A Layman’s Definition of a Buy-Sell Agreement
My brief definition of a buy-sell agreement is:
A buy-sell agreement is an agreement by and between the shareholders (or equity partners of whatever legal description) of a privately owned business and, perhaps, the business itself. A buy-sell agreement establishes the mechanism for the purchase of stock following the future death (or some other form of usually adverse change) of one of the owners. In the case of a corporate joint venture, a buy-sell agreement also establishes the value for break-ups or for circumstances calling for one corporate venture partner to buy out the other partner.
Prenuptial agreements prior to marriage may not be romantic, but they make good sense for couples where one or both parties have assets or income to protect. They are the documentation of agreement between couples regarding what happens to whose assets and income in the event of a future divorce. They are entered to prior to marriage and both parties are normally represented by counsel.
Buy-sell agreements have been likened to business owners’ prenup agreements. They are certainly not romantic, but buy-sell agreements are among the most important and most neglected of corporate agreements.
As noted in the definition, buy-sell agreements reflect the documentation of agreements between a company’s owners and the company itself. These agreements relate to what will happen in the future if a provision of the agreement is “triggered” and require future thinking if they are to provide reasonable resolutions for future transactions that may result from their operation.
Key Business Issues in Buy-Sell Agreements
Buy-sell agreements are legal contracts. What is not clearly understood, however, is that they are also business and valuation documents. We refer to buy-sell agreements this way because they represent contractual agreements between the respective parties concerning the following:
- Business objectives. Buy-sell agreements are designed to facilitate business objectives of companies and their shareholders including:
- Limiting ownership to an existing group or family (or multiple families).
- Maintaining relative ownership between or among groups of shareholders.
- Integrating the operation of a buy-sell agreement with the estate planning of one or more owners.
- Limiting the ability of parties to the agreement to sell their shares, except pursuant to the terms of the agreement.
- Pricing. Buy-sell agreements determine how the pricing of transactions will be determined. In other words, buy-sell agreements determine how the valuation of businesses (or business ownership interests) will be determined in future transactions that may or will occur.
- Terms. Buy-sell agreements also dictate the terms upon which future transactions will occur.
This material is written from the perspective of a businessman and a business valuation expert. It is based on personal experiences spanning more than 35 years. I have reviewed hundreds of buy-sell agreements and been involved in dozens of what, for lack of a better term, I’ll call “buy-sell agreements gone bad.”
These experiences suggest that many existing agreements contain (or omit) language that will almost certainly create the potential for problems when they are triggered. Buy-sell agreements drafted currently without specific business and valuation input may also perpetuate historical problems, which we will examine later.
Some buy-sell agreements have and will accomplish their objectives. However, buy-sell agreements often offer proof of the law of unintended consequences – most do not and will not facilitate desired or desirable results. The main problem is companies and their shareholders simply do not know what could or might happen when their agreements are triggered.
Buy-Sell Agreements Are Common to All Corporate Forms and Industries
Many business owners think that their industry is different in its unique problems and issues. And within their industry, their company is also unique. They are, of course, at least partially right. However, buy-sell agreements are used in every industry where different owners have potentially divergent desires and needs – and that includes every industry we have seen to date.
The content of this series is applicable regardless of the form of corporate organization of a business. Buy-sell agreements are necessary and/or appropriate for most corporate forms, including:
- Corporations, whether organized as S corporations or C corporations
- Limited liability companies
- Partnerships, whether between individuals or between entities such as corporate joint ventures
- Not-for-profit organizations, particularly those with for-profit activities
- Joint ventures between organizations (quite often overlooked)
Profile of Companies Addressed in New Book
The focus of my newest book, Business Valuation Issues in Buy-Sell Agreements: A Handbook for Attorneys, is on companies, however organized, in any industry that have four primary characteristics:
- Substantial value. There are many hundreds of thousands of business that might be categorized as “mom and pop” enterprises (with no disrespect whatsoever), and generally do not attain significant economic value. We will focus on businesses of substantial value, or those with millions of dollars of value (as low as $2 or $3 million) and ranging upwards to many billions in value.
- Privately owned. When there is an active public market for a companies securities, there is generally no need for buy-sell agreements.
- Multiple shareholders. Most businesses of substantial economic value have two or more shareholders. The number of shareholders may range a small number of founders or initial investors, to many dozens, or even hundreds of shareholders in multi-generational and/or multi-family enterprises.
- Corporate buy-sell agreements. Many smaller companies, and even some of significant size, have what are called cross-purchase buy-sell agreements. While much of the book will be helpful for companies with such agreements, the focus here is on companies who have corporate agreements. In other words, the buy-sell agreement includes the company as a party to the agreement, along with the shareholders.
If a your client’s business has substantial economic value and multiple shareholders, this book is designed to help.
The next post (and it may take two or three posts to accomplish) will provide an overview of the primary categories and types of buy-sell agreements. It will provide my recommendations for which types of buy-sell agreements to avoid, if possible. The post will also provide an overview of valuation process agreements, including those using multiple appraisers and those using a single appraiser. Finally, the post will provide my recommendation for the type of buy-sell agreement that, based on years of experience, has the best chance of working to provide reasonable resolutions when trigger events occur.
My two most recent books are available in an Ownership Transition Bundle. The bundle, priced at $35 plus s/h, has been attractive for many business owners, appraisers and attorneys.