Most of the events that “trigger” buy-sell agreements are not pleasant to consider, particularly to a group of owners who may have just come together for a common business purpose.
Why are such incidents called “trigger events”? Circumstances could be such that the shareholder most affected by a trigger event has a proverbial gun to his or her head! In the alternative, the company may perceive that it has a gun to its head in order to fulfill the repurchase requirements of a buy‑sell agreement.
Buy-sell agreements are designed to accomplish one or more business objectives from one or more of several viewpoints: the corporation, the employee-shareholder, the shareholder who is not an employee, and any remaining shareholders. The buy-sell agreement provides for what happens to the shares of owners who leave, for whatever reason, whether favorable or unfavorable.
From the corporation’s viewpoint, the buy-sell agreement may prevent the departing shareholder from retaining his shares.
- By requiring a departing shareholder to sell his or her shares to the corporation, the corporation and remaining shareholders eliminate any potential for conflict over future corporate policies with the departed shareholder.
- The agreement may eliminate the potential for the departed shareholder to benefit from future success of the business created by the remaining shareholders.
- The agreement may also prevent a shareholder (or his or her estate) from selling shares to “undesirable” parties, enabling the remaining shareholders to decide who the next shareholder will be, if any.
These reasons for buy-sell provisions apply to virtually all trigger events.
An Acronym: QFRDDD
The term “trigger” can have a benign connotation. If A happens, then B is triggered or set in motion to happen. However, the majority of trigger events related to buy-sell agreements have less benign connotations. Consider the acronym “QFRDDD” to list the primary triggering events for buy-sell agreements:
While it is easy to think of these events in personal terms, analogous situations also happen to companies. “Quits” equates to withdrawal from a venture; “disabled” could mean inability to answer a capital call; and “dies” represents bankruptcy of a participant. Let’s look at the suggested trigger events.
Common Trigger Events
Q – Quits
A buy-sell agreement may provide a mechanism for shareholders who leave a business to sell their shares to the corporation or other shareholders. A shareholder may quit under a variety of scenarios, some of which are more favorable to the corporation and other shareholders. The circumstances of quitting may determine how the departing shareholder is treated under the buy-sell agreement.
- Favorable circumstances. A shareholder may decide to leave a company to pursue other interests that are not competitive with the activities of the company. Assuming the ability to fund the purchase, the company and remaining shareholders are likely to view such a departure on favorable terms.
- Unfavorable circumstances. Alternatively, a shareholder may decide to leave a company and to pursue competitive activities. Under such circumstances, the company and remaining shareholders may be reluctant to pay full price (whatever that means – to be determined as we proceed) and desire to stretch out payment as long as possible. After all, no one wants to finance a competitor!
F – Is Fired
When an employee-shareholder is terminated, most corporations desire to retain control over the shares. Terminations generally result in diverse, or more likely, adverse interests between the fired shareholder, the corporation, and remaining shareholders.
- From the employee’s viewpoint, the buy-sell agreement assures that his or her shares can be sold at the buy-sell price and creates a market for the shares.
- From the corporation’s viewpoint, buy-sell agreements create the right or the obligation to purchase the departing employee-shareholder’s shares.
- A repurchase requirement on termination also eliminates the potential for the terminated shareholder to benefit from any future success of the business created by the remaining employees and shareholders.
- Some agreements call for a penalty to the valuation in cases of termination, particularly for cause. It is important that the parties exercise care regarding potential valuation penalties and that their agreements be explicit regarding when and/or how such penalties would be applied.
R – Retires
The retirement of an employee-shareholder creates a potential divergence of interests between the shareholder and the corporation.
- The shareholder may desire current liquidity over the uncertain future performance of the corporation.
- The corporation may desire not to have potential interference or disagreement with corporate policy, or to have the retired shareholder benefit from future appreciation in value.
- The corporation and the remaining shareholders likely do not want a retired employee to continue to benefit from their ongoing efforts.
D – Disabled
After a defined period of time, the corporation may have the right (from its viewpoint) or the obligation (perhaps, from the employee’s viewpoint) to purchase the disabled employee’s shares. If disability is a trigger event, it is essential to have a clear definition of what “disability” means. If the company carries disability insurance for key owners, one simple definition of disability for buy-sell agreements is that of the insurance carrier. If the carrier considers a shareholder to be disabled and begins to make disability payments under the policy, the disability clause of a buy-sell agreement could become effective on the date of first payment.
D – Dies
The death of a shareholder creates issues that are often resolved by buy-sell agreements. Many corporations use life insurance as a vehicle to fund the repurchase of a deceased owner’s interest. If the corporation owns the life insurance, the proceeds received upon the death of an owner can be used to acquire that owner’s interest from his or her estate.
Keep in mind two facts as we think about trigger events. First, the death of an owner is only one of many possible trigger events. And second, for any group of owners coming together at a point in time (assuming they are all in reasonable health at the outset), death is the least likely trigger event to occur.
If a shareholder dies owning a minority or controlling interest in a corporation for which there is no market for its shares, the illiquidity of the stock can create estate tax issues.
- The shares must be valued for estate tax purposes, and the appraisal amount will add to the estate’s value.
- To the extent that the estate is taxable, there may be no liquidity to pay the estate taxes.
- Buy-sell agreements provide a mechanism for determining the value of shares that may be applicable for estate tax purposes and for monetizing that value for the estate, generally in cash or in a term note (or a combination of the two).
- The shareholder’s estate realizes liquidity and can pay taxes due. As result, the estate can minimize the combination of uncertainties of independent valuation and the certainty of payment of taxes in the absence of liquidity.
- From the corporation’s viewpoint, the buy-sell agreement eliminates the need to address uncertain ownership dictated by the deceased shareholder’s will and can create the requirement for funding.
D – Divorce
Unfortunately, divorce is quite common today. When any group of investors comes together, one of the most likely things that will happen in their collective futures is that one or more of them will be divorced.
- Because of the frequency of divorce, most buy-sell agreements have provisions enabling the corporation (or the other shareholders) to purchase shares that otherwise might be granted to the working (or non-owner) spouse in a property settlement decree in a divorce.
- The purpose of “divorce provisions” in buy-sell agreements is, of course, to prevent shares from falling into the hands of potentially unfriendly ex-spouses.
While it is true that all of the QFRDDD trigger events are important for buy-sell agreements, there are numerous other events that it may be appropriate for clients to consider in their buy-sell agreements.
Some clever person thought of the phrase, “the Ds of Buy-Sell Agreements.” In the next post, we will cover some twenty “Ds” of buy-sell agreements. There will be some repetition of the QFRDD, but we will see that there are a variety of potential trigger events, some of which are appropriate for consideration by owner groups as they develop or refine their buy-sell agreements.
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