR (but cannot do so with respect to phantom stock units due to Code Section 409A requirements). From the company’s perspective, the employee gains parallel shareholder gains. The employee has no gain unless the share value increases. Finally, the holder of a SAR is not considered a shareholder. Thus, performance-based stock compensation can be awarded without increasing the number of shareholders or otherwise diluting existing shareholders.

Like SARs, the advantage of phantom stock is that it provides a means for the employer to compensate an employee with the value of company stock without having to issue actual shares stock. Similar to SARs, the employee has the potential to receive large gains and yet avoids the financing costs of options and stock ownership. Unlike a SAR, however, the employee who receives a phantom stock unit can receive substantial value even if the company’s stock performs poorly. Based on the example above, if the value of company stock decreased from $10 to $5 per share, the employee would still receive a cash payment of $50,000 based on the ownership of the phantom stock. With a SAR, if the value of the company’s stock declines or remains the same, the employee receives nothing. 

There is one additional, significant benefit to majority owners for issuing SARs and phantom stock to key employees rather than providing them with actual equity. These types of synthetic equity provide contractual benefits, and the employee must therefore remain employed by the company to receive them – this is a “must be present to win” component. When actual stock is issued to employees, the company or majority owner has to repurchase the shares when the employee resigns or the employment is terminated, which can lead to conflicts about the value of the stock being redeemed. With SARs and phantom stock, however, these rights are extinguished automatically when the employee departs from the business and, therefore, there is no stock or ownership interest the majority owner or the company needs to repurchase.