By Jim Newman, Holland & Hart LLP
Your business is successful, things are going fine and then you come to work on Monday morning to find out that a tragic car accident claimed the life of one of your fellow owners. Or, one of your fellow owners comes into your office and tells you he and his wife are going through an ugly divorce.
Your reaction, of course, is grief in the first instance and feeling bad for your colleague in the second instance. Many times, the second reaction doesn’t register — what is going to happen to the stock or other equity that was held by your fellow owner in either instance? There are any number of things that can go wrong in a business with multiple owners that can keep any of the owners up at night. A buy-sell agreement (they come in many forms and with different names) can help everyone sleep better at night.
Some business owners aren’t aware that shares of stock, limited liability company and partnership interests and other types of equity are items of personal property that are freely transferable unless such transferability is restricted by contract.
Without an agreement, partners/stockholders may be forced to deal with a buy-out of another owner at a time when circumstances are less than ideal. And, if there is no buy-sell agreement in place, there won’t be any pre-established or agreed-upon terms and conditions governing the buy-out of the departing owner.
There are typically certain “permitted transfers” in such agreements, such as for estate planning purposes. “S” corporations should use this as an opportunity to include language on preservation of the corporation’s election to be treated as an “S” corporation.
Why do so many companies not have a buy-sell agreement? Often, this is an expense item that just isn’t a high priority for many companies and their owners. However, the cost of negotiating and drafting these agreements is almost always less than the cost of a protracted dispute among the owners. Also, discussing some of the issues that come up in buy-sell agreements is, for many business owners, almost like discussing a “company divorce” in advance — so like other unpopular or uncomfortable discussions, this often gets delayed or is simply never addressed.
What kinds of issues typically need to be addressed in a buy-sell agreement? The most important topics are triggering events, valuation and payment terms. Some of the most common triggering events (the events that cause the buy-sell agreement to become “operative”) are death, disability (it is important to define and address duration and other related issues), dissolution of a marriage, the employment of an owner is terminated, an owner simply wants to leave and do something different, bankruptcy and the equity interest is subject to attachment or seizure.
Valuation is the process of determining the price of the equity interests to be transferred under the provisions of the buy-sell agreement. This is of critical importance because with closely-held companies, there is no ready market or exchange to value the interests. Also, issues like discounts for lack of marketability and minority interest may come into play with respect to valuation. What are some of the common methods? “Agreed upon value” is one; the owners agree to establish a value periodically, say once a year.
This sounds good but is only a good choice if the owners will revisit this periodically, and most don’t. Another popular method is getting an appraisal, which involves hiring a third party to determine the company’s value. This can be more “accurate” than other methods but is typically one of the more expensive alternatives. And, it is not free of controversy — the business owners have to agree not only on who does the appraisal, but the final appraised value. Arbitration is another method, but it can be expensive and time-consuming. Many buy-sell agreements include several methods as a precaution.
Payment terms are often a challenge because many closely-held businesses find themselves to be “cash-poor” at different points in time, or the departing owner wants the buy-out amount all in cash, whereas the business has its own cash needs and may not feel it can afford paying the departing owner in a lump sum. When death is the triggering event, it can be funded with “key-person” life insurance. If a note is involved between the parties, someone is going to be a private lender and that person needs to be concerned about risk, rate of return and collateral.
These issues are complex and often difficult to discuss among owners. But dealing with these issues earlier rather than later is almost always recommended. Your business and your livelihood (and that of your fellow owners) are important enough to merit serious consideration of a buy-sell agreement for your company.
Jim Newman is a partner in the Reno office of Holland & Hart LLP where he practices primarily in the fields of corporate, mergers and acquisitions and real estate law. His honors and awards include The Best Lawyers in America (2012-2015), Martindale-Hubbell , AV Preeminent Rating and Nevada Business Magazine, Nevada Legal Elite (2014). Jim is also the Administrative Partner of Holland & Hart’s offices in northern Nevada. www.hollandhart.com/reno