Buy-Sell Agreements Attorneys in Fairfax, Virginia

Buy-Sell Agreements: The Business Owner's Best Friend

Husbands and wives fight and divorce. Many business owners may split from their former partner(s). But in the case of businesses, the financial disaster of a business break-up can be worse than a divorce. How? In a divorce, you lose half of your stuff, but with a business bankruptcy, you can lose everything.  

If a partner dies, gets divorced, or becomes disabled, the problems created can be handled by a buy-sell agreement. 

A buy-sell agreement is a separate agreement among shareholders in a corporation. In a partnership or LLC, it is part of the partnership or operating agreement. 

How Buy-Sell Agreements Work 

The owners get together and decide what they want in their buy-sell agreement. We coordinate this meeting by asking a series of questions. These questions are attached at the end. As a sample question, if one of the owners wants to retire, can the retired owner still get profits from the business while retired?  Many will say no, because they want all owners to know the ups and downs and opportunities and problems of the business when it comes to making decisions. Others will want a retired mother or father to continue to receive income from the business and know the parent will work part-time and give seasoned advice.  

Will an owner be allowed to sell their shares to an outsider, who is a stranger to the partners in the business, who are all family members? What if someone gets divorced and the divorce court orders that half of the shares of the divorcing partner must be turned over to the ex-spouse? What if a partner dies, do the remaining owners want to be in business with their children? What if a partner is convicted of a serious felony, is that grounds to buy out the felon? If a creditor of a partner tries to take over the shares of the debtor partner, will the remaining owners want to be in business with the creditor? 

All of these problems have a strong negative effect on a small business with two to 20 owners. For mega-companies such as Exxon, these are generally not problems. A small business runs and succeeds on the skills, reliability, mutual trust, and dedication of the owners and cannot afford to have an owner who does not pull their weight. 

Once the owners have decided under what conditions an owner must sell their interests, they generally agree that the person required to sell must first offer their shares or membership interests to the company. The funds available, such as in an insurance contract or cash on hand, may be available in the coffers of the company. Or the current owners want to reduce the number of shares outstanding by having the company buy the shares. On the other hand, the remaining owners will want to buy the membership interests in their own names to receive a tax step-up on basis.  

If the owners agree that the Company will not buy all of the shares, then the shares to be sold are deemed to then be offered to the shareholders or members who are not selling their shares. The shareholders/members have the right to buy out the offered interests according to their percentage interests in the company.  

Determining the Price 

The buy-sell agreement will permit the buyer and seller to agree to a price acceptable to both. If they can not agree, then the agreement will set forth a formula for determining the price. The price is then the value of the company times the percentage interest being sold.  

Often, owners agree to a fixed value for the whole company and put that in the agreement. The danger of this is that busy owners may forget to update the value as the company grows and the years go by. Then, one day an owner, Fred dies, and the company is worth $10 million but the agreement says it is worth $2 million because the agreement was not kept up to date. Fred owned 50% and Fred’s widow only gets 50% of $2,000,000, rather than the $5,000,000 she should receive.  

This problem can be resolved using a formula that considers recent profits. An example would be an average of the last three years of earnings before taxes, interest, and amortization (EBITA) times four. 

Where the sales will be between related parties, it is important to require the price to be determined by an independent appraisal. A sales price between related parties (parents, spouses, and siblings) does not have to be accepted by an IRS auditor. Instead, the auditor can retain their own appraiser and impose large taxes on the seller.  

Example. Allan dies and leaves his 100% interest in the company to his daughter Ellen. The buy-sell agreement says the value of the company is worth $3 million. In an audit of an estate tax return of Allan, the IRS auditor retains an appraiser who appraises the value of the business as $8 million. The IRS auditor states that 40% is due in taxes from the estate on the $8 million which is $3,200,000. Allan’s widow receives $3 million to pay a $3.2 million tax bill, and there goes the funds for the retirement of the widow.  The daughter Ellen is powerless as she is bound by the contract. If the buy-sell agreement said the price was determined by an independent appraisal, then Allan ‘s widow would be protected. 

