The founder of a company asked me whether he needs a buy-sell agreement. Having granted shares to key personnel, he wanted to make sure that a departure from the team did not jeopardize the company’s operations.
A buy-sell agreement can apply to any type of closely-held business (one in which ownership and voting control are concentrated in the hands of a few investors). I will refer, below, to shareholders of a corporation. However, most of the following information applies equally to members of a limited liability company and partners in a partnership.
Buy-sell Agreement Objectives
The fundamental objective of a buy-sell agreement is to provide for orderly change in business ownership and management. Toward this end, a buy-sell agreement typically will do the following.
- Limit share ownership to individuals who will be actively involved in managing the company and helping it succeed.
- Preclude the transfer of shares to third parties who are not approved by the other shareholders – often by giving the other shareholders and the corporation a right of first refusal to purchase those shares.
- Provide liquidity for the shares of a deceased shareholder.
- Preclude a share transfer that would jeopardize S Corporation (tax pass-through) status, when applicable.
- Provide a way to value shares that are not publicly traded.
Buy-sell Agreement Issues
If you believe a buy-sell agreement might be appropriate for your company, here are some issues to think about before the agreement is prepared.
- Should shareholders be permitted to transfer shares to family members (sometimes desirable for estate planning purposes)?
- Should the corporation buy life insurance policies so it will have funds available to purchase the shares of a deceased shareholder?
- Is there a share valuation formula that is applicable to companies in your industry?
- What are reasonable payment terms for share purchases (cash down payment, interest rate, and length of payment term)?
- Should a selling shareholder be precluded from competing with the company?
Preparing a buy-sell agreement takes time and money, but much less than if an unplanned shareholder departure disrupts business operations.
Dana H. Shultz, Attorney at Law +1 510 547-0545 dana [at] danashultz [dot] com
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.