The Company Buy-Sell Agreement
Incredible Result: “We will have only the right Owners at all times.”
Avoidable Train Wreck: Company ownership is not correctly controlled or funded with the right buy-sell- hold options.
Main Play: The Company Buy-Sell Agreement
What This Is: Your Owners have agreed to help protect ownership with transfer restrictions and specific, realistic pricing, proper life insurance funding and payment terms for share purchase upon each Owner’s death, disability, divorce, departure or dispute, with bring-along rights if the majority Owner decides to sell the Company.
Every owner in an American enterprise is free to transfer his or her shares to whoever he or she would like. And none of your fellow owners are required to ever purchase your shares. That is the American way. Yet that can produce many undesired results. You could find yourself with partners you don’t want and you could find yourself without the ability to sell your shares. So, how are Family Business Pioneers fixing this?
The Company Buy-Sell Agreement
A Buy-Sell Agreement is a critical Fourth Quarter Planning tool. This is an agreement amongst the co- owners of a business which addresses the times and the terms for the future purchase or sale of stock of a company. In a sense, this type of agreement is your own private stock market.
Unlike a public stock exchange, under this private stock market, you and other co-owners are not necessarily free to buy and sell stock to whomever you may please. However, this type of private stock market does create the ability to have some circumstances in which your stock can be purchased or in which you can cause the purchase of another co-owner’s stock.
In addition, this type of agreement provides the ability to restrict co-owners from selling their shares to an outside party which the core owners do not want to share company ownership with. In this sense, it also acts as a very solid protective measure for the business operations.
Buy-Sell Agreements are prepared based on the needs and objectives of the co-owners. Included below are the various types of provisions which, along with proper price and payment terms, should generally be included, or considered for inclusion, in a Buy-Sell Agreement.
- Transfer Restrictions. Owners of a closely held company should not be without limitation on their ability to transfer their shares to outsiders. Co-owners have some right to expect that they can choose their fellow co-owners in a closely held company. However, American law typically does not permit an absolute restriction on the right of an owner to transfer his or her shares. Therefore, the most common type of transfer restriction used in a Buy-Sell Agreement is the right of first refusal. Under this provision, if an owner wishes to transfer his or her shares to a third party, that owner must first offer the shares either to the Company and/or to the other owners for sale on the same terms and conditions that would be offered to the outside third party. This provides the Company and the other owners with the option to purchase the shares, thereby retaining ownership of the Company within the closely held group of owners. Typically some exceptions would be made to this right of first refusal to enable owners to transfer shares to their spouse and family members, as well as a living trust for estate planning purposes.
- Purchase Upon Death. This type of provision operates in one of two ways. First, this can provide the Company (and the other owners) with an option to purchase the shares of an owner who has died. Alternatively, this provision can give the estate of the deceased owner the option to sell (i.e. to “put”) the estate’s shares to the Company (or the other owners). This gives the Company and the other closely held owner group the option to control share ownership without letting it become disbursed throughout a fellow owner’s family, in particular when that owner is no longer around to provide some control over potential disputes within the family. The alternative approach also provides some liquidity to that owner’s estate by providing a limited market for the shares in exchange for cash at some pre-agreed value method. It’s critical that your Life Insurance Portfolio be carefully designed with your professional Insurance Advisor so the death options under your Buy-Sell Agreement are properly funded.
- Purchase Upon Total Disability. This provision can also be established in one of two principal ways. The Company (and other owners) can have an option to purchase the shares of an owner who has become totally disabled. Alternatively, the disabled owner can have an option to sell the shares to the Company (and/or other owners). This again provides the Company and the closely held owner group with the ability to pull in shares from an owner who is no longer active, whereas the alternative provision provides an ability for a disabled owner to have a limited market for the sale of his or her shares in exchange for cash.
- Purchase Upon Termination of Employment. A termination of employment provision in a Buy-Sell Agreement will give the Company (and/or the other owners) the option to purchase an owner’s shares upon termination of employment. Alternatively, the provision may give the terminated owner an option to sell his or her shares to the Company (and/or the other owners). This provides the Company with the option to call in the shares, depending on the circumstances of the termination, whereas the alternative provision gives a terminated owner a limited market for his or her shares upon termination. When the owner receives the shares as a share bonus, then it is possible that the share pricing upon termination of employment might be less than fair market value. In addition, it is possible that the owner/employee would not yet be fully vested in all of the shares he or she owns. These terms could be set forth in the Buy-Sell Agreement, or in a separate agreement relating to the share bonus program.
- Purchase Upon Bankruptcy. It is common to include a provision that enables the Company to call in the shares if an owner was to declare bankruptcy. This helps to provide the Company with the option to disentangle itself from the individual financial problems of an owner.
- Purchase Upon Divorce. Typically, if an owner is involved in a divorce from his or her spouse, and as a result of the divorce proceedings is not awarded the shares in the Company, then, to prevent disputes and business disruptions which might be caused by the marital separation, the owner member of the couple who was initially issued the shares would typically have an option to purchase these shares from his or her spouse, with a secondary option to the Company (and/or the other owners) if the first option is not exercised.
- “Texas Shootout”. In a “Texas Shootout”, the owners are given the ability to each go their separate ways. This type of provision would more frequently be included in an agreement where you have roughly equal owners. If an owner wishes to separate, then he or she can make an offer to sell all of his or her shares to the other owner upon stated pricing, terms and conditions. The other owner either must accept the offer, or refuse the offer, in which case, the initial offering owner must purchase the shares of the declining owner at the same price, terms and conditions initially offered.
- Drag-Along Option. This type of provision typically exists when a majority owner or group of owners wish to sell the shares of the Company to an outside third party. Since an outside third-party would most likely want to be able to purchase 100% of the shares, this provision gives the majority owners the right to require the minority owners to sell their shares on the same price, terms and conditions which the majority owner is receiving.
- Tag-Along Option. Under this provision, a minority owner would have the option to require that a majority owner include the minority in a transaction for the sale of the share of the Company. This would occur, for example, when the majority owner did not exercise a drag-along option, but the minority owner, nevertheless wanted to be included in the sale.
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