Maximizing Your Buy-Sell Agreement
Christopher Kramer, Managing Director, Strategic Equity Group
Most entrepreneurs primarily focus on growing their businesses. Corporate issues like buy-sell agreements, and the details contained in those agreements, are usually given much less attention than issues involving growing sales, addressing the competition, etc. This is especially true in high-growth companies, where entrepreneurs have time to do little else but run the day-to-day aspects of their fast-paced, growing companies.
A properly drafted buy-sell agreement contains the important terms that are to be followed in the event of a transition in the ownership of a business. Carefully considering the terms of such an agreement so that the wants, needs and desires of all business owners are met in a fair and consistent manner can ensure that ownership changes happen in a relatively pain-free manner.
Indeed, hastily constructed agreements, where the wishes of shareholders have not been adequately addressed, can lead to disastrous consequences. When it comes to buy-sell agreements, the devil is truly in the details. The following bullet points should be considered whether you are crafting your first buy-sell agreement or looking for tips on how to ensure that your current document addresses your intentions and those of your business partners when it is time for a shareholder to leave.
- Review your buy-sell agreement once each year. A routine review of the agreement can help business owners ensure their document takes into account changes in personal circumstances or changes in the business itself. Do not put the agreement in a file and forget about it. Just like people, businesses are dynamic, changing entities. The number one reason business owners get into disputes, even when they have a buy-sell agreement in place, is that the circumstances of the shareholders or the company have changed and the agreement has not been updated to reflect new shareholder desires
- Draw the distinction between ownership and employment. Especially in the early stages of a company’s growth and development, the lines between ownership and employment are often blurred. As the company gains traction and begins to stand on its own, it is important to not only separate the benefits of ownership from those of employment, but to consider the impact one may have on the other in the event of change. For example, an active shareholder/owner may want to voluntarily pursue other activities on a day-to-day basis (i.e., no longer remain employed by the business), but still maintain ownership. Is this provided for in the agreement? Is it acceptable to all shareholders? How do the circumstances surrounding their departure impact their rights and responsibilities? Are they treated differently if they leave voluntarily as opposed to being forced out? Is this provided for in the agreement?
- Ensure your agreement very specifically details what happens when one of the following events occurs:
The death of a shareholder can have a dramatic effect on the value of a business, especially when the business is in its early stages or growing very rapidly. The buy-sell agreement should clearly state whether the valuation should consider the potential loss in value, if any, from the loss of the entrepreneur. Other issues should also be detailed in the agreement, including whether proceeds from any life insurance are to be factored into the valuation. A typical structure is to have some of the proceeds remain in the business to offset any decline in value due to the loss of the principal, with the remainder being used to repurchase the shares.
- Voluntary Departure
The agreement should set forth the respective rights and responsibilities of the parties in the event of a voluntary departure, which may be very different than a death or disability. Further, you may want the rights and responsibilities for shareholders who leave to start a competing firm to be different from shareholders who simply want out of the business for another reason. Keep in mind that the value of the company may also be impacted by the terms of a key person’s departure.
- Involuntary Departure
In instances like these, the treatment of the departing shareholder may depend upon the circumstances surrounding the involuntary departure. A person’s who is asked to leave as a result of a difference in goals and objectives may be viewed very differently and have different rights and responsibilities than a person who leaves because of performance issues. This is an especially important consideration when it involves an individual who was brought in to grow the company and received stock as a performance incentive.
- Ensure your agreement has very specific language regarding valuation of the shares under various scenarios. The valuation of a business, especially in a high-growth scenario, is more art than science. A complex capital structure, such as one that typically arises when venture capital or other outside investment has been obtained, can make the exercise of business valuation more challenging. Finally, an interest of less than 100.0% will further complicate the valuation process because ownership interests of less than 100.0% may be subject to discounts (i.e., may not be worth a proportionate amount of the total).
That being said, any valuation must be forward looking and consider the present value of future benefits. In a high-growth scenario, this can be especially important, as historical results rarely capture the underlying value of what has been built. The employment role of a departing shareholder and the circumstances surrounding his or her departure may have significant impact on the future of the business. Your buy-sell agreement should allow for this by providing guidance as to how shares should be valued and what business assumptions are appropriate.
- If a valuation formula is set forth in the agreement, it must be flexible enough to account for the future prospects of the business. A company that just signed a significant new contract must be worth more than a company that just lost one, even though all of the financial information would look the same at a given point in time.
- If the agreement calls for the valuation by a third party, sufficient guidance should be given to the third party to account for the issues previously discussed (i.e., consideration of the circumstances surrounding the departure of a key employee).
- Language with respect to whether discounts are to be considered should also be included, especially for interests representing less than 33 and 1/3 percent (in California, anyway).
- The terms of payment for the shares and the source of the payment should be carefully considered and aligned with the language in the buy-sell agreement under various repurchase scenarios. While key-person life insurance is the most common funding mechanism in the event of the death of a shareholder, careful consideration must be given to how a buy-out of a shareholder will be financed and put into effect in a repurchase not involving the death of a shareholder.
While all possible scenarios can never be fully anticipated or documented in a buy-sell agreement, most agreements fail to address the particulars of even the most likely scenarios that would trigger their terms. In some cases, hastily drafted buy-sell agreements can actually create more areas of disagreement than they resolve. As a result, it is critical to consider how shareholders should be treated under different scenarios and to have your buy-sell agreement detail those desires. While none of us wants to believe that our association with our shareholders may some day come to an end, as it relates to buy-sell agreements, it is always good to remember that “the devil is in the details.”
Editor’s Note: The information in this article is provided for educational and informational purposes only. This information does not provide legal or other professional advice and is not the substitute for the advice of an attorney. If you require legal advice, you should seek the services of an attorney familiar with your specific legal situation and the laws of your state.
© 2006 Christopher Kramer. All rights reserved.