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Buy/Sell Agreements:
A Critical Component When Forming Partnerships
Many business partnerships start out with great chemistry, but over time they can reach a point where the relationship among partners becomes strained. Unless you plan to be lucky forever, you’d better have a buy/sell agreement. Without it, a closely held or family business faces a world of legal, financial and tax problems
- when you and your partner(s) decide to dissolve the partnership or
- if a partner dies, is incapacitated, gets a divorce, files for bankruptcy, retires, or decides to sell his portion of the business.
A buy/sell agreement protects your assets and investment in the company.
I. What Is A Buy/Sell Agreement?
It is a document or contract between all the partners in the business that lays out the framework and explains who can buy a partner's stake in the company. It also delineates what a fair price would be, and can provide a mechanism to determine the fair price in the event of a dissolution.
II. If One Partner Leaves
If only one partner decides he wants to leave the company, a buy/sell agreement protects the remaining partners and their interests in the company. It outlines to whom the leaving partner may sell his stake (i.e., exclusively to the remaining partners or to a replacement). It also allows the remaining partners to have a voice in choosing a new partner, protecting them from being forced to accept someone who may have a negative effect on the business. In addition, the buy/sell agreement includes a fair price formula to insure that the departing partner receives reasonable payment for his/her share in the company.
III. What Is A Fair Price And How Is It Determined?
Determining a fair price at the outset of the partnership can be difficult. No one can predict with certainty future growth or the company’s worth in five, ten or 25 years. A few standard methods for calculating a fair price are discussed below.
- Partners decide on a price when they first establish the partnership. This is rarely recommended since the market value of the company will always fluctuate, and this fixed price may not be reasonable at the time of sale.
- Once a year the price agreed upon is reviewed and recalculated to the fair market value of the company.
- Partners agree in advance on what percentage—or how much of the net worth—each partner is entitled. Then, at the time of the buyout, the partners calculate the net worth of the company by subtracting the debts from the assets of the company from the latest business quarter. (Other tangible and intangible items such as property or patents that increase the company’s value can be added into the agreement as well.)
- For an established company, fair value may be based on an average of the annual profits from the years that the partner was involved. All partners take a risk with this stipulation. If, for instance, the departing party initially endured a few lean years, but left after a successful year or two, the average annual profit would probably be less than the present market value.
- A commission driven, service company may decide to pay a percentage of the continued commissions from the departing partner’s customers. This provides the retiring partner and the company an incentive to make sure that customers stay with the company.
- The agreement stipulates that at the time of sale, a designated third party determines a fair market value price of the company and the departing owner's stake in it.
IV. What Other Occasions And Problems Are Cause For A Buyout?
Other scenarios in which a buy/sell agreement should be used to determine what should be done with the ownership stake follows.
- Death: If a partner dies, his stake needs to be bought out. The buy/sell agreement should specify whether his family inherits shares in the company or the share must be sold to the company. The best interests of both the company and the family need to be addressed.
- Disability: One of the owners becomes disabled, either physically or mentally, and needs to be bought out.
- Retirement: If a partner decides to retire, does he have an option to keep his stake for a certain amount of time, or does he have to sell immediately?
- Firing: A partner is fired or asked to step down. What mechanisms are in place to sell his ownership stake?
- Divorce: The partner gets divorced. His stake in the company may have to be divided according to property and divorce laws of the states. A buy/sell agreement can stipulate that in the case of a divorce, a spouse must immediately sell the interest back to the company.
- Bankruptcy: One partner goes bankrupt. The courts may order that he use the money from his business to pay off his debts. To protect the company, a buy/sell agreement may require that the bankrupt partner notify the other partners prior to filing for bankruptcy, and must sell back his shares to the remaining partners.
V. How Should A Buyout Be Paid?
Very rarely will the payout be a lump sum payment. Usually, the company pays a percentage of the buyout price immediately, followed by a monthly payment plan that extends over the course of several years with accrued interest.
VI. Conclusion
A buy/sell agreement is akin to a "premarital agreement" that protects everyone's interests, setting the price and terms for a buyout. Every day that value is added to a business without a plan for future transition, partners incur greater financial risk. Having the foresight to protect yourself can help you to avoid costly, time-consuming and embarrassing litigation that will have a negative impact on your company.
Contact the offices of Lawler Mahon & Rooney to learn more about the best way to draft and execute a buy/sell agreement.
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