By Joseph L. DeSimone, CPA

Buy/sell agreements generally are advisable for closely held businesses with more than one owner.  A properly crafted buy/sell agreement can:

• Prevent unwanted persons from becoming owners
• Ensure continuity of ownership
• Provide a ready market for an owner
• Establish a value of the business
• Provide procedures for transferring ownership if owners have a “parting of ways”
• Provide for unanticipated events such as the disability, divorce, insolvency, or disability of an owner

Buy/sell agreements are important for closely held businesses with multiple owners because there is no ready market for selling an ownership interest in such a business.  Without a buy/sell agreement, the party that needs to sell (because of death, termination of employment, divorce, etc.) is at a bargaining disadvantage.  The remaining owners may see this as an opportunity to increase their ownership at a bargain price.  Thus, one of the most significant advantages of buy/sell agreements is that none of the owners know who the agreement will apply to, so there is an incentive to set a fair price or fair formula to determine price in the agreement.

A primary purpose of a buy/sell agreement is to restrict the ability of business’s owners to transfer their ownership interest.  This restriction can be critical.  Rarely do two or more owners “get along” indefinitely.  Disagreements and disputes inevitably arise.  Thus it is prudent to provide a way for owners to depart without forcing the remaining owners into a business relationship with potential unwanted “partners”.

Buy/sell agreement defined
A buy/sell agreement is a contract that places restrictions on owners’ of a closely held business to freely transfer their ownership interest.  The agreement provides that an owner’s interest in the business will be sold (or at least offered for sale) at a specified price to the other owners and/or the business entity itself upon the occurrence of specified events.  This prevents unwanted individuals from becoming members of the ownership group and ensures a ready market for closely held ownership interest.

Common types of buy/sell agreements
The most common type of buy/sell agreements are:

• Redemption agreements
• Cross-purchase agreements

Redemption agreements In a redemption agreement, the owner of a business and the entity itself enter into a contract.  The owner agrees to sell his ownership interest to the entity according to the price, terms, and circumstances specified in the contract.  Such transactions are referred to as redemptions.

Frequently, a redemption agreement amounts to giving the entity the right of first refusal when an owner wishes to sell the interest to a party outside the current ownership group.  If the entity chooses not to exercise its right, the owner is typically free to sell to the third party.  In some cases, the selling owner must offer the interest to the other owners after the entity has declined to purchase the interest.  If there is no third party buyer, the entity must buy the owner’s interest in the event of certain circumstances (typically death, disability, or retirement). 

Cross-purchase agreements A cross-purchase agreement is a contract between the owners of a business.  The owners agree to offer their ownership interests for sale to the other owners at the price and terms designated in the contract.  If there is no third party buyer, the owners are generally obligated to buy the interest in the event of certain circumstances (e.g., death, disability, or retirement).  Thus a cross-purchase agreement is essentially a right of first refusal combined with a purchase obligation.  Cross-purchase agreements typically work best when the business only has two or three owners.  As the number of owners’ increases, the mechanics of making the agreement work become more complex.

Structuring buy/sell agreements
There is no universally accepted standard form for buy/sell agreements.  The scope of buy/sell agreements can vary significantly based upon the complexity of the ownership structure and the needs of the owners.  The following are provisions found in most buy/sell agreements.  It should be noted that the drafting of a buy/sell agreement constitutes the practice of law.  Accordingly, an attorney should be involved in the design and drafting of the agreement.

Generally, all buy/sell agreements should provide for the following:

• Valuation method to determine the purchase price
• Events that will trigger the obligations of the parties
• Terms of sale
• Method for funding the purchase obligation

In addition, they typically include the following basic provisions:

• When a potential third party buyer exist, a right of first refusal is granted to the entity and/or the other owners
• When a third party buyer is not available, there is an obligation of the entity and/or the other owners to purchase the interest of a deceased or withdrawing owner in the event of certain circumstances (such as disability or retirement).
• When there is a dispute among owners, there is a mechanism to separate ownership.

Setting a purchase price The parties normally want to be certain of the valuation method used to fix the price that will be paid.  As a result, the owners typically will agree in advance to a specific value or to a formula approach for determining the value of the business.

