A Guide to Forming a Buy/Sell Agreement
By Cecile Duhnke Some call them prenups for businesses. Others refer to them as business wills. Still others call them shotgun clauses. Whatever you call them, Buy/Sell Agreements are designed to ensure continuity of ownership in a business when one owner/investor dies or leaves the business. A closely held company’s owners and shareholders change over time, just as life changes. An owner can die, become disabled, retire or simply want to sell out. A Buy/Sell Agreement helps maintain stability in the ownership in the midst of that change. Buy/Sell Agreements offer a formula for owners or shareholders of a company on how to value shares when an owner/shareholder leaves. It can exist as a clause in a business partnership or operating agreement, or it can stand alone. It sets a precedent on these and other decisions: · Who can buy a departing partner’s or shareholder’s share of the business? (Only other partners? Third parties? Family members?) · What events trigger a buyout (death, disability, retirement, bankruptcy, etc.)? · What price will be paid for a partner’s or shareholder’s interest?
Stock Redemption Agreement or Cross‐Purchase?
Two basic forms of Buy/Sell Agreements exist, which directly address the death of an owner. In a Cross‐Purchase Agreement, each owner of the corporation purchases a life insurance policy on the other owners and is named the beneficiary of the policy. In a Stock Redemption Agreement, on the other hand, the corporation purchases life insurance policies for each owner. In either case, the corporation or the other owners use the life insurance policies to redeem the deceased owners’ interest in the corporation.
Drag‐along‐and‐tag‐along Provision
When the majority owners want to sell their company to a third party, a drag‐along‐ and‐tag‐along provision specifies that they can force the sale of the stakes of minority owners. On the plus side for the minority owners, it promises that they receive the same proportionate price as the majority owners.
Shotgun Clause
Especially helpful in two‐person partnerships, Shotgun Clauses dictate that one partner can offer to buy the other out at a price the first partner chooses. The second partner must then accept the sale or buy the company for the same price. Since the clause favors the wealthier partner, the poorer partner may want to add another clause maintaining that the buyout can be funded over time or with profits from the ongoing business.
Right of First Refusal
Many maintain that any Buy/Sell Agreement should be accompanied by a Right of First Refusal, a clause created to prevent a company from being purchased by a stranger. So, if a partner finds an outside buyer for his shares, he must first offer those shares to the existing owners, who must match the outside buyer’s price to purchase the shares at issue. This shields the remaining partners from suddenly having strangers running the company.
The Up‐ and Downside of Using Life Insurance for Funding
Using life insurance to buy out a partner has its upside as well as its drawbacks. These agreements generally benefit both the corporation and the individuals that stand to inherit the remaining shares of the exiting partner. A life insurance claim creates a lump sum of cash to fund the buy/sell agreement at death. The proceeds are usually paid quickly. Life insurance proceeds are generally income tax free. If sufficient cash has built up in the policies, the funds can be used to purchase business interest following retirement or disability.
Cons
There is also a downside to using life insurance to fund the sale of a departing owner’s shares. Here are a few of the wrinkles:
Life insurance premiums are paid with after‐tax dollars. Premium requirements serve as an ongoing expense. Some of the owners may be uninsurable due to age or illness. If the owners’ ages vary widely, younger owners will have to pay higher premiums on the lives of the older co‐owners. You know what they say about an ounce of prevention? Well, it’s worth at least a pound of cure toward reducing the chaos and uncertainty that can ensue when a business partner dies or sells his or her shares. Protect the future of your business by setting up a Buy/Sell Agreement funded with life insurance. But remember, thoroughly research your particular situation, set the agreement up to meet many different contingencies and guard against negative tax consequences.
Structuring Your Buy/Sell Agreement
Here are a few of the questions that you should consider when creating a Buy/Sell Agreement. Should the agreement be structured to: Require the buyer to buy and the seller to sell? Give the buyer an option to require the seller to sell? Give the seller an option to require the buyer to buy? Give a right of first refusal to the buyer?
When an Owner Dies
Should the death of an owner cause an automatic buyout of the deceased owner’s interest? Should the family of a deceased owner be given the opportunity to hold onto the interest in the company?
Buyout Price and Payout
Should the buyout price from the estate or heirs of a deceased owner be addressed? If so, when should it be paid? What interest rate should the price bear? How should the buyout price be addressed with a disabled owner? When would it be paid?
Applicability
Should the agreement apply to current owners or to all owners throughout the life of the business entity? Should the agreement state that it supersedes all other agreements to redeem a business interest? Should the agreement be reviewed annually? This article was written by Cecile Duhnke of Scottsdale, Ariz., especially for infoUSA. Cecile is Marketing Communications Manager with LegalACE (www.LegalACE.com), an online legal document preparation company. For more information, contact her at info@legalace.com or call (866) 434‐3706.