Buy-Sell agreements are an essential component for every small business. A properly written and funded Buy-Sell ensures that the business can continue its operations, without a negative ‘hit’ to its cash-flow, while the departing partner (or the departing partner’s estate) receives a fair economic pay-out.
A Buy-Sell agreement is a legal contract outlining the legal rights and obligations of when and how a departing partner’s interest/shares will be obtained by the remaining partners. There are many traps for the unwary, but before we discuss the eight common drafting mistakes with Buy-Sells, there are two fundamental mistakes that business owners make before pen even touches paper:
It is difficult to overcome the second mistake, as most business owners need an extra two to three hours a day simply to run the business. But I would strongly suggest that a Buy-Sell becomes your new priority.
As for the first mistake, I hope you can use this information to help you choose the right attorney and craft the Buy-Sell that works best for your business. There are too many mistakes to list them all, but here are the eight biggest ones:
Mistake 1: Identifying the Key Trigger Events
The conversation that leads to what triggers ‘action’ under the Buy-Sell is critically important. Each business has different goals, and the partners’ situations can all be different. The conversation will lead to the risks (and rewards) for each potential trigger and to create the desired result. It all starts with the list of potential triggers:
Mistake 2: Failing to Properly Fund the Buy-Sell
Once the triggers are identified, now a determination on how to pay based on that event (i.e. buy the interest/shares from the departing partner). The key is to ensure cash flow continues to work both during the funding of the Buy-Sell, as well as when the trigger event is triggered. Life insurance is a way to fund the ‘death’ trigger event, but there is no “divorce insurance” or “I just quit insurance.” So considerations on how those payout will look and impact the business.
Mistake 3: Using a Fixed Purchase Price
Fixing a “sales price” has some merit – it’s amicable and agreed upon, as well as being easy. However, you also do not want to continually amend the pay-out section as your business grows. Or even worse, having an old, stale sales price that does not reflect the current economics of the business.
To mitigate this issue, your Buy-Sell should state that a fair market value should be determined by an appraisal or formula. Of course, even this may be ‘challenged’, so having a process to deal with that situation is just as important.
Mistake 4: Failing to Define Fair Market Value
Your Buy-Sell requires the purchase price to be determined by an appraisal or formula (rather than an agreed-upon fixed price), then the next question will there be any discounts, such as lack of marketability or lack of control, attributed to the fair market value? If the agreement does not include a definition of fair market value, the purchasing owner may have a strong argument that the purchase price for the stock should be discounted, particularly if the equity interest is less than fifty-one percent.
Additionally, it may make sense for the partners to define fair market value differently based on the triggering event. For example, the owners may want fair market value to be determined without discounts for death or disability triggers, but may want discounts applied if the trigger event is the termination of an owner or employee for cause or a divorce in which the owner may lose half of the shares.
Mistake 5: Missing a Right of First Refusal
Many buy-sell agreements fail to address the issue of a partner’s sale of an ownership interest to an outside, third-party. This can be handled with a Right of First Refusal – giving the remaining owners the ability to purchase the interest before the third-party. Though, even those that contain a right of first refusal, the language fails to address some inequities – in one example, a majority owner may exercise the right at less than fair market value; in another, the selling partner may ‘threaten’ a sale to a competitor, thus giving the competitor access to the companies financials and leaving the remaining partners desiring to pay a premium.
The solution is for the right of first refusal to state that the remaining partner(s) has the option to either match the offer made by a third party or use a value determined by an independent appraisal. Moreover, the buy-sell agreement should provide the remaining partner(s) with the option to use the third party’s offer terms or the payout terms spelled out in the buy-sell agreement (e.g., twenty percent down payment and quarterly payments for four years at the prime interest rate).
Mistake 6: Failing to Consider Related Properties or Entities
Buy- Sell agreements should contemplate other interests and entities owned in whole or part by the partners in the primary business. It is one thing to provide for sale of ownership interests and quite another to consider related property. Related property can include life insurance policies on the life of a departing partner, interests in affiliated businesses, or interests in land or other property co-owned by some or all of the remaining owners (such as real estate where the business operates). It can also include intellectual property, leases, or other contractual rights or obligations. Relationships, needs, and interests that were aligned may no longer mesh after a sale. Failure to address these continuing relationships within the Buy-Sell can negatively impact operations down the road. It may not be necessary or advisable to solve all of these issues within the Buy-Sell, but the conversation should be had so each party understands the benefits and risks of including such provisions.
Mistake 7: Missing Terms for Post-Trigger Event Sale
What happens if the business is sold shortly after the trigger event (e.g. death of one of the partners)? If the Buy-Sell is silent, the surviving partner may end up unjustly enriched. The partners should consider including language in the Buy-Sell that addresses the sale of the business during a specified period after a trigger event.
The owners should consider provisions that contemplate the acceleration of any payments remaining due to the departing/deceased partner, as well incorporating language providing that if a sale occurs after a trigger event (within a defined period of time, for an amount in excess of the trigger valuation) the former partner (or the former partner’s heirs) will receive some increased amount. The amount could be on a sliding scale based on how long after the trigger event the sale occurs. Proper guidance and advice will help the partners decide if this type of section is necessary and included in the final Buy-Sell. The important aspect is the conversation to help the business owners decide if it makes sense for their business ownership arrangement.
Mistake 8: Having Down Payment and Covenant Not to Compete
Last but not least, some Buy-Sells require the departing partner (e.g., due to retirement, voluntary termination, or for cause termination) to sell their interest and the remaining owners to purchase the equity interest for a fair market value (as discussed above). The terms of payment often include some down payment, with the remaining amount to be paid over time.
If the down payment is too large, it may put a strain on the cash flow for the on-going business. Further, the downpayment may be, in essence, financing the opening of a competing business by the former partner. Partners should consider including a covenant not to compete in the buy-sell agreement (note: as of this writing on April 24, 2024, the FTC has issued a ban on non-compete. Litigation challenging this ruling is forthcoming, and Buy-Sells will need to be written to adhere to these rules). Further, as many payment terms include a payout of the purchase price over a term of years, the agreement could also include a clause that a former owner who violates the covenant not to compete will forfeit any remaining payments. Such provisions reduce the risk that the former owner or employee will become a direct competitor.
Buy-Sell agreements are critical documents for multi-owner businesses. Getting a Buy-Sell in place is crucial. If you already have one, that is great news, but you should have it reviewed to make sure it still works for your business and all of the partners.
Jim Plitz is an estate planning and business succession planning attorney with the law firm Waters, Tyler, Hofmann & Scott, LLC. Jim is licensed in Indiana, Kentucky, New Mexico, and Arizona.
Jim can be reached at EstateLaw@WTHSLaw.com or 812-949-1114