By Michael Raum
Photo courtesy of Fredrikson & Byron Law Firm
As a business lawyer, I’m frequently asked about buy-sell agreements. These are important agreements that owners of closely held businesses should have as part of their business plans.
This article is written for business owners who share company ownership or are considering going into business with a partner(s). Buy-sell agreements allow principals to transfer ownership in the event of a sale, bankruptcy, death or retirement.Michael Raum focuses his practice on commercial law, with a specific emphasis on tax matters. He works with publicly and privately held companies on business transactions, including structuring, financing and advising on general corporate matters.
Disclaimer: Since each business situation is different, readers should consult a qualified attorney for legal advice. This article addresses common questions on the topic but should not be considered legal advice.
1. What Is A Buy-Sell Agreement?
A buy-sell agreement is an agreement between owners of a company that dictates what will happen to each owner’s interest in the company under certain conditions. They effectively seek to deal in advance with the questions that arise during times of stress and transition.
2. Why Is A Buy-Sell Agreement Important?
Closely held companies almost always depend on the personal relationships of their owners. Those owners have chosen to go into business together, and they are unlikely to want strangers involved in the company.
In addition, a closely held company is very hard, if not impossible, to sell on the open market because third parties rarely want to enter into a business with people they don’t know well. Buy-sell agreements seek to deal with these issues by setting forth what will happen at those times when one owner’s interest in the company may pass to someone else.
3. Is There A “Standard” Buy-Sell Agreement?
Just as every company is different, every buy-sell agreement has to be different. While there are common issues and various common approaches to how to solve them, there is no “standard” agreement that would fit every situation. This article outlines some typical approaches to common situations, but each case must be examined on its own before deciding how to proceed.
4. What Are Some Of Those Times?
A buy-sell agreement should deal with every “triggering event” when ownership may transfer. Typically, those include at least the following situations:
- A voluntary sale to a third party
- An involuntary transfer such as a levy by a creditor, bankruptcy filing or appointment of a guardian
- Death
- Desire of one of the principals to retire from the company
There may be other situations to be addressed, depending on the exact circumstances of the company and its owners.
5. How Would An Agreement Deal With These Situations?
- An agreement might give the remaining owners an option to buy the interests at issue. In the case of a sale to a third party, that might be either for the price offered or for an agreed formula price. This is common for voluntary and involuntary sales.
- It might require the remaining owners to buy the interests. This is most common in cases of death, when the parties want to ensure that the dying owner’s estate receives value. Some agreements also require a buyout in case of retirement, though many grant an option instead of a requirement in such cases.
6. Would The Company Arrive At A Buyout Price?
Most agreements call for the parties to arrive at an agreed-upon price periodically — usually every year. They may also set forth a formula such as “a certain multiple times cash flow.” Alternatively, they may require an appraisal.
7. How Does A Buy-Sell Agreement Integrate With Estate Planning?
A buy-sell agreement is certainly part of a business owner’s estate plan and should be prepared with the estate plan in mind. For example, if an owner wants to be able to pass shares to his or her estate or to a trust created to assist with estate planning, the agreement should specifically exempt such transfers from any restrictions. The agreement may also limit such transfers to family members to make sure they are really part of an estate plan.
Similarly, if the plan is to require a buyout at death, then the parties should consider the use of life insurance to make sure there are adequate funds to make the payments. In the alternative, they may set up payments over time to allow the remaining owners to make the payments without destroying all their cash flow.
8. What If One Owner Just Wants Out?
This is one of the trickiest problems with buy-sell agreements. Generally, an investor in a closely-held company has no right to a return of his or her capital. An investor takes the risk of buying into an illiquid investment and taking the good times with the bad.
Therefore, an agreement that simply allows an unhappy owner to walk away can be very problematic because a company’s cash flow could be badly strained if investors could simply leave with their capital as soon as things get bad. The agreement should therefore not create an incentive to leave as soon as things get tough, which could create a kind of “race” to get out.
On the other hand, investors may be unwilling to put money into a company if they have no way to get their money out. One middle ground is to require that if a withdrawing owner is not bought out, then the parties must work together to sell the company.
While this, too, can present challenges, it at least provides some relief for owners who think they are trapped in an illiquid investment. The implications of this decision should be carefully considered before the parties agree to it however.
9. Do Courts Enforce These Agreements?
Generally, yes. North Dakota and Minnesota law both specifically contemplate that shareholders may enter into buy-sell agreements and have enforced them in various cases. There is never an absolute guarantee that a court will enforce any agreement, but as a general matter, a court will enforce the terms of a buy-sell agreement entered into between owners of a business.
10. Who Should Have A Buy-Sell Agreement?
Almost every business owned by more than one person should seriously consider a buy-sell agreement. Even businesses owned by family members — such as a husband and wife or parent and child — who plan to pass the ownership between them face the risk of an involuntary transfer.
About the Attorney
Michael Raum focuses his practice on commercial law, with a specific emphasis on tax matters. He works with publicly and privately held companies on business transactions, including structuring, financing and advising on general corporate matters. He can be reached at [email protected].
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