A buy/sell agreement is a must for businesses with multiple owners. Think of a buy/sell agreement as an internal contract between members, shareholders or owners of a business that spells out what happens to the shares of a departing business owner. They are designed to address and mitigate the business problems that arise when one of the owners of a business dies, retires, becomes disabled or departs.
The first thing to define in a buy/sell agreement is a “triggering event.” The purchase options or obligations become operative upon the occurrence of stated conditions. The most common occurrences are retirement, employment discharge, death, disability or incapacity. While it may seem straight-forward to define when these events occur, it’s a difficult trick to say when someone becomes “disabled” or “incapacitated.” The last thing in the world you want is court litigation over the meaning of “disabled” while a business owner is in the hospital and the business is losing money because he or she cannot work.
Additionally, keep in mind that some involuntary triggering events are possible and should be accounted for: such as divorce, insolvency or foreclosure arising out of a secured transaction (debt).
Now, upon the occurrence of a triggering is where things get interesting and when attorneys and business owners can be creative. Buy/sell agreements may grant options or impose an obligation to purchase all or a portion of the departing owner’s business interest. These can be done all at one time or in installments over a stated period of time. Undoubtedly, however, the biggest influence here is going to be taxes. For the departing business owner, he/she would probably want the business assets out of his or her estate for estate tax purposes. Similarly, depending on whether the company is a C Corporation (double taxation), S Corporation (pass through taxation) or LLC, then arrangements would need to be tailored so as to minimize tax exposure.
Having said this, there are three primary types of arrangements. First, there is the Redemption Agreement, which is when business itself purchases the departing owner’s interest. Second, there is the Cross-Purchase Agreement, where the remaining business owners purchase the departing owner’s interest. And finally, there are mixes of the two where either the company or remaining business owners have an exercisable option to purchase, and if the former does not exercise its option, then the latter can purchase. As stated, choosing one of these arrangements primarily depends upon the type of business entity involved, and the particular estate planning objectives of the business owners.
Perhaps most important to departing business owners, is the manner in which the purchase price is determined. This valuation is usually calculated pursuant to a formula created by the business owners or quoted by an independent appraisal. Provisions are also usually added if the departing business owner left on “bad terms.” For instance, if a business owner is ousted “for cause” (which would need to be defined concretely in the agreement), then he or she may have a very low purchase price for the share he or she possesses. Conversely, the agreement could contain provisions which make a more favorable valuation for a business owner departing because of disability or incapacity.
Lastly, what happens in cases of disagreement where a business reaches a stand still because there is a fight between current ownership and past ownership? In such cases, there are various dispute resolution procedures that can be implemented in the agreement that attempt to reach a compromise without causing the business to suffer, or in the worst case scenario, dissolve and wind-up.