One of the most common ways that a small business can be disrupted is when an owner wants to sell or transfer his or her interests the company. As a result, small businesses usually restrict the transfer of ownership in their companies.

Business relationships end for many reasons, sometimes unexpectedly. It is highly probable that there will come a time when of your partners will want to sell his or her shares or interest in the company either to a third party, to the company, or the remaining owners. It is important for business owners to address these issues early on, when the owners can reach an agreement on how to structure these transactions.

A buy-sell agreement ensures that the business remains in the hands of the current owners and provides a ready market for buying out a departing owner. It creates a mechanism for the orderly acquisition of the ownership interest of an owner who leaves the business. A buy-sell agreement describes the circumstances when an owner can sell or transfer his or her interest, obligates the remaining owners and/or the company to purchase that ownership interest, and sets the purchase price and other terms for the sale.

Buy-sell agreements address the following issues:

Ownership

Most businesses have restrictions on who can buy ownership interests in the company so new owners cannot be added without the approval of the existing owners. Frequently, the buy-sell agreement includes a right of first refusal so the remaining owners and/or the company have the option to purchase the interest before an owner can sell his or her interest to a third party.

Trigger events

The most common events to trigger the buy-sell provisions include the following:

• an owner wants to leave the business or retire

• an owner dies

• an owner is divorced and his or her spouse is awarded an ownership interest in the business

• an owner’s employment with the company is terminated

• an owner is permanently disabled

• an owner files for bankruptcy

• an owner is convicted of a felony

Valuation

There are several methods to value a business when a trigger event occurs, including:

• the stated value method where the owners agree on the value of the company

• the formula method, where the owners specify a formula to compute the value of the company

• the appraisal method, where the owners select an appraiser to value the company

Payment terms

Frequently, the remaining owners or the company will not be able to pay the entire purchase price in cash when the departing owner leaves the business. In many cases, particularly if the company is buying the ownership interest, the buy-sell agreement allows an option for a portion of the purchase price to be paid pursuant to a promissory note.

Owners should consider how to determine the purchase price and terms for payment from both sides, as a seller and as a buyer, to reach a fair arrangement.

Business owners also need to consider how the buyout will be funded. The owners may want the company to purchase life insurance and/or disability insurance policies so there is a lump sum of available funds to pay the purchase price in the event an owner dies or is disabled. Additionally, the owners may want to limit the amount the company can commit to the buyout process each year to avoid liquidity issues.

Finally, buy-sell agreements need to be reviewed periodically to be sure they meet the current needs of the owners. For example, the process for valuing the company that was appropriate when the company started out may need to be revised or updated as the company matures. Likewise, insurance policies need to be updated as the value of the company increases.

Buy-sell agreements can be tricky.  Business owners should consult with their legal and tax advisers. For more information, please contact Kathy Tremmel at Tremmel Law, PLLC at (512) 539-0317 or kathy@tremmellaw.com.