In today's Freedom Friday blog and email newsletter, I want to talk about a topic that often comes up with my business formation clients, especially those that are starting a new LLC and its two or more “partners” forming the business together.  In such a case, the LLC operating agreement needs to have a buy-sell provision or agreement, and most of the time when I bring that up, the client(s) scratch their heads, and “What's that mean?”  So, in today's Freedom Friday blog and email newsletter, I'm answering the question, “What is a buy-sell agreement?”

So, what's a buy-sell agreement, which is also sometimes called a buyout agreement?  This is an agreement among business “partners” or co-owners, which determines what happens to an ownership interest in case of certain circumstances which include, among other events, life-changing circumstances like death, disability, retirement, and even sometimes divorce.  The buy-sell agreement can also be triggered when a partner or co-owner voluntarily decides to leave the business for other reasons.  The aim of a buy-sell agreement is to prevent conflicts or disputes and protect the business so that it can continue even though one of the owners is leaving or has left the business.  Here are five (5) factors you should consider when creating a buy-sell provision within your LLC operating agreement, or if you need to draft a separate buy-sell agreement with your partners or co-owners:

1.  Triggering Events

The first factor you should consider when creating a buy-sell agreement or provision is what events will trigger the buy-sell provision.  The most common events which trigger a buy-sell provision are death, disability, failure of an owner or partner to meet their contractual obligations, retirement, and even in some circumstances, divorce.  Your buy-sell agreement should explain what happens as a consequence of these types of events.  Some events do not need to trigger a buy-sell provision.  For example, sometimes a partner or co-owner will desire to retain ownership after retirement or will want to pass on their ownership interest to a surviving spouse or child after death.

2.  Consider Your Options

The second factor you should consider when creating a buy-sell agreement or provision is to consider your options, that is what type of buy-sell clauses are appropriate in your situation.  For example, a “wait-and-see” clause commits business partners to a sale while deferring the specifics until a triggering event occurs.  So long as the co-owners trust one another, this flexibility is beneficial from a tax and ownership perspective.  A “shotgun” clause commits the co-owners to a specified share price in case one of the owners wants to sell all their ownership interests and leave the business.  This clause protects the remaining owners from a long and expensive court battle which can seriously damage the business.  A “drag-along” clause binds together a minority owner and a majority owner in the potential sale of ownership interests, protecting the majority owner(s) from minority owner(s) who might stop the deal.  A “tag-along” clause commits majority owners to allow minority owners to join any deals which may be made, guaranteeing the minority owners get the same deal as majority owners do.

3.  Find the Right Buyer

The third factor you should consider when creating a buy-sell agreement or provision is finding the right buyer.  If a specific owner is essential to the business operation, the person who buys that person's ownership interest should be capable of filing that role within the business.  In a family-owed business, it is especially important to determine which owners will hold voting or non-voting interests, so that the control of the business stays with the people who are running the business effectively.

4.  Setting a Purchase Price

The fourth factor you should consider when creating a buy-sell agreement or provision is setting a purchase price.  When it comes time to actually buy ownership interests from a departing owner, deciding on the purchase price can be contentious.  Written procedures outlined in the LLC operating agreement or in a separate buy-sell agreement can ensure price disputes get resolved quickly.  Some options include agreeing annually to a predetermined purchase price or agreeing to a purchase price set by a third party, such as an appraiser, or a CPA skilled in business valuations.

5.  Balanced Buyout Terms

The fifth factor you should consider when creating a buy-sell agreement or provision is crafting balanced buyout terms.  Even after you set a purchase price or figure out the way the purchase price will be determined in the future, payment defaults are not uncommon, especially if the price of the ownership interest is going to be paid out over time.  If an ownership interest is being paid out over a payment schedule of any kind, its important to discuss interest rates, amount of down payment, buyout periods, security guarantees, etc.

Thinking about starting a small business?  Or maybe your small business is having issues with contracts, leases, business partners, collection issues, or experiencing other barriers to growth?  Please contact me at [email protected] to schedule a FREE strategy session.

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