Answers to Frequently Asked Questions About Buy-Sell Agreements
|Prepared By: Melissa C. Marsh, Los Angeles Business And Corporate Attorney
Written: March 2009
Q. Isn't A Buy-Sell Agreement Used To Buy And Sell A Business
A. NO. Despite the name, a buy-sell agreement has little to do with buying or selling a business. A Buy-Sell Agreement is a binding contract between shareholders of a corporation, members of an LLC, or co-owners of a partnership (hereafter all referred to as "owners") that sets forth when the owners can sell their interest, who can buy an owner's interest, and what price will be paid. A buy-sell agreement comes into play when an owner retires, goes bankrupt, becomes disabled, gets divorced, dies, wants out, or is being forced out -- in other words, a buy-sell agreement is a sort of prenuptial agreement between business owners.
Q. In a Buy-Sell Agreement, how is an Owner's Interest Valued?
A. The primary goals of any well drafted buy-sell agreement is to: (1) simplify the buy-sell process, (2) keep the accounting and legal fees to a minimum, and (3) ensure fairness for all owners in the event a buyout is triggered. Setting a fixed price or formula on how the business is to be valued is integral to the process. The most common methods used to determine the purchase price under a buy-sell agreement include: (1) establishing a fixed price; (2) using an independent appraiser to determine the Fair Market Value; and (3) using a formula. The goodwill in a business combined with the principal business activities engaged in by the business generally determines the standard valuation methods that should be applied to a particular business. As a corporate attorney for 10+ years, I have found that the simplest method is for the owners to set a fixed price each year based on a formula. If in any given year, the owners cannot agree upon a value, then the owners can agree that: (1) preceding year's valuation will control; (2) the company's CPA will determine the value based on the formula provided; or (3) the owners will select an agreed upon business appraiser to determine the company's fair market value. Valuations provided by an appraiser, however, can be very expensive and typically cost between $10,000 and $30,000 for the small business, and $30,000 plus for a larger business.
Because of the inherent unfairness of a sale at book value and the large expense involved with establishing a purchase at fair market value, most attorneys and CPAs will recommend a formula approach to establish the company's fair market value without a formal appraisal. The formula may be based on the book value plus an arbitrary percentage reflecting the withdrawing owner's share of the business goodwill; or it may be based on the company's net earnings or gross earnings.
Whatever valuation method you select, it is also critical to consider how the owners should be treated under different situations and to have the buy-sell agreement detail those differences. For example, the death of an owner can have a dramatic effect on the value of a business. To remedy this, the buy-sell agreement should clearly state whether the valuation should consider the potential loss in value, if any, from the loss of the owner. In addition, the Buy-Sell Agreement should address whether proceeds from any life insurance are to be factored into the price or valuation. A typical structure is to have some of the proceeds remain in the business to offset any decline in value due to the loss of the principal, with the remainder being used to repurchase the shares.
What if a partner simply wants out? Should that owner be paid the same amount as the surviving spouse of a deceased partner? A buy-sell agreement should set forth the respective rights and responsibilities of the parties in the event of a voluntary departure and involuntary departure such as death or disability. A buy-sell agreement should also consider setting forth a separate formula for an owner who is being expelled for acting against the interests of the business (e.g. fraud) versus an owner who is involuntarily being forced to sell their shares as a result of a difference in opinions and goals or performance issues.
While none of us want to believe that our business relationships will fail, the reality is they often do; sometimes for foreseeable reasons, and sometimes for reasons we never truly considered.
We have assisted hundreds of clients with the preparation of s buy-sell agreement, and we can assist you. We recommend that all corporations with multiple shareholders, all LLCs with multiple members, and all partnerships have a buy sell agreement prepared as soon as possible after formation.
If you would like us to prepare your buy-sell agreement for a low fee (typically about $750 to $1,000), please call us at: 818-849-5206.
