If you own a closely held business, the owners/partners will greatly benefit from entering into what is typically called a “Buy-Sell Agreement.” The basic idea is to ensure that ownership shares/units are not sold to third parties without the agreement of the owners. Likewise, the agreement ensures that the shares/units of any departing owner are either sold to the remaining owners or are only sold to a buyer that is acceptable to the other owners.

For example, take a situation where one of four owners dies unexpectedly. According to the deceased owner’s Last Will and Testament, the spouse inherits everything. Well, now the three other still-living owners of the company have the spouse of the decedent on the Board of Directors or Management Committee. That might be very unfortunate for the company’s continuing success. Aside from circumstances involving death, buy-sell agreements also attempt to handle ownership problems associated with incapacity, disability, retirement, individual bankruptcy/lender receivership of an owner, and divorce. There are three common types of buy-sell agreements. These are:

• Owners only — essentially, the ownership units of departing/withdrawing owners must be sold to other owners
• Company purchase — ownership units must be bought by the company — useful option if the ownership interests are balanced; selling to the company will not typically upset that balance for control purposes
• Third party allowed by agreement — sale of ownership units allowed but only if agreed by the remaining owners; can require unanimous consent

Of course, there are other options that might involve splitting control from the right to income. Thus, it might be agreed that a spouse might inherit, but only as a non-voting, incoming-receiving owner.

Aside from these issues, a good buy-sell agreement will have a number of other key provisions. These include:

• Clearly defined “trigger” events — death, disability, divorce, bankruptcy, lender receivership, retirement, etc.
• Limits on encumbering ownership units
• Can there be a forced buyout or a force-out? — suppose an owner wants out; can that owner demand to be bought out?; alternatively, can the other owners force out an owner?
• Price or calculation method — the price can be stated or set out in a defined formula; if the price is to be calculated by an expert, the method should be defined; slightly different calculations might be agreed upon for different triggering events; maybe slightly less for a voluntary withdrawal, etc.
• Dispute resolution for valuation — often, the method used is the “average of [some number of] expert valuation opinions” — consider including an arbitration requirement (arbitration being less costly and avoiding litigation)
• How to fund — life and disability insurance is often used but does not cover some circumstances like divorce, bankruptcy, forced buy-out, or a force-out
• Alternative payment methods — lump sum is desired, but that is not always possible; installment payments are an alternative; details should be agreed to, including the number of payments, interest, etc.
• “Binding on heirs” provisions — the agreement must be binding on an owner’s Estate and heirs; without this, the purpose of the agreement might be defeated
• Specific performance provision — a provision providing the remedy of specific performance is required in case there is a court challenge to the agreement

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For more information, contact the experienced Business Lawyers at Revision Legal. You can contact us through the form on this page or call (855) 473-8474.

Valuation Methods: The Most Litigated Element of Buy-Sell Agreements

If there is one aspect of a buy-sell agreement that generates the most post-triggering-event conflict, it is valuation. Courts have repeatedly held that vague or silent valuation provisions are unenforceable in specific performance actions. The agreement should specify one of four recognized methods:

• Agreed book value. The parties agree in advance on an annual or biennial valuation recorded in a schedule attached to the agreement. Simple and inexpensive, but must be updated regularly — a schedule last updated five years ago will produce a result neither party considers fair.
• Formula-based valuation. Common formulas include a multiple of EBITDA, a multiple of gross revenue, or a combination of asset value and earnings. The formula should specify the measurement period (trailing twelve months, trailing three-year average) and the source of financial data (audited financials vs. tax returns).
• Independent appraisal. Each owner commissions an appraisal from a certified business valuator. The agreement should specify the standard of value — fair market value (used for estate tax purposes), fair value (used in many state dissenter’s rights statutes), or investment value. Discounts for lack of marketability (DLOM) and lack of control (DLOC) can reduce value by 20–40 percent; whether those discounts apply must be agreed upon in advance.
• Shotgun clause. One owner names a price; the other must either buy at that price or sell at that price within a specified period. Effective but aggressive — useful primarily when the parties have equal economic sophistication and resources.

Funding the Buy-Sell: Insurance, Installment Notes, and the Tax Consequences

Life insurance is the standard mechanism for funding a buy-sell triggered by death — the only mechanism that guarantees immediate liquidity. The agreement must address ownership of policies (cross-purchase vs. entity-redemption), policy type (term vs. permanent), and what happens if a policy lapses. A cross-purchase structure, where each owner holds a policy on each other owner, provides a step-up in basis to the surviving owner upon purchase — a meaningful tax benefit that entity-redemption structures do not provide.

Disability is statistically more likely than premature death, yet it is frequently underfunded in buy-sell agreements. Disability buyout insurance is available but expensive and subject to elimination periods (typically 12–24 months before the policy pays out). The agreement must define what constitutes a disability triggering event and specify what happens during the elimination period — does the disabled owner continue to receive distributions?

When insurance proceeds are unavailable or insufficient, installment payments apply. Key installment terms include the interest rate (at least the Applicable Federal Rate to avoid imputed interest issues under IRC § 7872), the payment period (two to seven years is typical), security for the installment obligation (typically a pledge of the purchased units), and acceleration provisions upon default.

Buy-Sell Agreements and Divorce

In community property states — Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin — a spouse may claim a community property interest in an owner’s business units, which can impose an involuntary transfer upon divorce. Even in equitable distribution states, a divorcing spouse will attempt to secure a judgment lien against business interests. The buy-sell agreement must address this scenario with a right of first refusal in favor of the other owners, triggered upon any involuntary transfer including divorce. The valuation for a divorce-triggered buyout should use the same formula applicable to other voluntary withdrawals, preventing a court from imposing a different standard of value in equitable distribution proceedings.

Courts in several states have held that buy-sell valuation provisions in shareholder or operating agreements are binding in divorce proceedings when both spouses were represented by counsel and the agreement was signed with full financial disclosure.

Drafting Checklist: Provisions Frequently Omitted

• Non-compete and non-solicitation obligations triggered upon departure — type of work prohibited, duration, and geographic scope
• Treatment of deferred compensation, retirement plan balances, and phantom stock at departure
• Governing law and venue for disputes — critical for businesses with owners in different states
• Amendment procedure — unanimous consent vs. majority vs. supermajority
• Integration clause ensuring the buy-sell supersedes all prior oral or written agreements on the subject
• Transition services obligation requiring a departing owner to cooperate in the transition for a defined period

Revision Legal’s business attorneys draft and negotiate buy-sell agreements tailored to the specific ownership structure, industry, and exit goals of each client. Contact us at (855) 473-8474 or through the form on this page.