Buy-Sell Agreement for Shareholders of a California Corporation Explained
|Prepared By: Melissa C. Marsh, Los Angeles Business And Corporate Attorney
Written: March 2009
A shareholder buy-sell agreement is also commonly referred to as a shareholder agreement and a shareholder buy-out agreement. If your California corporation will be owned by more than one individual (excluding a husband and wife and domestic partners) having a Shareholder Buy-Sell Agreement is crucial, but often put off until it is too late. Have you considered what will, or should, happen if you want to force a shareholder out, or if a shareholder just wants out? How much is that shareholder's interest worth and how will it get paid? The reality is, no one wants to engage in this type of discussion especially when all of the shareholders resources are being used to finance the business. But this can be a very costly mistake since 85% of all business relationships fail primarily because of disputes on how to run the business, but also because of factors beyond the business owner's control (e.g. death, disability, divorce, personal bankruptcy, etc.). By having an attorney prepare a shareholder buy-sell agreement with a predetermined valuation method for the business, the owners of a small, privately held corporation can: (1) protect the value of their business interest for their heirs; (2) protect the business from interference from third parties (ex-spouses, creditors, and the beneficiaries of a deceased owner); and (3) provide an orderly means to divide the business if a shareholder wants to be bought out, is being forced out, or worse, becomes disabled, dies, files for bankruptcy, or gets divorced. This is why many banks will often require a privately held corporation to have a buy-sell agreement before it will issue a loan, and why many bonding companies will insist a contractor have a shareholder buy-sell agreement in place before agreeing to provide bonding for a construction job.
What is a Shareholder Buy-Sell Agreement?
Simply put, a shareholder buy-sell agreement is a binding contract between the shareholders (owners) of the corporation that sets forth (while everyone is getting along and willing to be fair) the terms and conditions of a future sale of their interest in the corporation if a triggering event occurs. A shareholder buy-sell agreement will typically set forth: 1) what events will trigger a buyout (e.g. death, disability, bankruptcy, divorce, retirement, etc.); 2) the price that will be paid for the shareholder's interest in the business, which may vary depending on the type of triggering event; and 3) who can buy an owner's interest in the business (e.g. outside third parties, just other shareholders, or just the corporation itself). In the absence of a shareholder buy-sell agreement, each shareholder of a corporation will typically spend tens of thousands of dollars on having their own business valuation prepared and litigating each other in court.
What Happens When a Corporation Does Not Have a Buy-Sell Agreement.
First, when there is no written shareholder buy-sell agreement is in place, the chance of being forced to litigate is greatly increased. Cha Ching for us lawyers and forensic accountants. Shareholder disputes often wind up costing, on average, over $50,000 to resolve because the experts alone that are needed to testify about the value of the corporation often charge over $20,000 to perform a forensic evaluation of the business. To make matters even worse, if the dispute is not resolved before trial, the outcome may be quite different than what the shareholders of the corporation would probably want, or expect, to happen.
If a Shareholder of a Corporation (“Owner”) Dies, What Happens?
Absent a written shareholder buy-sell agreement with provisions to the contrary, California law provides that the deceased shareholder's heirs will step into that shareholder's place. In essence, this means that the surviving shareholders could be forced to operate the business with the deceased shareholder's spouse, children, other relative, or friend. However, a well written shareholder buy-sell agreement can change this default by providing a formula to will value deceased owner's interest in the business and a means to pay out that interest to the deceased owner's estate either in a lump sum payment, or over a period of time.
What Happens if a Shareholder Becomes Disabled?
California law provides that absent a written shareholder buy-sell agreement, if a shareholder becomes disabled, the disabled shareholder still retains his or her shares and profit participation as if nothing had occurred. This means that despite not having any participation from the disabled shareholder, the disabled shareholder will still be entitled to his or her share of the profits. To avoid this prospect, a shareholder buy-sell agreement will typically first provide a definition of what constitutes being disabled, and then will provide a mutually agreeable solution that will fairly compensate the disabled shareholder, but more effectively enable the business to continue operating.
