Do the organizational documents of your business include a buy-sell agreement? If not, are you aware of the complications that can arise without one? In this blog, we’ll walk you through what a buy-sell agreement is and the advantages of having one.
It is common for the organizational documents of a business (articles of incorporation and bylaws or the operating or partnership agreement) to include certain transfer provisions restricting how and when an ownership interest can be transferred to a third party. Typically, a majority or unanimous vote of the non-selling owners is required for an owner to transfer their interest.
Sometimes, through a right of first refusal provision, owners must first offer the ownership interest for sale upon the same terms to the company and non-selling owners before a sale with a third party can take place. Transfer provisions such as these allow privately held business owners to control who they are joint owners with. A buy-sell agreement can help ease the transition of a business.
A buy-sell agreement is a supplemental legal document often used to sell ownership interests upon several different events, including voluntary transfers (the death or disability of an owner) or involuntary transfers (marital dissolution or an owner's bankruptcy). A buy-sell agreement usually references the use of "fair market value" as the standard of value to be used, along with the payment terms of the potential transaction scenarios (percent down, remaining balance payment term and stated interest rate).
In the past, it was not uncommon for a buy-sell agreement to define a formula for value, such as the book value per share or a multiple of last year's income. However, in our experience, the strict definition of value tends to cause problems over time as there can be a divergence between the defined value calculation and the actual fair market value. In addition, the courts have tended to rely upon fair market value instead of an outdated calculation contained in a dated buy-sell agreement when disputing legal cases.
Potential Issues When a Buy-Sell Agreement is Not Maintained
As business appraisers, we frequently encounter situations where a business owner passes away unexpectedly, leaving the remaining owners to establish who will buy out the deceased owner's interest. Without adequate planning, the required buy-out payment due to the deceased owner's estate could jeopardize the solvency of the business or fray the relationship with the deceased member's family. These situations could be prevented with proper planning.
There is also a wave of baby boomers looking to transition their interests in closely held businesses or the unexpected desire of a partner to leave the business. It is never too early to begin planning for these transitions, with increased importance placed on identifying possible replacements or establishing stock transfer or stock compensation programs to ensure the continuity of the business.
Proper Establishment and Maintenance of Buy-Sell Agreement
If you own a closely held business and a buy-sell agreement has not been adopted, we highly recommend working with an experienced corporate attorney to formalize an agreement for your company. Even if there are limited owners and you have no current worries about business transition, it is still a good idea to formalize an arrangement in the case of an unexpected event.
Once the buy-sell agreement has been established, calculating the fair market value pursuant to the buy-sell agreement and having all owners acknowledge and agree to the value computation procedures is imperative. Doing these procedures before they are needed is beneficial. We encourage implementing an 'annual certificate of value' that is completed by an accredited valuation professional, followed by annual updates after the completion of year-end tax or accounting work. This establishes a continuity that helps mitigate potential problems using the buy-sell agreement provisions.
Please contact us if you would like to discuss establishing and maintaining a buy-sell agreement or have any other questions!
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