When two or more individuals decide to join forces and found their own enterprise, they are usually full of hope and optimism about the future. Unfortunately, the future does not always unfold as we expect. Unanticipated events, such as a disabling illness, the death or divorce of a shareholder, or a personality dispute, can often disrupt the future of a small business.
One of the best preventive measures of preventing such a crisis is a carefully drafted buy-sell agreement that specifies the occurrences that can give one shareholder the legal right to purchase the interest of another shareholder.
The elements of a buy-sell agreement
Perhaps the most important provision in any buy-sell agreement is the clause that specifies the events that can give one shareholder the right to purchase the interest of another shareholder. Such provisions, called “trigger clauses,” usually enumerate the situations in which the mandatory buy-sell provisions are operative.
These situations can include the death or permanent disability of a shareholder, a deadlock on the board of directors or managers, the divorce of a shareholder, or the destruction of a significant portion of the assets of the business.
The second most important clause in any buy-sell agreement is the determination of the price to be paid for the interest of the departing shareholder.
Some authors of buy-sell agreements specify a dollar price in the agreement and then never review or amend this provision. Alternatively, the price of the interest can be tied to the value of the business, but this method can lead to further disagreement.
Perhaps the most reliable method of determining value is to ask the company’s accountant to make a calculation according to standard accounting practice.
After one of the events enumerated in the trigger clause comes to pass, one shareholder has the right to provide notice to the other shareholders of the intent to exercise their right to purchase the interest of the departing shareholder.
Generally, this notice is accompanied by a tender of the purchase price determined in accordance with the valuation clause.
A well-drafted buy-sell agreement should spell out the mechanism by which the legal interest of the departing shareholder will be transferred to the buying shareholder or to the company.
Funding a buy-sell agreement
The occurrence of a trigger event will impose a significant financial burden on the entity that will be purchasing the interest of the departing shareholder.
In many situations, a life insurance policy on each principal is used to provide cash to fund the required purchase. A life insurance policy will obviously not work to fund a buy-out predicated on shareholder disagreement or disability.
Other methods of providing funds should be explored with the firm’s accountant or financial adviser.
Depending upon the nature of the business, a buy-sell agreement can become very complicated. Anyone considering asking their fellow principals to sign such an agreement may wish to consult an experienced business attorney.