Updating Your Buy-Sell Agreement

Nikolaos Tsouros LL.M.
December 6, 2007 — 1,897 views  
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During the formation of a closely held business, such as a Corporation, Partnership or Limited Liability Company, attorneys frequently prepare Buy-Sell Agreements for their clients. A Buy-Sell Agreement (also know as a Shareholders Agreement, Limited Partnership Agreement, Limited Liability Company Operating Agreement) is a contract among the owners that addresses numerous issues relating to the business entity such as operations, management, voting rights, transfer of ownership, purchase price/valuation of the business, buyout payment terms as well as what occurs upon the dissolution of the business entity. In the absence of a Buy-Sell Agreement, these issues are governed by the laws of the state where the business entity was created or, if necessary, by a judicial proceeding.

Small businesses should have this important Agreement reviewed regularly by their attorney and their accountant to determine whether the Agreement meets the owners' current needs, and to ensure it is in compliance with any changes in the laws governing Buy-Sell Agreements. If a Buy-Sell Agreement needs to be updated due to changed circumstances such as a new owner or other personal matters, or needs updating to include current provisions, this can be accomplished in two ways. Your attorney can prepare either an Amendment to the Agreement, which revises only select provisions, or an Amended and Restated Buy-Sell Agreement, which replaces the current Buy-Sell Agreement.

Types of Buy-Sell Agreements
There are three basic types of Buy-Sell Agreements: a Redemption Agreement, a Cross-Purchase Agreement and the Hybrid Agreement. The Redemption Agreement is a contract between the owners and the business itself, whereby the business entity agrees to buy the offered ownership interest upon the occurrence of the specified event causing the transfer of ownership. A Cross-Purchase Agreement is a contract among the owners only and the business entity itself is not a party, whereby the owners agree to buy all of the offered ownership interest. A Hybrid Agreement is a combination of the Redemption Agreement and the Cross-Purchase Agreement whereby both the business entity and the remaining owners are able to participate in purchasing the offered ownership interest. It is important to note that each type of Buy-Sell Agreement has different tax consequences, which must be considered before making a decision on the type of agreement to choose. The consideration of these tax consequences is beyond the scope of this article but should be reviewed in detail with your attorney and accountant.

Terms That Should Be Reviewed Regularly
Terms of a Buy-Sell Agreement that should be reviewed regularly include:

Restrictions on Transfer of Ownership Provisions
In order for a Buy-Sell Agreement to establish a value for federal estate tax purposes it must have restrictions on the transfer of ownership. Typically, provisions restricting the transfer of ownership in a Buy-Sell Agreement are as follows: (i) requiring the consent of all of the other owners; (ii) transfers may only be to a family member; (iii) owners/business entity has a "right of first refusal" for any bona fide third party offers, (iv) transfer upon the death of an owner, (v) transfer upon the disability of an owner, or (vi) transfer upon termination of employment or retirement of an owner.

Profit and Loss Provisions
The provisions governing the allocation of profits and losses under a Buy-Sell Agreement should be reviewed from time to time to determine whether they need to be updated. Usually such provisions are based upon to the ownership interest of the business entity, but there are special circumstances for a Limited Liability Company or Limited Partnership whereby the profits and losses may be based upon a special allocation method due to the nature of the owner's participation in the operations of the business or capital contributions.

Control and Management Provisions
The provisions of a Buy-Sell Agreement regarding the authority of the owners to make decisions for the business, voting rights and procedures, and the duties of the owners of the business should be reviewed frequently to ensure no changes are required. Whether an action taken by the owners requires unanimous consent or majority consent is a major consideration in the event there is a disagreement regarding a decision for the business.

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. An independent appraisal may also be used if a value or formula method cannot be agreed upon between the parties. 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 a business entity can be dissolved, the process of dissolution and how distributions of assets are made among the owners are also critical terms to be reviewed in a Buy-Sell Agreement. Additionally, it is important to determine whether these decisions require majority or unanimous consent.

Suggested Additions to Buy-Sell Agreements

Transfer of Interest Provisions
There are a variety of circumstances in which the ownership interest of a business may need to be transferred, including the divorce or death of an owner, and it is important to plan for these events. With respect to the possible divorce of an owner, a transfer of ownership interest provision can be added to establish whether or not such ownership interest may be transferred to a former spouse, and if so, that such former spouse will be required to sign and abide by the terms of the Buy-Sell Agreement. Another transfer provision that may be added is a transfer upon conduct by an owner that constitutes "cause." This would be commonly found in a business where the owners would like to ensure that if any owner engages in conduct that could be detrimental to the business reputation, that owner's interest can be bought. Further, a majority owner can retain some control over the business entity by adding a "call" provision, which allows a majority owner to buy out a minority owner at any time, for any reason.

Additionally, a "rights of first refusal" provision can be added to the transfer of ownership provisions to give current owners or the business entity a certain amount of time to match any third party offers. If the other owners purchase the ownership interest, there should be a mechanism to prevent the dilution of ownership interests by allowing each remaining owner the opportunity to purchase a pro-rata share, therefore allowing them to retain the same percentage of ownership in the business, prior to the transfer.

Purchase Price Provisions
Different purchase prices may be assigned to different transfer events. For instance, in the case of death of an owner, the purchase price might be equal to 100 percent, but in the case of a buyout due to disability or some other reason, the purchase price might only be 90 percent.

Covenant Not to Compete Provisions
A "covenant not to complete provision" may be added to the Buy-Sell Agreement to prevent former owners from competing with the business entity if a dispute arises and an owner decides to leave. The restrictions placed on competing must be for a reasonable period of time and may only cover a reasonable geographic area.

Resolution of Disputes Provisions
If a dispute should arise among the owners, it is advisable to have an arbitration section in the Buy-Sell Agreement. This section sets forth the rules to be followed for selecting arbitrators and determining the jurisdiction and the venue of the arbitration. A provision for legal fees and costs is typically contained in this section. The inclusion of a dispute resolution provision reduces the chances of protracted and expensive legal proceedings in the event there is a dispute among the owners.

Individuals who own closely held business should have their Buy-Sell Agreement reviewed frequently to ensure that they have adequately addressed the current needs of the owners and the business entity. Additionally, those business entities that do not currently have a Buy-Sell Agreement in place should have one prepared to establish a written understanding among the owners regarding the operations, management, dissolution/liquidation, valuation and succession of the business entity. The Business Department at MacElree Harvey has a team of experienced business attorneys who can assist you in all of your business needs, including updating your existing Buy-Sell Agreement or preparing a new one. Please contact us at your convenience if you would like our assistance and we will forward to you a Buy-Sell Agreement Checklist to begin the process.

© Copyright 2006 MacElree Harvey, Ltd. All rights reserved.

Nikolaos Tsouros LL.M.

MacElree Harvey