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BUSINESS MANAGEMENT
Buy and Sell Agreements: Planning for "What If"
Bob and Joe are partners in a small, profitable manufacturing business. They work well together and have taken the company from nothing to a major player in the market. Bob dies, leaving all of his assets to his wife, with whom Joe has never seen eye-to-eye. Bob’s wife, however, is now Joe’s partner because there was never a partnership agreement to deal with this situation.
Bill and Janet are shareholders in a construction company. Each of them works very hard in the business and each draws a salary. Bill is badly injured in an automobile accident and incurs permanent mental and physical damages. Bill requires money to live but cannot draw a salary since he is no longer able to fulfill the duties of his employment. Janet wishes to buy Bill’s share of the company but his guardian wants far too much for the share and wants it in cash.
Mary, Jean and Cathy are equal shareholders in a retail clothing store. Cathy has a disagreement with the other two and wishes to sell her shares. She receives an offer from a third party which will give her a significant profit. Mary and Jean do not consent to the transfer of the shares and offer Cathy a fraction of their value. Cathy must sell the shares to Mary and Jean, remain as a shareholder, or seek remedies in the courts.
Each of these scenarios has occurred many times. The consequences are often business failure and long legal battles. During the life of a business, there are many changes. People die, become disabled or have major disagreements. The prudent businessperson will plan for these contingencies and develop a solid formula for their resolution.
A buy-sell agreement (shareholders agreement, partnership agreement) is a must where two or more people conduct business in a partnership or corporate form. The agreement will establish the rules by which the owners operate the business and deal with each other in a variety of circumstances. A properly structured agreement will leave no major contingent event to chance.
The following sections will outline a number of items that are covered by a buy-sell agreement.
Sale of Shares/Partnership Interest When a shareholder/partner wishes to leave a business, he generally has only two places to turn; his partner or a third party. In the absence of a buy-sell agreement, he may be restricted from selling to a third party by the Articles of Incorporation. Conversely, his co-owners may not have any say whether, or to whom, he sells.
Typically the agreement will provide for a first right of refusal for the co-owners in the event of a third party offer. It may also provide a formula for valuation of the shares/partnership interest and payment terms if there is no third party offer. These provisions allow the remaining owners to maintain full ownership of the business if they wish, while giving the selling party access to a fair market value for his/her interest.
Death of a Shareholder/Partner As in the example above, an individual will generally leave his assets to a spouse upon death. Shares in a company or a partnership interest are part of these assets. The surviving owners, therefore, become co-owners with the deceased’s estate, trustee or spouse. This may not be a desirable situation for either side.
A buy-sell agreement will generally provide for a mandatory purchase of the shares/partnership interest by the surviving owners. In this way the deceased’s heirs receive cash or equivalent value for the shares and the surviving owners retain control of the business.
In order to fund such a buy-out the owners will often have life insurance policies on their co-owners. The proceeds from these policies are then used to purchase the deceased’s interest from his estate. These mandatory buy-outs should be structured to provide maximum tax benefits for all concerned.
Disability When a co-owner becomes disabled such that he can no longer discharge his normal duties he becomes a burden on the business. A buy-sell agreement will provide for such an event by invoking a mandatory buy-out of the disabled owner’s interest at the price and terms specified in the agreement. The payment terms usually extend over a period of years so as not to put the business into financial difficulty. There are also insurance policies available to fund such disability buy-outs.
Disagreement It is quite possible that the owners of a business become dissatisfied with their co-owners. The disagreement may be such that they are unable to continue in business together. A buy-sell agreement will provide for a mechanism to enable a withdrawing shareholder to receive fair value for his share of the business. In some cases each of the owners may want to stay in the business, albeit without the other owner. Typically a “shot-gun” clause in a buy-sell agreement will settle the issue.
Retirement Retirement can be a difficult task for the owner of a business. Negotiation of the terms of retirement can be time consuming and emotionally draining. The retiring owner is often at a distinct disadvantage. A buy-sell agreement will set down the terms of retirement including valuation, minimum age and payment schedules.
Governance Issues A buy-sell agreement may also deal with the governance of the business by establishing who will be directors of a company, who will be the officers, what actions may require unanimous approval of the owners. It may also restrict the levels of capital expenditures and the types of business that may be undertaken.
A buy-sell agreement is a fundamental document in the organization of a multi-owner business. Circumstances change over time. Relationships and financial position may not be the same 5 years from now as they are today. Preparing a buy-sell agreement early in the life of a business will benefit all of the owners.
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