A savvy business owner plans for the future. Unfortunately, life events can occur that can adversely affect the management and control of a business. This is particularly problematic for a business which has more than one owner. A common issue is when one of the owners separates from the business due to death, divorce, bankruptcy, and/or a voluntary or involuntary departure from the business. The part of the business ownership agreement that plans for these moments is called a “buy-sell agreement.” Note that buy-sell agreements can also be stand-alone agreements, but more commonly, they are part of the ownership agreement.
What Issues Are Addressed in a Buy-Sell Agreement?
A buy-sell agreement sets forth what happens when a partner or owner leaves the business. It may address:
- Partnership rights to buy or dispose of a partner’s interest;
- Partner’s rights to sell or dispose of his or her own interest;
- Partnership rights to expel a partner from the partnership;
- Valuation of the partnership interest;
- Requirements and approval of buyers of a partnership interest.
Most often, the buy-sell agreement provides that either the remaining partners or the partnership will buy the departing partner’s interests.
Why Is a Buy-Sell Agreement Necessary?
While buy-sell agreements should be used for corporations and limited liability companies (LLCs), they are particularly important in partnerships. A partnership can dissolve by operation of law on the expulsion, bankruptcy, or death of a partner unless there are provisions in the partnership agreement to the contrary. As a result, partners will sign the buy-sell agreement to ensure the continuing operation of the business.
In addition, a buy-sell agreement can help avoid disputes with the departing partner or his or her heirs or estate. An agreement can prevent problems such as an unintended third party (i.e., the partner’s spouse or child) becoming a partner, disagreements over the value of a partner’s interest, delays in probate, and/or the impact of a partner’s disability.
What Types of Agreements Exist?
There are two broad types of buy-sell agreements:
- Redemption buy-sell agreement. The deceased/departing partner’s interest is purchased by the partnership.
- Cross Purchase buy-sell agreement. The remaining partners agree to buy each other’s interest when a partner departs or dies.
In addition, a combination of the two is also available where both the partnership and the partners have the option to buy out the departing owner or their estate.
To What Extent Can the Partnership Control Transfers of a Partner’s Interests?
The buy-sell agreement can contain various kinds of restrictions on a partner’s ability to transfer shares. These allow the partnership to control who becomes a partner. However, some provisions may not be enforceable as follows:
- No transfer is allowed for any reason. Generally, this is not enforceable as being against public policy, but might be allowed if there is a valid business purpose and the restriction is reasonable in light of the circumstances of the case.
- Any transfer is subject to the consent of all of the other partners. This restriction is enforceable provided that the non-transferring partners are required to act reasonably and in good faith;
- A transfer is only permitted under certain limited circumstances, such as to heirs. This may be enforced. However, the agreement will often provide that the transferee agrees to be subject to the partnership agreement, including restrictions on voting rights of transferees and other requirements.
The partnership may also have certain priority rights to acquire a deceased or departing partner’s interest. Common examples include:
- A partner dies, becomes disabled or departs, the partnership has an option or even a requirement to purchase the interest;
- A partner is selling, the partnership and/or partners have the right to purchase the interest themselves before the selling partner may offer the interest to third parties;
- A partner is selling, the partnership and/or partners have the right of first refusal on any third-party offer;
- A partner is selling, partners may purchase the interest in accordance with their pro-rata ownership percentage in the partnership.
The above restrictions and priorities can be used individually or in combination to direct how sales or other transfers may proceed.
How Are Partnership Interests Valued?
The value of the interest being transferred is usually set forth in buy-sell agreements so as to avoid disputes with the departing partner or third parties. There are various methods to set the value including:
- Fixed price with inflation or other specified adjustments in value over time;
- Book value;
- Multiple of business earnings;
- Third party appraisal.
How Can Partners and Partnerships Buy Partner Shares?
When a partner leaves, he or she will be bought out, which means the partners, or the partnership must have the cash to pay for the shares. Life insurance policies are sometimes taken out by either the partnership (redemption agreement) or the partners (cross purchase agreements) to cover the costs of buying a deceased partner’s interest. Another option is to set money aside for this purpose.
Conclusion
When setting up your partnership and planning for its future, the best practice is to plan for both good moments and bad. Like a prenuptial agreement or a will for individuals, a buy-sell agreement sets forth clear guidelines addressing life-changing events with the goal of minimizing disputes and litigation later.
If you are involved in a business with more than one owner, or are considering partnership, contact us for a consultation.