If you own a business by yourself, certain things are straightforward. Things—for better or worse—are done your way, or they are at least done the way you believe your clients or customers need/want them to be done. But what about situations in which you, and one or two partners own a business together? What happens if you come to disagreements about the future of the business? Or if one of you gets sick or dies? A small business with multiple owners should consider drafting up what is commonly called a “buy-sell” agreement.
A buy-sell agreement is more than just an agreement about buying or selling, and often can be included in a shareholder’s agreement of a closely held corporation, or the operating agreement of a limited liability agreement. It is an agreement among the owners of the company to set up procedures for future contingencies in an effort to fairly protect the varying interests of the company owners as well as the continuity of the company’s business. What types of contingencies? Here are a few:
- A partner wants to leave[1]. What happens when one owner wants out of the business? On the one hand, the remaining owner(s) should not be able to hold the departing owner’s company share hostage (not paying any salary, not paying any dividends), such that the departing owner’s share is effectively worthless. At the same time, the remaining owners do not want a departing owner to cripple the ongoing business by, for example, requiring a full cash payout just because he wants to leave. A good buy-sell agreement can provide a fair mechanism to address these issues before they happen. One common way to address such a circumstance is to require the company to buy out the departing owner using a pre-arranged valuation method (for example, the per-unit share price determined by the company’s CPA in its most recent tax filing), but then to allow the company to buy out the departing owner’s shares in installment payments rather than in cash. In this way, the departing owner gets paid for his company interest, but he essentially finances much of the purchase for the remaining owners so that his departure does not create severe cash flow problems.
- A partner gets an outside offer to buy his company interest. What happens if one of the partners is offered a buyout by a third-party who is an outsider? Often a small business’ success was in part due to the relationship built among the owners, who knew each other. The remaining owners likely do not want a stranger coming in to the business; at the same time, the selling owner wants his company interest to be liquid and sellable. A good buy-sell agreement will provide a mechanism to deal with these situations fairly, usually by requiring that before the owner can sell his company interest to an outsider, he has to offer it to the company and/or its remaining owners on the same terms—a right of first refusal.
- A partner dies. One of the most important benefits of a buy-sell agreement is that it can deal with the unhappy situation of a partner dying. Most business partners would agree that they want their family/heirs/estate to obtain the benefit of their company interest, but would also agree that if they were the surviving partner, they would not necessarily want to continue the business with the deceased partner’s wife or children being their new partners. Once again, a good buy-sell agreement can provide mechanisms that both (1) provide continuity for the surviving partners while (2) providing a cash-out for the deceased partner’s estate.
- A partner is a minority owner in conflict with the majority owners. Though business partners hope that they can get along amicably with their fellow partners, sometimes things will change and their relationships will sour. Understanding human nature going in, provisions should be made in a buy-sell that will protect each partner if he suddenly is at odds with his fellow partners—especially if his company interest is a minority and the majority are opposed to him. General provisions should be made to protect the interests of a minority holder, such as providing that the company cannot take certain actions without unanimous (or at least super-majority) approval. Specifically, a buy-sell agreement may have restrictions against (1) issuing new shares/membership interests (thus diluting the interests of an owner), (2) allowing in new shareholders/members (also diluting the interests of a minority owner), and even granting salaries to the owners, unless all owners agree.
Business partners go into a business planning and hoping for success. However, part of that planning should be providing rules for contingencies that may arise. A good buy-sell agreement can help set the ground rules for these contingencies. If you need assistance with your business planning needs, please call the Deaton Law Firm, at 704-489-2491.
[1] I’m using the term “partner” loosely, and am referring to fellow shareholders, fellow LLC members, etc., by this term.
