Sunday, October 19, 2008

Business Survival: Buy-Sell Agreements

I have written before about the problems solved by having a buy-sell agreement, but Importance of having buy-sell agreements from Bermuda's The Royal Gazette presents the issue again in a very well written article.

What follows applies to any business organization having more than one person as owner: corporation, limited liability company, partnership.

"As a business owner, one of the earliest decisions you will make is how to build your team. Should you run the business on your own, or take on partners? There are strong arguments both for and against partnering with others and sharing equity; however, we would like to focus on a different aspect of partnerships that many do not think about - until it is too late. While partnerships are almost always formed with the best of intentions, it is important to have a mutually agreed framework for ending the business relationship BEFORE it is needed."
Not a single thing I disagree with in this paragraph - including the "BEFORE". The article then gives three scenarios where not having a buy-sell agreement means trouble, if not ruin, of the business. Followed by this:

Benefits of a buy-sell agreement include:

• Establishing a "fair', structured plan for a shareholder exit - this is particularly important during contentious circumstances.

• Enabling a smoother transition while normal business operation continues.

• Creating liquidity and a ready market to sell a business interest - exiting shareholders are more certain of being able to "cash-out" of their equity positions. In Bermuda, where there is a limited pool of buyers, this can be critical!

• Mapping out the events which will trigger the buy-sell - this aids in eliminating ambiguity and reducing possible disputes.

• Providing procedures for dispute resolution, removing emotion from the decision-making process.

Pre-determining the process by which the business interest will be valued - this will save both time and money when it comes time for a shareholder to sell their stake.

• Assigning a value to the business interest without necessitating a purchase/sale transaction - this is particularly important in divorce scenarios!

• Protecting against unwanted new partners - this provides incumbent shareholders with an opportunity to either increase or decrease their existing shareholdings.

• Determining payment and financing terms.

Bermuda may be smaller than Indiana but selling a closely held business is not easy. Indiana has no great pool of buyers looking to buy out a closely held business. The article goes onto describe the process for reaching an appropriate buy-sell agreement:

1 Choose the appropriate agreement structure. The three basic types of buy-sell agreements are repurchase agreements (in which the entity buys the interest from the exiting party), cross-purchase agreements (in which one or more existing shareholders buy the interest from the exiting party) and hybrid agreements (which may allow the founder first priority to buy the interest and other owners or partners the second option to buy).

2 Negotiate the major provisions. The provisions are the meat of the agreement and outline how exactly a business interest will be sold and to whom.

3 Determine value and price. Map out how the business interest will be valued and priced in support of the provisions. Will a business valuation professional be used? Will a previously agreed upon formula be used?

4 Determine triggering events. What events will trigger the buy-sell agreement? These can include death, long-term disability, voluntary or involuntary termination, or third party actions, such as personal bankruptcy or divorce.

5 Choose how the buy-sell will be funded. How will the exiting party be paid for their business interest? Will it be an all-cash transaction or can the transaction be financed? What insurance needs should be considered in order to provide immediate cash without causing financial harm to the company.
Which is pretty much the process I have used for years. For those having set up their businesses themselves, I have two questions:
  1. Have you got a buy-sell agreement in your corporate bylaws (if you set up a corporation), your operating agreement (if you set up a limited liability company) or partnership agreement?
  2. If you do have a buy-sell agreement, does it cover all the points outlined in this article?
You can access my other articles on buy-sell agreements here and here and here.