Take the Time to Check on Your Buy-Sell Agreements
By Thomas Tongue and Lauren Hunter
The stability and continuity of the ownership group in a closely held business play a critical role in the success of the business. A properly drafted buy-sell agreement can help ensure that stability and continuity, but only if it is carefully tailored to meet the needs of the company and its owners.
Do I need a buy-sell agreement? Closely held businesses with more than one owner are strongly encouraged to have a buy-sell agreement. These agreements restrict each owner's ability to transfer his or her equity in the company to a party that would not be acceptable to the other owners.
How does a buy-sell agreement work? A buy-sell agreement lists specific instances when a co-owner is permitted to transfer ownership in the business. The idea is to limit transfers in a way that will be acceptable to the non-transferring owners. There are two general categories of transfers: voluntary and involuntary. A voluntary transfer occurs when an owner makes a conscious decision to transfer equity in the business. An involuntary transfer occurs if an owner is required to transfer his or her equity as a result of some triggering event. A properly drafted buy-sell agreement should address each type of transfer situation.
How do buy-sell agreements address voluntary transfers? A buy-sell agreement will define a list of permitted transfers. For example, the agreement might allow an owner to make a transfer with the approval of a majority of the non-transferring owners. Alternatively, the buy-sell agreement might allow an owner to first offer to sell to the other non-transferring owners before selling to a third party (known as a right of first offer). The types of permitted transfers will vary from business to business, but the concept is to provide the ownership group with assurance that if a transfer of equity occurs, it will not destabilize the business.
How do buy-sell agreements address involuntary transfers? Involuntary transfers pose additional challenges because they can arise unexpectedly. Typically, a buy-sell agreement will define a list of involuntary transfer triggering events, such as death, divorce, or bankruptcy of an owner. If a triggering event occurs with respect to an owner, the agreement will provide the company and the other owners with either an option or an obligation to purchase the equity. The agreement should define a method for valuing the equity and set forth the terms of purchase. An obligation to purchase the equity can be problematic if the company and the other owners lack the funds necessary to complete the purchase. As a result, most buy-sell agreements provide the company and the other owners with an option to purchase. Further, the agreement should allow the payment of the purchase price over time with a reasonable interest rate.
Aside from death, divorce, or bankruptcy, what are some other common triggering events? In situations where the owner also works for the company, it is common to include discontinuation of employment as a triggering event. This helps protect the co-owners from a situation where one owner stops working, but still expects to retain his or her equity position and associated distributions.
What are the common methods used in buy-sell agreements to value the equity being sold? Most buy-sell agreements will give the parties an option to agree on a price. However, if they cannot agree, the price is normally determined by a third-party appraisal or a formula. Formulas are often problematic. On the surface, they appear to provide a quick and inexpensive means of valuing the equity. Often the formula makes sense when the buy-sell agreement is first executed, but the factors that influence a business's value change over time, rendering the formula obsolete. If a buy-sell agreement includes a formula, it should be reviewed on a regular basis to ensure that it continues to meet its intended purpose of providing a fair valuation for the equity.
How does the buy-sell agreement become enforceable? First, all of the owners must agree to be bound by the buy-sell agreement. Second, any certificate evidencing ownership in the business, such as share certificates, should be marked with a legend noting the existence of the buy-sell agreement. Each owner's spouse should sign a consent to the buy-sell agreement to help ensure the enforceability of the agreement in states with community property laws.
Can buy-sell agreements help protect the status of a business as an S-corporation? Buy-sell agreements can help protect the S-corporation status of a business. Many small businesses elect to be taxed as S-corporations. S-corporations provide certain tax benefits to business owners. The Internal Revenue Code limits who can hold shares in an S-corporation. If an owner transfers shares to a non-qualified party, the business will automatically lose its S-corporation status, which can result in significantly higher tax liabilities for the business and its owners. Any business that has elected S-corporation tax status should have a buy-sell agreement in place prohibiting any transfer of shares to a party that is not qualified to hold S-corporation stock.
A carefully drafted buy-sell agreement can play a critical role in helping ensure the stability and continuity of a business. It is equally important to review these agreements on a periodic basis to ensure that they continue to meet the needs and demands of the business.
As published in the Oregon Daily Journal of Commerce, August 2015