What Happens if an Owner Gets Divorced?
Absent a written shareholder buy-sell agreement, if an owner gets divorced, the other owners of the business will likely find that they have a new shareholder that has been involuntarily imposed on the business by a court. In California, the former spouse of a shareholder may claim not only his or her rightful monetary interest in the corporation, but also the right to actively participate in the business of the corporation. Consequently, where there was one shareholder with say 100 shares, now there will be two shareholders, each with 50 shares. Alternatively, the divorcing spouse’s attorney and the court might get involved and ask the corporation to expose its books. To avoid these prospects, a shareholder buy-sell agreement will generally require the former spouse of a divorced shareholder to sell any interest received in a divorce (or divorce settlement) back to either the corporation, or the other shareholders, at the price set forth in the shareholder buy-sell agreement.
Now Isn't A Buy-Sell Agreement Looking Attractive?
The above is just a small sampling of what can occur when a corporation fails to execute a shareholder buy-sell agreement. Nevertheless, most California corporations fail to prepare and execute a shareholder buy-sell agreement because attorneys typically charge $2,500+ for a shareholder buy-sell agreement. However, my years of experience has enabled me to provide you with a customized shareholder buy-sell agreement for about $750 depending on how complicated the individual shareholders want to make it. The key to a successful buy-sell agreement is providing mutually agreeable buy-out terms (which may vary based on the situation) that will ensure a quick, reasonable, and mutually agreed upon payment without the hassle and expense of going to court, paying multiple appraisers, and paying exorbitant legal fees. Different purchase prices may be assigned to different transfer events and the corporation can set the value of the business on a yearly basis when the corporation's tax return is prepared and filed. For instance, in the event the owners mutually agree someone has to go, the purchase price might be equal to 100 percent, but in the case of a buyout due to an owner just wanting out, it may only be 80 percent of the established value.
What Events Typically Trigger A Buy-Out?
A shareholder buy-sell agreement generally should require a buy-out in the event a shareholder purposely commits certain acts that intentionally harm the corporation and expose the other shareholders to personal liability (such as fraud), dies, becomes permanently disabled, files for bankruptcy (so the court does not take control of the shares, or simply wants out. In addition, a shareholder buy-sell agreement can provide that in the event a shareholder gets divorced that the other shareholders and the corporation will have the right to purchase the stock, or business interest, acquired by the former spouse. More often than not, the shareholders in a privately held corporation don’t expect or want to deal with an owner's spouse. But that is exactly what might happen if there is no written buy-sell agreement in place.
A well-drafted shareholder buy-sell agreement will also provide a right of first refusal if a shareholder wants to sell to a third party. The right of first refusal is typically first given to the corporation and then to the remaining shareholders. The agreement typically requires the person exercising the right of first refusal to purchase on the same terms and price as offered by a third party.
Any new business will inevitably see its partners, members and shareholders come and go. A carefully drafted buy-sell agreement will promote the goal of allowing the corporation to continue while fairly compensating the departing shareholder. Failing to execute a buy-sell agreement can lead to a total upheaval in the business, many trips to the lawyers, and possibly to bankruptcy or a court ordered dissolution of the business.
Over the past 15 years I have seen the devastation that can result when the shareholders of a corporation neglect to execute a shareholder buy-sell agreement. We strongly recommend that every California corporation with two or more shareholders enter into a shareholder buy-sell agreement as soon as possible after incorporating. If you would like our assistance, please call us at: 818-849-5206.
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California business lawyer, Melissa C. Marsh, is based in Sherman Oaks and West Hollywood, and serves businesses throughout Los Angeles County, including: West Hollywood, Miracle Mile, Beverly Hills, Century City, Santa Monica, Burbank, North Hollywood, Valley Village, Toluca Lake, Studio City, Sherman Oaks, Van Nuys, Encino, and Woodland Hills.
© 2009 Melissa C. Marsh. All Rights Reserved.