In today’s Freedom Friday blog and email newsletter, I want to talk about a topic that does not come up often enough with my business clients, especially those that are starting an LLC, or are restructuring their LLC, and that’s whether or not they have a satisfactory buy-sell (or buyout) provision in their operating agreement. Most of the time when I bring this up, the client scratches his or her head and wonders, “What’s that mean?” So, in today’s Freedom Friday blog and email newsletter, I am talking about what buy-sell provisions are, and why your LLC operating agreement needs a buy-sell provision if you have more than one member (or owner) of an LLC.
First of all, a buy-sell provision (or a buy-sell or buyout agreement) is an agreement among business “partners” or co-owners which determines what happens to an ownership interest in certain circumstances which include, among other events, life-changing circumstances like death, disability, retirement, and even divorce. A buy-sell provision can also be triggered when a co-owner voluntarily decides to leave the company for other reasons. The goal of a buy-sell provision is to prevent conflicts or disputes and ultimately to protect the business so that it can continue even though one of the co-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:
1. Triggering Events
The first factor you should consider when creating a buy-sell provision within your LLC operating agreement is which events would trigger the buyout provision. The most common events which trigger a buy-sell provision are death, disability, failure of an owner to meet contractual obligations, retirement, and even in some circumstances, divorce (especially if the co-owners of an LLC are a married couple). Your buy-sell provision should explain what happens as a consequence of these triggering events. Some events do not need to trigger a buy-sell provision. For example, sometimes a co-owner will desire to retain ownership after retirement or desire to pass on his or her ownership interest to a surviving spouse or a child after death.
2. Consider Your Options
The second factor you should consider when creating a buy-sell provision within your LLC operating agreement is to consider your options and figure out what type of buy-sell provisions are most appropriate for your situation. For example, a “wait and see” clause commits co-owners to a sale while deferring the specifics until a triggering event occurs. So long as the co-owners trust each other, 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 co-owners wants to sell their ownership interest 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 with a majority owner in the potential sale of ownership interests, protecting 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.
3. Find the Right Buyer
The third factor you should consider when creating a buy-sell provision within your LLC operating agreement is finding the right buyer. If a specific owner is essential to the business operation, the person who buys that person’s ownership interest may need to be capable of fulfilling that role in the business, especially if none of the remaining owners are qualified to manage the business. In a family-owned 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. Set the Purchase Price
The fourth factor you should consider when creating a buy-sell provision within your LLC operating agreement is setting the purchase price. When it comes time to buy an ownership interest from a departing owner, deciding on the purchase price can be contentious. Written procedures in the operating 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.
5. Balance the Buy-Sell Terms
The fifth factor you should consider when creating a buy-sell provision within your LLC operating agreement is to balance terms of the buy-sell provision. Even after you set a purchase price or figure out the way the purchase price will be determined, payment defaults are not uncommon, especially if the purchase price will be paid out over time. If an ownership interest is being paid out over a payment schedule of any kind, it’s important to discuss interest rates, amount of down payment, buy-sell 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 Jonathan@libertylegalok.com to schedule a FREE strategy session.
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