Bad Boy Bought Out 

What if the selling partner embezzled funds from the company? Do the remaining owners have to pay full price to the embezzler? The buy-sell agreement should provide discounts on the prices paid for people who damaged the company, embezzled funds from the company, or lost their shares to a personal creditor. 

Refusal to Sell 

What if the seller is required by the agreement to sell their shares, but refuses to sell their shares? The buy-sell agreement will appoint a company officer who has the power to transfer the shares or membership interests on the books of the company for the owner who refuses to sign over their shares. The buy-sell agreement will not recognize any transfer of shares or membership interests done without conformance to the agreement. Our experience is that the recalcitrant seller will eventually give in and follow the buy-sell rules. 

How it Works: An Example 

Susan and her two sisters start a high-tech company that becomes very successful and is now worth nine million dollars. Susan is married to Elmer who stays at home, does not work, does not share in the housework, and claims he is too busy writing novels to take out the garbage, although he has never finished or published a novel. He wrote only one short newspaper article twelve years ago. He likes to attend University courses on creative writing at Susan’s expense and spends hours on Twitter and Facebook condemning people who think it is important to be a productive person. Elmer meets Twinkie, a twenty-something barbie doll in one of his classes who is enamored by his wit and status as a writer. They decide to take a world cruise funded by a divorce settlement with Susan. Since Susan and Elmer have been married for ten years, the divorce court awards Elmer one-half of the $3 million value of Susan’s share in the business. Without a buy-sell agreement, Elmer would then own 1/6 of the company and be able to sell the shares to an outsider investor bottom-fisher shark for 50% of the value. After divorce expenses, Elmer nets $500,000, funding his planned two-year five-star tour of the world with Twinkie. 

Susan and her sisters had the wisdom to have a buy-sell agreement. Under the buy-sell agreement, when a divorce court orders the transfer of shares pursuant to a divorce, that automatically triggers a requirement that the shares subject to the divorce decree must first be offered to the company and then to the other partners. Also, the price for the shares is set at a 33% discount to recognize restrictions on transfer and centralized management of the LLC. Payments are made only once a year on January 1 divided up over 20 years of payments, with the interest being the minimum allowed by the IRS. As a result, Elmer will only get about $53,000 a year, not enough to fund the planned luxury life world tour. Elmer settles for a cash offer of $200,000, the number he and Twinkie needed for their world cruise with an open free bar.  

Admission as Only an Assignee in an LLC 

In an LLC, often the operating agreement provides the rights of members to keep informed as to the finances and operations of the company, to participate in company meetings, and to vote on key issues such as the sale or purchase of major assets or the company. The buy-sell agreement will require that new owners must agree to all terms of the operating agreement as a condition of receiving an interest in the company. Also, the buyer of the membership interests must apply to be a member of the LLC. The existing Members may not want the applicant as an active partner participating in meetings and having a vote on key issues. Instead, the buyer is allowed to purchase membership interests but only receives interest as an assignee and cannot attend company meetings or vote. The assignee only receives their allocated share of the profits.  

Buy-Sell Agreements: Getting Started

The major issues in a buy-sell agreement for owners of a corporation or an LLC are listed below.  There may be some issues that are not on this list.  Yes (Y) means that the seller or buyer must sell or purchase the interest.   No (N) means that there is an option to sell or purchase but there is no requirement to sell or purchase.   You can have different requirements for each issue or within issue. 

Choose a Y or N for each event.  

What will be the method to compute the price: 

Initial agreement price: __________________________  

Annual review:  Yes  

Multiple of Gross: ____________ 

Multiple of EBITA____________  

Average profit last three years: _________________  

Qualified Appraisal: ________________  

Liquidation value: _________________ 

Minority or Control Discounts: __________________   

Historic accounting shareholder equity: _______________  

Methods to fund: 

All cash:  Cash up to the amount of insurance, installment sale thereafter.  

Cash reserves: _______________  

Installment sale: By agreement at the time.   

Insurance: ____________________________    

Who will own insurance:  ______________________________   

Deferred compensation: ______________   

Bank loan:  _____________________________.  

Will LLC own the insurance: ____________________  

Will owners own the insurance: __________________  

Will Company own the insurance: ________________