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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. 

Private company majority owners and minority investors often focus on the company’s financial health and growth prospects, and may not take the time to review the operating documents of the business – bylaws for corporations or company agreements for LLCs. These governing documents are legal in nature, but they should not be left to the purview of the lawyers because they are not cookie-cutter agreements. Instead, by studying and making necessary changes to the provisions of controlling documents, owners and investors may head off disputes with their business partners or substantially limit the scope of future conflicts. 

This post reviews a number of key provisions that are normally included in governance documents of private companies, which control the company’s operation. This post does not discuss Buy-Sell Agreements, but these agreements also play a critical part in lessening or avoiding conflicts between when a partner exit from the business takes place. Read our post discussing Buy-Sell Agreements.

The key provisions discussed in this post include:

  • Control provisions and veto rights of minority partners
  • Distribution/dividend policy and management discretion
  • Addition of new business partners and dilution provisions  
  • The right to amend the governance documents
  • Dispute resolution provisions

Governance/Control Provisions

In most company governance documents, the majority owners have the final say regarding company decisions. But as the company grows and needs new capital, it may add new partners who invest in the business, and these new partners will want to have some voice regarding management decisions. It is therefore common for substantial minority investors to have “super-majority” rights, which effectively give them a veto over certain management decisions. For example, when the minority investors hold at least 26% of the units in the company, the LLC Agreement may require that a decision to expand the board of managers requires a 75% vote of the members. Minority investors therefore need to decide what key decisions by management over which they want to seek super-majority voting rights.

Management decisions that are commonly subject to super-majority provisions in governance documents include:

  • The size of the board of directors or managers
  • Appointment of a new CEO/president
  • Company mergers or major new acquisitions
  • Taking on debt over a certain prescribed limit
  • Adding new partners above a certain percentage
  • Dissolving the company or filing for bankruptcy
  • Amending the governance documents

Distribution and Dividend Policy and Related Discretion

Typical governance documents also give full discretion to the majority owner (or to a board of directors or managers controlled by the majority owner) to decide whether or not to issue a dividend or distribution. The minority investor, however, should consider whether to seek a mandatory dividend policy before making an investment. At a minimum, minority investors may want to insist that the governance documents require the company to issue dividends or distributions in an amount that is sufficient to cover the tax liability of all partners based on the profitability of the company.

LLCs and Subchapter S companies are “pass through” entities, which means that the companies do not have to pay taxes on their income, and instead, the tax on the company’s profits is paid for by the owners. Therefore, if the company does not make distributions to the owners to cover their tax liability, the owners will be subject to “phantom tax,” i.e., they will have to pay their share of the tax on the company’s profits, but without having received any actual cash distribution from the company. This can happen when a company is retaining earnings to pay for investments that will grow the business. Thus, the company is profitable, but if it retains all of its earnings, the owners will have to pay the taxes on those profits based on their percentage ownership in the company. 

Minority investors could go farther, however, and insist that at least some amount of the profits be distributed to the owners each in addition to the distributions that are made to cover the tax liability of the owners. This discussion will require the company’s owners to decide whether or not they want to reinvest all of the profits in the business or whether they want to provide that the owners will receive a current return of some percentage of the company’s profits.

Anti-Dilution Provisions

As the business grows and new partners are added to the company, the percentage held by the existing owners will have to decline (unless another class of stock or units is created). Minority owners may therefore want to insist that their ownership percentage not be subject to this dilution resulting from the addition of new owners. That may not be acceptable to the majority owners, however, who recognize the need to bring new owners on board who provide additional capital for the business. The argument by the majority owners is that while dilution is taking place (the piece of the pie owned by minority investors is getting smaller), the size of the business is increasing (the pie is getting larger).

Whether dilution will apply to the minority owner’s interest – and if so, on what terms and to what extent – is a subject that the owners should discuss before the minority owner makes an investment in the business. For example, the minority owner could agree that dilution of his/her interest will take place, but only to a point, i.e., the minority owner who holds 15% of the company originally could agree to dilution, but also provide that his or her ownership stake will not go below 10% at any point.    

Right to Amend Governance Documents

The right to amend the governance document rarely receives much attention. This provision, however, can turn out to be of great importance if the majority owners choose to amend the bylaws or the company agreement in a manner that negatively impacts the rights of the minority owners. In this regard, the majority owners could amend the governance agreement to (i) lessen management rights of minority investors; (ii) restrict access to documents; and even (iii) allow the majority owners to remove the minority investors from the business by creating new stock redemption rights, which set the terms on how they will be compensated for their ownership interest in the company.

To avoid this scenario, minority investors may want to insist that any changes to the governance documents be adopted only with unanimous approval of all shareholders or members, or at a minimum, that a super-majority of the shareholders or members must approve any amendments. The limit on the majority owners’ ability to amend the company’s governance documents is potentially a game changer that should not be overlooked.

Dispute Resolution Provisions  

A final key provision of governance documents is the method by which disputes between the owners of the business will be resolved. Typically, serious ownership disputes are resolved through litigation, but one alternative to consider is the use of arbitration as a dispute resolution device. While arbitration may not be right for every company or situation, it is something the owners should consider, because arbitration provisions can be tailored to (i) require the claim or dispute to be resolved quickly in a matter of just a few months; (ii) sharply limit the scope of discovery; (iii) permit the arbitrator(s) to award legal fees to the prevailing party (including a party against whom the claims are made if that party successfully defends against the claims); and (iv) dictate that only certain types of disputes or claims will be subject to arbitration.

For example, the parties could agree that disputes regarding the value of the business, or the value of a minority owner’s interest in the business, are subject to arbitration. This avoids a lengthy court battle over the value of a minority ownership stake in the business, as the parties can agree that a dispute over value will be resolved in 60 days. The parties could further agree that the manner for them to resolve a valuation dispute will be for each side to call a valuation expert and then let the arbitrator or arbitration panel decide the value.

Conclusion

Knowing the rules of the road is critical when traveling, and the same holds true in regard to owners and investors in private companies. The governance documents of private companies are specialized documents that should be read and understood by all owners in the company. For majority owners, they need to have a good grasp of their authority and the specific rights that they are exercising in controlling the business. For minority investors, if they have not read the governance documents, they may be surprised to learn they are in a poor bargaining position because they ceded authority to the majority owners that they never intended. Minority investors may be especially stunned when majority owners amend the governance documents in a manner that is prejudicial to their interests. 

Thus, the takeaway is that private company governance documents may contain unwelcome news for the unaware majority owner or minority investor. It is far better for owners and investors to take the time to closely review the governance documents of the company before they add any new partners to the business or become a new investor. This preview of the documents opens the door to a discussion and negotiation of the terms that both parties want to include in the governance documents to meet their business objectives as co-owners in the company.