Choosing the triggering events Events that trigger a buy/sell agreement can be specified as desired by the owners.  However, triggering events are generally any circumstances that might cause an owner to dispose of an ownership interest voluntarily or involuntarily.  Typical triggering events include, but are not limited to:

• Death
• Disability
• Divorce
• Insolvency or bankruptcy
• Loss of professional license
• Conviction of a crime
• Retirement or termination
• Desire to sell or withdrawal from the business before retirement
• Disagreement between the owners

Terms of sale Depending on the triggering event, the exercise of the purchase obligation may have varying terms.  For example, if an owner dies, the purchase price may be paid in the form of a lump sum (because the entity or the other owners hold life insurance on the deceased owner to fund the purchase obligation).  If the owner retires or becomes disabled, the purchase obligation may be met through an installment payment arrangement (which avoids an immediate outlay by the entity or the remaining owners for the entire purchase price).  In addition to provisions regarding payment terms, the owners may want the agreement to provide for different prices depending on the nature of the triggering event.  For example, the owners may feel a less generous price is appropriate in the event of retirement before a specified age.

Funding the purchase obligation The most common means of funding buy/sell agreement obligations is with insurance.  Life insurance often is the only way to ensure that the entity and/or remaining owners can afford to pay for the interest of a deceased owner.  The general rule for life insurance used to fund buy/sell agreements is that the insurance proceeds are received tax-free by the beneficiary named under the policy.  The beneficiary is the entity and/or the remaining owners with the obligation to buy the ownership interest of the deceased owner.

Buy/sell agreements should clearly describe the funding method.  If insurance will be used, the amount of insurance should be reviewed regularly to make sure it is adequate.

Restricting ownership transfers
Buy/sell agreements usually restrict transfers of an owner’s interest in one of the following ways:

• Transfers cannot be made without the consent of the other owners
• Owners have a right of first refusal on all proposed sales
• Transfers can only be made to permitted classed of transferees

Consent of owners required A buy/sell agreement may require the selling owner to obtain the remaining owners’ consent prior to transferring an ownership interest.  A consent restriction allows the ownership group to approve the admission of a prospective owner.  Consent restrictions are generally upheld if the consent is not unreasonably withheld and refusals are based on legitimate business reasons.

Right of first refusal Buy/sell agreements may grant the remaining owners (or the entity) a right of first refusal.  A right of first refusal requires an owner to offer the remaining owners (or the entity) the right to purchase his interest when he receives an offer to purchase his interest from an outside party.  Rights of first refusal are a common method of restricting the transfer of an ownership interest and are generally held to be enforceable.  A right of first refusal usually allows the remaining owners to purchase the interest at either:

• The price offered by the third party
• The price stated in the buy/sell agreement
• The lower of the two

Restricting transfers at death The most common restrictions in buy/sell agreements restrict transfers at death.    Business owners use buy/sell agreements to eliminate the risk an owner’s heirs will disrupt business operations.  This is usually accomplished with a provision requiring the mandatory purchase (by the surviving owners and/or the entity) of the deceased owner’s interest in the business.  Alternatively, the surviving owners may be granted an option to acquire the deceased owner’s interest.

Restricting transfers pursuant to divorce One of the most common and potentially disruptive transfers occurs when a business owner gets a divorce.  All too often, the business is the owner’s largest asset.  Thus, a portion of the owner’s interest can be awarded to the spouse as part of a property settlement.  The disruption caused by the transfer of an owner’s interest pursuant to a divorce can be minimized by granting the divorcing owner a right of first refusal to acquire any transferred interest.  This allows the divorcing owner to maintain his present percentage ownership in the business.  The divorcing owner would be entitled to purchase any interest awarded to a spouse pursuant to a divorce.  The price paid for the interest would be fixed in the buy/sell agreement.  A buy/sell agreement can also require a mandatory buyout in the event of an owner’s divorce.

Documenting buy/sell agreements
A buy/sell agreement should be documented in a written contract between the parties (the owner of each interest and the entity and/or other owners).  Oral agreements are not appropriate because of the possibility for misunderstanding among the parties.  In addition, an oral buy/sell agreement is unenforceable in most states.

All parties to be bound by the agreement must sign it.  Spouses, particularly in community property states, may receive legal interests in a business by operation of law even if the owners do not intend to involve their spouses.  Accordingly, each owner’s spouse should consent to the buy/sell agreement and agree to be bound by its provisions. 

Valuation formulas and triggering events should be stated with precision to prevent misunderstandings and costly litigation.  Whenever possible, definitions of terms such as “disability” and insolvency” should be carefully worded and the ultimate decision, in the event of a dispute between parties, should be left to an independent arbitrator.

Conclusion
A well thought out and documented buy/sell agreement serves to protect an owner of a closely held business, his family and the business.  A buy/sell agreement provides a ready market for an owner of a closely held business, as well as, ensures the continuity of the business and the remaining ownership group. 

Closely held businesses with multiple owners should review, with the input of both the company’s legal counsel and accountant, the adequacy of their buy/sell agreement on a regular basis.   Failure to do so will more likely than not result in unwanted consequences.