Buy-Sell Agreements – A Must for Start-Ups with Multiple Owners

No one wants to think about the break-up before the marriage. The same can be said about a new business with multiple owners. Owners of a start-up are so passionate about getting their products and services out the door that often not enough time is spent thinking through what happens if the owners decide to part ways. Trust us – it is easier to navigate a later transition if the buy-out terms are spelled out in writing before business really takes off.

The document that accomplishes this task is called a Buy-Sell Agreement. Think of it like a pre-nup for business owners. The Buy-Sell Agreement addresses voluntary separations – i.e. an owner wants to retire, finds other interests or simply loses the spark with his/her co-owners. A Buy-Sell Agreement also covers involuntary separations – events no one wants to think about, much less plan for – things like bankruptcy, becoming disabled, or passing away.

In all of these situations, your company has various options available:

• General Voluntary Buy-Sell Terms. The most common buy-sell arrangement provides that if an owner decides to sell his/her interest, the selling owner must first offer his/her interest to the company, and if the company declines to purchase the interest, then the selling owner must offer its interest to the remaining owner(s). That’s fair, right? No one wants to be forced into business with a stranger. If no remaining owner is interested in purchasing, the selling owner is free to sell to a third party on such terms as he/she desires. No complaints allowed if you didn’t jump when you had the chance.   

• General Involuntary Buy-Sell Terms. Involuntary buy-sell arrangements typically specify that the company must purchase an owner’s interest upon employment termination, death, disability, bankruptcy, divorce, etc. In the event of death, the agreement often provides that the company can purchase life insurance on the life of any owner and that such owner consents to the purchase of the life insurance (and the inevitable pokes and prods that accompany life insurance coverage). In the event of death, the life insurance proceeds are used to pay the purchase price and the company does not necessarily have to come up with the cash.  

Other “fancier” options include:

• Tag Along Rights. Tag along rights provide that if a third party offers to purchase an owner’s (often a majority owner’s) interest, then that owner can require another owner to “tag along,” i.e. sell their interest on the same terms as proposed by the third-party offer.This prevents the little guys from getting shut out and guarantees they get the same deal as majority owners.
• Drag Along Rights. Speaking of little guys, drag along rights provide that if a third-party offers to purchase a majority owner’s interest, that owner can “drag along” the minority owners into the deal, i.e. sell their interest on the same terms as the third-party offers to the majority owner. This protects majority owners by preventing minority owners from stopping a deal. 
• PUT Option. A Put option requires that the company buy an owner’s interest if that owner desires to exit the company. Sounds nice, right? But be careful here. These require that the Company have enough cash on hand to buy-out the selling owner in the first place.
• Texas Shoot Out. This is a fun one. As the name implies, it provides for a sale of interest where two equal owners are experiencing a deadlock. (Cue Old West music.)  Here, when one owner wants to sell his/her interest, the first owner must offer to sell to the second owner at a specified purchase price. After a certain period of time passes, the second owner then has two options: accept the first owner’s offer and purchase the interest, or decline, at which point the first owner is obligated to purchase the second owner’s interest on the same terms as he/she specified in the initial offer to sell. See what happened there? If you want out, make sure your proposed selling price is one you are willing to pay!                                              

Regardless of how the buy-sell agreement is structured, you will want to include a provision for calculating the valuation of the exiting owner’s interest. There are several available:

• Owner Determination. The Agreement could provide that the company and/or its owners will first attempt to agree on a price. If an agreement cannot be reached, the company and/or owners agree to have the ownership interest appraised. Remember, appraisals can be pricey so it may be best to agree to agree.
• Express Agreement. The Agreement could provide that the interest will be purchased or sold at book value or some other predetermined value or formula. In this instance, the company’s CPA may be called upon to make the price determination.
• Third-Party Price. The Agreement could provide that whenever a disinterested third-party is the first to offer to purchase an owner’s interest, that price is the price the company or another owner must pay if they purchase the interest instead. This is similar to a classic “right of first refusal.”
• Payment Plan. Companies rarely have enough cash set aside for a lump-sum payment, so regardless of how the price is determined, Buy-Sell Agreements often include a payment plan at a predetermined interest rate in the event the company or remaining owners decide to purchase the interest.

The Buy-Sell Agreement should also define potentially contentious terms, such as what type of “disability” or employment termination triggers a buy-out. You will want to specify whether your agreement is binding on current and future owners (most common), or just current owners, and whether future owners who purchase an interest in the company will receive voting rights or just financial dividends.

Finally, don’t forget to consult your tax attorney, who can advise on potential implications of a company buy-out and how to structure these deals upfront to avoid any unexpected tax consequences.

For more information about Buy-Sell Agreements and other legal issues facing start-ups, please contact Amy Plummer.

The material in this blog is not intended, nor should it be construed or relied upon, as legal advice. Please consult with an attorney if specific legal information is needed. 

- Amy Plummer