Published May 30, 2014 | Updated June 16, 2014
by Kathy Tremmel, Business Attorney
A Buy-Sell Agreement is the Members' Exit Strategy
A Buy-Sell Agreement is designed to create a mechanism for the orderly acquisition of the membership interest of a member of an LLC or a corporation on the happening of a specified triggering event. 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.
Relationships End for Many Reasons, Sometimes Unexpectedly
Small businesses in particular tend to be closely held and the owners generally desire to keep things that way. These owners often place restrictions on the transferability of the shares or interests in these companies where circumstances call for a change in ownership. It is best to have considered the issues relating to both the transferability and the termination of the relationship before the parties end their business relationship.
One of the most common ways that a small business can be disrupted is when an owner desires to sell or transfer his interests the company. It is risky to believe that your co-owners will still be with you five years down the road. It is likely that there will come a time when of your co-owners will want to sell his or her shares or interests in the company to someone else.
Buy-Sell Agreements Are Like Insurance Policies
It is a cost of doing business that you hope you never need, but when you need it, you are really glad you purchased it. A good Buy-Sell Agreement is an important part of your business plan. No prudent business person would invest in a new business without first creating an exit plan. Without a Buy-Sell Agreement, at the time an owner wants to leave a business it is unlikely that everyone will agree on how to end their business relationship and how much money will change hands!
- What events trigger the Buy-Sell? Common events that should be considered include:
- A member wants to leave the business or retire
- A member’s death
- A member’s divorce
- A member’s termination of employment with the company
- A member is permanently disabled
- An event of default under the operating agreement
- A sale of a majority of the ownership interests of the company
- A member files for bankruptcy
- A member is convicted of a felony
- Who can buy the interest? Should the company have the right to purchase shares or the individual owners? The most common provision in a buy-sell agreement is a right of first refusal where the owner who wishes to sell his interests first offers it to his co-owners before anyone else.
- Should the company prohibit transfers of interests to certain persons or not allow transfers without the written consent of the other owners?
- Should an owner be able to give away his interest? Often owners wish to grant their interests in a company to a trust for estate planning reasons. This could be problematic because technically the trust would own the shares of the business.
- Which events are mandatory purchases and which merely give the company and other members an option to purchase? Some triggering events such as termination of employment or death of a member are almost always mandatory purchases.
- How will the company be valued? A very important task of the Buy-Sell Agreement is to state how the purchase price will be calculated. There are several methods to value a business:
- Stated Value Method: The members agree on the value of the LLC, they state the value in the Buy-Sell Agreement. It is important that the members update the price regularly because the price always changes.
- Formula Method. The members agree on a formula to compute the value of the company.
- Appraisal Method. The selling member and the company mutually select an appraiser to value the LLC, but if they cannot agree, each party selects an appraiser (and pays the cost thereof) and the value of the LLC is the average of the two appraisals. If the difference is too great, the two appraisers select a third appraiser (the cost is split) and the value determined by the third appraiser is the value if it is between the first two appraisals.
- How much can the company spend on the buy out process? Are there restrictions on the amount the company can commit to each year in the buy out process so as to avoid liquidity issues that may bankrupt the company?
- How will the buyout be funded? An excellent way to fund the purchase of the interest of a deceased member is for each member to purchase a life insurance policy on the life of the other members.
- What are the terms and conditions of the purchase? Once a member becomes obligated to sell and the company or other members become obligated to buy, the Buy-Sell Agreement sets the terms and conditions applicable to the sale, particularly how the purchase price will be paid (cash and/or promissory note), any guaranties of payment on the promissory note, and specifies the time for payment.
Article and information is courtesy of Kathy Tremmel, Business Attorney at Tremmel Law, PLLC. Amplify Credit Union does not endorse or guarantee the perspectives, the advice, the users, the businesses, or the products or services sold by any users or businesses that appear in this article.