Q. How is an Owner's Interest Purchased If A Buy Out Is Triggered?
A. A well drafted buy-sell agreement should provide for terms negotiated and mutually agreed to by the parties. It should not require the company to unduly expend its resources to purchase a departing owner's interest. Typical terms might include a 10 to 20 percent down payment, with the balance payable in equal monthly payments over a two to five year period, with interest on the balance owed at the prime rate. In the event of a death, the down payment might be increased, and if funded by insurance then all, or part, of any insurance proceeds may be payable to surviving spouse. When payment is to be extended over a term of years, the buy-out agreement should also provide additional terms to ensure the departing owner, or his estate, receives the agreed upon buy-out price. To this end, the buy-sell agreement might require personal guarantees from the remaining owners, a security interest in the remaining owner's personal assets, and/or a limit on the acquisition of new debt until the promissory note is paid in full.
We have assisted hundreds of clients with the preparation of a buy-sell agreement, and we can assist you. We recommend that all corporations with multiple shareholders, all LLCs with multiple members, and all partnerships enter into a buy-sell agreement as soon as the business is established.
If you would like us to prepare a shareholder or partnership buy-sell agreement for a low fee (typically about $750 to $1,000), please call us at: 818-849-5206.
Q. What happens if the company needs to buy out an owner, or owners spouse, but can't afford to?
A. Requiring an immediate 100% lump-sum cash buyout can prevent even the most successful business from buying back an owner's interest. An attorney who is not using some form book, who actually knows what she or he is doing, will often provide for a reasonable down payment (10% to 30%) with the balance being paid in equal monthly installments over a period of two to five years with interest at a specified formulaic rate. We don't want to specify an exact percentage interest rate, because interest rates change and we don't want the percentage to be unduly high or low. Having flexible payment terms built into a buy-sell or buyout agreement, signed in advance, can minimize litigation, and in some instances eliminate it.
Q. Why Your Buy-Sell Agreement May Need To Be Updated?
A. Ideally, a Buy Sell Agreement should be reviewed once a year. An annual review of your buy-sell agreement can help ensure that it takes into consideration any changes that may have occurred both in your business, and in the owner's personal lives. Small businesses should have this important agreement reviewed regularly by their accountant and attorney for two reasons: (1) changes in the law do in fact occur; and (2) changes in the structure and operations of the business may impact some of the buy-sell agreement's provisions.
The terms that should be reviewed, and possibly revised, on an annual basis include:
- Restrictions on the Transfer of Ownership Provisions. Typical provisions restricting the transfer of ownership in a Buy-Sell Agreement include: (i) requiring the consent of all of the other owners; (ii) allowing each of the owners to transfer their ownership interest to a permitted transferee; (iii) providing the business entity and then its owners with a "right of first refusal" before any bona fide third party offer to purchase may be accepted; and (iv) requiring a buy-out upon the death of an owner, disability of an owner, and/or upon termination of employment of an owner.
- Purchase Price, Valuation and Payment Provisions. The purchase price and payment terms of the possible buyout of the ownership interest of the entity is extremely important and should be reviewed often. These provisions should contain either an agreed-upon value for the business, or a formula method to establish the value. We shy away from recommending the use of an independent appraisal if a value or formula method cannot be agreed upon between the parties because of the expense. These provisions should also address whether life or disability insurance policies will be purchased to fund a potential buyout. The payment terms should also provide whether there will be a lump-sum payment or an installment payment via a promissory note. Additionally, these provisions should specify to whom any excess insurance proceeds above the purchase price will be distributed.
- Dissolution Provisions. The circumstances under which the business entity can be dissolved, the process of dissolution, and how distributions of the company's assets are to be made among the owners are critical terms to be reviewed in a Buy-Sell Agreement. Additionally, it is important to determine whether these decisions require majority, or unanimous consent.
If a Buy-Sell Agreement needs to be updated due to changed circumstances such as a new owner, new spouse, or other personal matter, this can be accomplished in two ways. We can prepare either an amendment to the buy-sell agreement, which revises select provisions, or we can prepare an amended and restated buy-sell agreement, to replace the entire then existing buy-sell agreement.
If you would like us to prepare or update a buy-sell agreement for your California corporation, California limited liability company, or partnership for a low fee, please call us at: 818-849-5206.
Ms. Marsh provides various low cost In House Counsel Plans
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California business lawyer, Melissa C. Marsh, is based in Sherman Oaks and West Hollywood, and serves individuals and 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.
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