3 Common Mistakes in Buy-Sell Agreements

Buy-Sell Agreements go by different names (Shareholders Agreement, Operating Agreement, Partnership Agreement, for example), but they all have a common goal: provide a clear roadmap for the company and owners to deal with changes in ownership, with minimal impact on the operation and value of the business. Bad Buy-Sell Agreements—those that do not minimize the impact of a change in ownership—share one or more of the following three mistakes.

Mistake #1: Cookie-cutter terms that just don’t work.

It’s a mistake to think that a generic Buy-Sell Agreement is just fine for every company. The terms of a Buy-Sell Agreement must fit the unique characteristics of the company. These unique characteristics may include unequal ownership interests, differing roles in the company, particular family relationships among owners, and industry-specific requirements. Unless the Buy-Sell Agreement takes into account all of the particular aspects of the company and its business, it’s likely that the Buy-Sell Agreement will fail when it is most needed.

The Solution: Every Buy-Sell Agreement must be carefully prepared to reflect the unique characteristics of the company and its owners, and it should be regularly reviewed and updated.

Mistake #2: Determination of the buy-out price is unreliable.

Because Buy-Sell Agreements are about the buying and selling of the company’s ownership interests (stock, membership units, partnership interests, etc.), price matters. If a fixed price set in the Buy-Sell Agreement is too low, then the selling owner (or his or her family) suffers. If a fixed price set in the Buy-Sell Agreement is too high, then the buying owners or the company suffers. For this reason, it’s a mistake for the Buy-Sell Agreement to state a fixed price for the company’s ownership interest, unless the parties are required to update the price regularly. It may be better for the Buy-Sell Agreement to contain a formula to determine the appropriate price, but even a formula can lead to problems if it depends on wrong or outdated presumptions. Because of the problems associated with stating a fixed price or a formula, many Buy-Sell Agreements require an appraisal at the time of a transfer of ownership interests.  An appraisal approach might be better, but it too can suffer from problems, such as failure to specify what facts the appraisal should take into account or gaps in the procedure for determining the price by appraisal.

The Solution: Whether a fixed price, formula, or appraisal, the price provision of every Buy-Sell Agreement must accurately reflect the specific nature of the company and it must be flexible and subject to periodic update.

Mistake #3: No assurance that cash will be available to pay the buy-out price.

Even if a buy-out price is determine appropriately, the buyer—the other owners or the company—must have the ability to pay it. Unless the Buy-Sell Agreement provides specific terms for the timing and source of paying the buy-out price, the buying owners or the company may be legally obligated to pay the whole amount immediately from operating funds. This debt obligation could cripple the company or the remaining owners.

The Solution: Every Buy-Sell Agreement should specify the intended source of funds for paying the buy-out price—often including life insurance and disability insurance policies—and a reasonable time period for payment of any unreserved amount.

Common Elements of a Good Buy-Sell Agreement

Buy-Sell Agreements should be unique documents, reflecting the particular characteristics of the company and its owners, but good Buy-Sell Agreements share most of the following common elements. Good Buy-Sell Agreements:

  • Prohibit transfer of ownership interests except as specifically provided;
  • Deal with the transfer of ownership interests in the following scenarios:
    • voluntary transfer by an owner;
    • involuntary transfer by an owner  (caused by divorce, bankruptcy, or creditor action, etc.);
    • death of an owner;
    • disability of an owner;
    • termination of employment of an owner; and
    • irreconcilable deadlock among owners;
  • Spell out the procedure by which buy-out may occur in each scenario;
  • Describe the method of determining the appropriate buy-out price;
  • Describe the source of funds for payment of the buy-out price (e.g., insurance);
  • Describe payment terms; and
  • Describe what should happen pending buy-out.

Most important of all, no Buy-Sell Agreement is a good Buy-Sell Agreement unless it is signed by all of the owners, including persons who become owners after the Buy-Sell Agreement is originally signed.

Do you have a good Buy-Sell Agreement? If you’re not absolutely sure, contact BrewerLong to have your Buy-Sell Agreement reviewed by an experienced small business attorney.

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