One of the most traumatic moments for a small business is the unexpected departure of an owner. A departure can take many forms, from an intractable shareholder dispute to the death of an owner. Without competent advance planning, these events can ruin an otherwise productive and profitable business. The most common solution is the drafting of a buy-sell agreement at the beginning of a business’ existence and the regular updating of that agreement.
The basics
A properly drafted buy-sell agreement will have several indispensable elements. First, the agreement must specify the events that will force a stockholder to sell his or her shares in the business. The agreement must also identify the person or entity that will be obligated to purchase those shares. “Triggering events” usually include the death or total disability of a shareholder, the divorce of a shareholder, an intractable dispute between shareholders, or any other event that the shareholders wish to designate as sufficiently serious to trigger the mandatory buy-out.
The agreement must also create a mechanism for valuing the shares of the departing shareholder. Using a stated price per share is usually ineffective because market and business conditions may vary substantially in the years after the agreement is signed. An annual valuation by the shareholders is one common method, but this method may invite one or more shareholders to simply state their subjective belief about the value of the company. Another and perhaps the best method is the use of a professional business appraiser to value the business.
Other considerations
Most buy-sell agreements prevent any shareholder from selling his interest in the business to anyone but a signatory to the buy-sell agreement. As new shareholders are admitted to the business, they too must sign the buy-sell agreement. A buy-sell agreement should specify the exact mechanism by which the purchase will be funded. Most business do not have sufficient cash on hand to fund a buy-sell agreement if the corporation is the mandated purchaser of the stock of the departing shareholder. Many corporations solve this problem by purchasing policies of term life insurance on each party to the agreement; when a shareholder dies or becomes disabled, the proceeds from the insurance policy can be used to pay for the shares of the departing or dead shareholder.
Buy-sell agreements can be very complex, especially if the company has several shareholders. Drafting such an agreement should be placed in the hands of a knowledgeable business attorney.
