Business can become personal for entrepreneurs who own a small business. Life changes such as divorce, disability, or death can affect not only the partner but also the ownership of the business. To retain stability when major changes occur, a business should have a comprehensive buy-sell agreement in place at its outset. Because life events will undoubtedly affect your clients’ businesses, you should be aware of and avoid common drafting mistakes in buy-sell agreements.
Important Aspects of Buy-Sell Agreements
When drafting a buy-sell agreement, a means of funding the buyout should be specified. For example, buy-sell agreements sometimes provide for the partners to purchase life insurance policies for each other. When one partner passes away, the proceeds from the life insurance policy will fund the surviving partner’s buyout of the deceased partner’s share of the business.
These arrangements typically fall into two categories: cross purchase and redemption agreements. A cross purchase agreement is when the remaining owners buy the shares of the departing owner. In a redemption agreement, the business purchases the departing owner’s share. Buy-sell agreements can be used for sole proprietorships, limited liability companies, partnerships, and closed corporations.
A buy-sell agreement can establish plans for other important elements of a business transition. It can specify whether one of the business owners is permitted to sell a share of the business to a third party or if the approval of other owners must first be obtained. The agreement can also provide a method for determining the overall value of the business. Since business succession can produce complicated scenarios, you should be aware of the five common drafting mistakes in buy-sell agreements.
1. Omitting Key Triggering Events
Triggering events are the life occurrences named in a buy-sell agreement that could result in the forced sale of a business share or the option to sell or purchase an interest. The following are some common triggering events and related questions to consider:
- Death (Should heirs get an interest in the business or its cash value?)
- Disability (What kind of physical or mental disability would constitute a triggering event?)
- Voluntary termination (If I quit as an employee, can I continue to own the business?)
- Involuntary termination (If I am fired for cause as an employee, can I continue to own the business?)
- Business disputes (What kind of impasse could terminate the partnership?)
- Divorce (Could an ex-spouse become an owner of the company?)
- Bankruptcy (Can the bankruptcy trustee sell the bankrupt owner’s share of the business, and if so, to whom?)
- Retirements (When can an owner retire? When must an owner retire?)
Similar to a couple discussing a prenuptial agreement, discussing these issues is usually unpleasant for partners who are about to start a business together. However, omitting important triggering events could result in a major headache at best and litigation at worst.
2. Fixing the Purchase Price
One of the most important parts of a buy-sell agreement is the valuation of the business. Setting a fixed price and memorializing it in the agreement without providing for periodic adjustments in the value of the business is not wise. Such provisions fail to consider the fluctuations of the business’s value and can cause an unfair result if the share must be sold at a predetermined price that does not reflect the business’s current value.
Keep in mind that certain factors can affect the fair market value of a share of the business. A lack of control or marketability may result in a discounted value in some circumstances, for example, if the business interest is less than 51 percent.
3. Failing to Establish a Right of First Refusal
When business owners start a new joint venture, the last thing they expect is to end up in business with different partners than those with whom they started their business. To avoid this problem, the buy-sell agreement can include a right of first refusal. When a partner wants to sell a portion of a business, the other partners should have the option to purchase the share at the offer price. A sale to a third party would be permitted only if the partners do not exercise their option to purchase the departing partner’s interest.
4. Failing to Plan for Divorce
Business owners can pour their heart, soul, and money into a business, only to see a part of their equity in the company transferred to an ex-spouse as a result of a divorce. A buy-sell agreement should provide that the divorcing partner or other partners have an opportunity to purchase the shares to retain full ownership of the business, preferably with each of the partners maintaining the same percentage of ownership. Establishing a contingency plan for divorce is important, even if one or more of the partners are single when the agreement is drafted.
5. Failing to Establish the Terms of Sale
The buy-sell agreement should specify the terms of the sale if a triggering event were to occur. This could include a down payment, regular installments, or a balloon payment. A noncompete clause or agreement is also essential to prevent a departing owner from using the proceeds of the sale to fund a competing business.
Learn More Ways to Avoid Drafting Mistakes
WealthCounsel is presenting a webinar on this topic April 13 at 1 p.m. (ET). Paul Bernstein, JD, will discuss “Buy-Sell Agreements: Important but Often Overlooked Drafting Issues.” Click here to register for the webinar.