Blog post by Keith R. Butler
When two or more individuals own a business, whether they are related or not, one of the most important details to be addressed is an agreement setting forth the rules they have agreed to regarding disposition of an ownership interest in the event of death, disability, divorce, retirement or termination of employment for any other reason (often referred to as a “triggering event”). As such, it behooves the owners to confront these issues, hopefully in advance of the start (or purchase) of the business. For purposes of this discussion, we will assume the business is a corporation, but the principles apply equally to a limited liability company.
When multiple shareholders form or purchase a business together, their intent is to share the business with each other; not the surviving spouse or other family members of their co-owners. Thus, a buy/sell agreement restricts the ability of anyone other than the immediate shareholders from owning stock. Most agreements provide the corporation and the other shareholders with a right of first refusal to purchase any stock that a shareholder proposes to transfer to a third party.
The most important functions of the buy/sell agreement are restricting transfer, defining which events are triggering events, and setting forth the terms of the sale of stock in the event of a triggering event. The terms typically vary depending on which specific triggering event has occurred. Here are some considerations for each:
- Death. This will result in the largest purchase price, because it can be funded with life insurance. The options for value are either: a fixed amount agreed in advance; a value that will be agreed upon at fixed intervals, such as every 3 years, and if a new value is not selected, value will be per appraisal; and appraised value. The advantage of a fixed amount is the certainty it provides, both in terms of obtaining life insurance to cover the expense, and estate planning for the shareholder. The disadvantage is that it may not reflect the true value of the business, and therefore result in the shareholder’s heirs receiving much less than the deceased’s share of the business is really worth. This is why the agreed value every 3 years or so is an attractive option. It allows the shareholders to reflect an increasing value of stock, and also allow some certainty. If the individuals remain insurable, additional insurance can be purchased as the value increases. The last option is appraisal, which will presumably be the most accurate in terms of heirs receiving actual value, but makes planning a bit more difficult. If the insurance falls short, the corporation or surviving shareholders, as the case may be, must come up with the cash shortfall, though payment can be over time.
- Disability. This option is trickier due to funding limitations. Often I recommend a book value purchase price and having each shareholder procure disability insurance to protect him/her and the family. This will minimize the burden on the company and other shareholders.
- Retirement. Careful consideration should be given to a buyout price for retirement. Upon first consideration, most business owners want a substantial buyout upon retirement. However, depending on how retirement is defined, and when one can retire (such as a minimum age), a substantial buyout can cause a situation where the first one to retire wins in the event of financial struggles by the corporation. It is therefore often best not to address retirement at all, and treat it as termination of employment for any reason other than death or disability. The parties understand that a retirement can be negotiated at the time between the retiring shareholder and the others to produce a fair result for all, taking into account the then business climate and needs of the corporation.
- Divorce. Typically, the spouses of the shareholders sign the agreement, in which they will waive their rights to obtain stock in the event of divorce. Instead, assets of equal value will be substituted. If for some reason a divorce court grants stock to the spouse despite this provision, the spouse agrees to sell the stock to the corporation at fair market value.
- Termination of employment for any other reason. I usually recommend a book value buyout, paid over time. Similar to the retirement situation, a “race for the door” can occur in hard times, and making the buyout too attractive can be counter-productive. Again, shareholders may want a nice big payday if they leave, but they have to realize that they have to live with these provisions if others leave first. Shareholders can also agree on some alternate provisions depending on whether termination was voluntary or not. You can look at this two ways. First, payout for involuntary termination should be higher to protect a shareholder from being ousted by the others. On the other hand, the buyout should be lower in the event a shareholder is not effectively doing his/her job, is not showing up for work or is in any other respect not living up to his/her obligations as an owner and employee of the business. Needless to say, this can lead to lively discussions.
More to come in Part 2, where I will discuss different types of agreements.