A Buy-Sell Agreement is typically a component included in a Shareholders Agreement, Partnership Agreement, Operating Agreement or Limited Partnership Agreement depending upon the type of entity that has been chosen to operate the business. The details vary depending upon the type of business entity, but the concepts of Buy-Sell Agreement are the same. A Buy-Sell Agreement is a contractual agreement between the owners of a closely held business regarding when and to whom the owners can sell their interests in the company. It can limit who can become owners of the company. It can specify the circumstances under which an owner (shareholder, partner or member) grants the other owners, or the company itself, an option to purchase or redeem the owner’s interest in the business before an owner can offer to sell his interest in the business to a third party (a person who is not already an owner of the business).
The following are the types of events that might be included in a Buy-Sell Agreement and trigger a mandatory purchase obligation or an option to purchase:
- Death of an owner
- Retirement of an owner
- Desire to sell or transfer an owner’s interest
- Termination of employment or active participation
- Involuntary transfer—bankruptcy, creditor attachment, divorce
There are two basic categories of Buy-Sell Agreements, known as Cross-Purchase Agreements and Redemption Agreements.
A Cross-Purchase Agreement provides that when a “triggering event” occurs, the other co-owners of the business have an option or a requirement to purchase the interest being sold or transferred by the owner leaving the business. Owner A pays Owner B for his interest and becomes the owner of Owner B’s interest (for example, his shares of stock).
Stock Redemption Agreement
A Stock Redemption Agreement is a buy-sell provision that grants the company itself an option or requirement to redeem or buy back from the owner the ownership interests to be sold or transferred. The company, rather than the other owners, buy the ownership interests from the owner following the occurrence of the triggering event. The company pays Owner B for his interest and in exchange Owner B returns his stock to the company (referred to as a “redemption”). In a redemption, the redeemed ownership interest is no longer outstanding and percentage ownership interest of Owner A is indirectly increased as a result of the elimination of Owner B’s shares.
A Buy-Sell Agreement should include a purchase price or a mechanism or formula for the determination of the purchase price when a triggering event occurs. The Buy-Sell Agreement can also provide that the purchase price be paid in a lump sum, in installment payments over a number of years and with or without interest accruing with respect to the installment payments. The Buy-Sell Agreement may include a right of first refusal in addition to or as a substitute for a specified purchase price.
There are countless types of purchase price calculation formulas or methods, but the following are a few common examples:
- Agreed upon value (periodically adjusted)
- Book value
- Adjusted book value
- Valuation by a certified valuation analyst
- Formula based on revenues, net income, EBITDA, etc.
- Earn-out provision
- Discounts-minority interests and lack of marketability
- Right of First Refusal
The Buy-Sell Agreement may provide that the owners (cross-purchase) or the company (redemption) must purchase and maintain life insurance on each owner. If an owner dies the life insurance proceeds are available to help fund the buy-out which is often mandatory in the event of death.