Small businesses often place restrictions on the transferability of ownership interests in these companies. It is best to have considered the issues relating to both the transferability of ownership and the termination of the relationship among the owners early on, when the owners can agree on how to handle these matters.
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. Relationships end for many reasons and sometimes unexpectedly. It is highly probable that there will come a time when one of your partners will want to sell his or her shares or interests in the company.
Businesses owners use Buy-Sell Agreements to ensure that their business remains in the hands of the current owners and to provide a ready market for buying out a departing owner. A Buy-Sell Agreement creates a mechanism for the orderly acquisition of the ownership interest of an owner who leaves the business. The Agreement creates a binding legal obligation for the owners to buy and sell an interest in the company, and sets the purchase price and the terms and conditions of the purchase.
Buy-Sell Agreements address the following issues:
- Ownership. Restrictions on who can buy ownership interests in the company. In most cases, 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 events that trigger the Buy-Sell provisions. The most common events 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. The value of the company when a trigger event occurs. There are several methods to value a business, including:
- The stated value method — the owners agree on the value of the company
- The formula method — the owners specify a formula to compute the value of the company
- The appraisal method — the owners select an appraiser to value the company.
- Payment Terms.The terms for paying the purchase price to the departing owner. 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. For more information, please contact Kathy Tremmel at Tremmel Law, PLLC at (512) 539-0317 or email@example.com.