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How a Buy-Sell Agreement Can Help Protect Your Business

posted in Contract Law, Corporate formation, Corporate Governance, Private Companies, Securities, Startups, Uncategorized by

All corporations should consider entering into buy-sell agreements with each of their shareholders. The purpose of a buy-sell agreement is to allow a corporation to maintain control of its shares in the event of a possible transfer of stock ownership, whether occurring because of a shareholder’s death, divorce, bankruptcy, or other voluntary or involuntary event.  In some circumstances, the corporation itself may purchase the shares. Or, the agreement may provide for a cross-purchase by the remaining shareholders. The buy-sell agreement will be executed between the corporation and its shareholders and will set forth the circumstances under which the corporation (or its remaining shareholders) may have the right to purchase the departing shareholder’s shares, and the circumstances under which it must purchase the shares.

A buy-sell agreement can:

  • Prevent shareholders from selling to competitors, allowing those competitors to have access to your company’s trade secrets and other proprietary information;
  • Prevent the transfer of shares to entities that threaten the company’s S corporation tax status;
  • Prevent the remaining shareholders from being forced to take on an undesirable new business partner;
  • Ensure that when shareholders depart from the company, that there is a set market for their shares; and
  • Avoid disputes over share price and method of payment.

Structuring the Buy-Sell Agreement

The buy-sell agreement should specify whether the corporation or its shareholders will be purchasing the shares.  If the corporation itself is purchasing the shares, the buy-sell agreement can be self-executing, thus streamlining the process. With this method, shareholders do not have to worry about their interests in the company becoming diluted because they are not in a position to purchase the shares at the time of the transfer. In California, a corporation cannot purchase shares if it would render the corporation insolvent. And, it must determine that at least one of the following is true: either the retained earnings of the corporation must be greater than the sale price; or, after the sale, the corporation’s assets must be greater than both its liabilities and the amounts it would need to pay out the other shareholders in a dissolution.

On the other hand, the agreement may provide that the remaining shareholders will repurchase the shares. This option works well when there are only a few shareholders in the company or if the corporation itself has only a few assets. In both cases, the corporation and shareholders should consult with counsel to consider tax and other legal implications.

Secondly, the agreement will need to set out the events triggering the purchase.  Some events your corporation may want to consider include: voluntary sales to third parties, court judgments, divorces, retirement, death, or disability of a shareholder, termination of employment, or bankruptcy. In order to guard against hostile or non-cooperative departing shareholders, shares issued to shareholders under the buy-sell agreement should bear a restricted legend and identify that they are subject to the buy-sell agreement. Additionally, if a shareholder is married and the buy-sell agreement would affect the shareholder’s spouses interest (as in the event of a death or divorce) the spouse will also need be a party to the agreement.

Third, the buy-sell agreement will need to specify the price of the shares when purchased. This may vary depending on the event triggering the sale, and can include:

  • The purchase price offered by a third party;
  • Appraisal at the time of sale;
  • Book value of the shares;
  • A formula determined by e.g. earnings, cash flow, or revenue; or
  • A fixed price set forth in the agreement.

The buy-sell agreement should specify how the sale is to be funded. It should provide whether the proceeds will be paid up front or over a specified period of time. For example, sometimes a corporation will be the beneficiary a life insurance policy over its shareholders, and in the event of the shareholder’s death or disability, the corporation will pay for the shares out of the proceeds of the life insurance policy.

Some buy-sell agreements contain tag along provisions that allow minority shareholders to sell a third party at the same price as the majority shareholder in the event that the minority shareholders cannot afford to purchase the majority shares. Conversely, some agreements may allow majority shareholders to force minority shareholders to sell to a third party at the same price as the majority shareholder.

Because the transfer of shares, whether through a buy-sell agreement or otherwise, may have various different tax and legal implications for a company, all businesses should consult with legal counsel about a buy-sell agreement that suits their needs.

Conclusion

A buy-sell agreement is one of the many ways a business can protect itself and its interests. Not only can a buy-sell agreement ensure that a corporation maintains control over its shares and protects its existing shareholders, but it can also help prevent disputes before they happen.

If you are interested in learning more about buy-sell agreements and whether they are right for your business, then please contact Larry Horwitz at lhorwitz@horwitzarmstrong.com.

01 Mar, 16

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