Buy-Sell Agreements Part II: What Should You Include in Your Buy-Sell Agreement?
In the first part of this series, our Alabama business litigation attorneys discussed the need for a buy-sell agreement, the risks of not having one, and what types of structures could benefit from one. In this post, we will explore what types of provisions you should include in your business prenup to ensure that it leaves no room for interpretation or error.
Every business situation is different, and what one company includes in its buyout agreements may not apply to your business. That said, your buy-sell agreement should contain primary provisions, such as the following:
Triggering events are events that may cause the agreement to go into effect. Some such events may include death, retirement, divorce, disability, bankruptcy, voluntary cash-out, dispute between owners, and a wayward owner who threatens the business’s integrity.
A Buy-Out Structure
There are four ways in which businesses typically structure their business prenups. Those are as follows:
- Traditional Cross-Purchase Plan: This type of buyout agreement structure is the most popular and usually works best with two to three members. This type of plans stipulates that remaining owners must buy a deceased, retired, or exiting partner’s share.
- Entity Redemption Plan: Under this type of contract, the business itself is required to purchase the share of a co-owner who dies, retires, or exits the business for whatever reason.
- One-Way Buy-Sell Plan: Per this agreement, only a single member of a multiple member corporation, or a spouse, child, or other heir, would purchase the share of a deceased, retired, or exiting co-owner. The buyer would do this via a life insurance plan in which he or she is the beneficiary.
- Wait and See Buy–Sell Plan: This type of agreement offers flexibility but may create some tension in the event that an owner dies, retires, or exits unexpectedly. Per this plan, the business has the first option to purchase the exiting owner’s share. If the business does not buy it, the surviving owners have the right to purchase the share to the extent of their choosing. Whatever portion is left over, the business must purchase it.
This particular provision should specify how potential buyers may purchase an available share of a company in the event that a triggering event occurs. Before businesses begin discussing buy-sell agreements, members often assume that cash is the only way to pay for an available share. While cash is often acceptable, there are several different ways in which shareholders may fund a buyout. Those are as follows:
- Cash (the most obvious and the easiest);
- Disability insurance;
- Life insurance (a common funding source);
- Cash value in a permanent life insurance policy;
- Stock options;
- Installment sales; and
- Deferred compensation arrangements.
The American Institute of CPAs offers a more comprehensive overview of how buyouts may be funded.
This is perhaps the most important aspect of a buy-sell agreement, as it is important that the remaining members value the business in the same way every time. The value of a business does not remain static and often fluctuates over the course of months or years. A strong business valuation method should take this fact into account. That said, there are two ways in which members may agree to value a business in the event that a triggering event occurs:
- Professional appraisal; and
- DIY with the aid of a business valuation formula.
Before we cover these different approaches, it should be noted that whichever method you choose to use, the buyout agreement should be very clear in what is to be included in the sale. Do you plan to value just the physical assets your business owns, or assets and debts? Will commercial property be included in the overall value of the business? Again, it is important to account for these questions, as they are sure to arise each time you are forced to enact the business prenup.
A professional valuation may be the easiest and most effective method, as a professional can take the guess work out of the process. It also puts the majority of the work in the appraiser’s hands, which means you and other associates are free to continue running your business as usual. Working with a professional also ensures that bias does not pose an issue, as the process is done by an objective third party. However, professional valuation is costly, running anywhere between $2,000 and $5,000, sometimes more.
DIY formulas are obviously the less expensive option, but they require each member to put forth a lot of time and effort. You can reduce the amount of time you must put forth by utilizing a universal appraisal formula, such as the seller discretionary earnings method.
How a Knowledgeable Business Litigation Attorney Can Help
At Cloud Willis & Ellis, our Alabama corporate law attorneys are familiar with buy-sell agreements and have helped countless clients draft such contracts that make the buyout process as seamless as possible for remaining owners. In addition to helping businesses draft business prenups, we also step in when a triggering event occurs to help mitigate conflict. If conflict does arise, we are prepared to help members mediate the issue and come to a fair agreement. Whether you wish to draft a buy-sell agreement, or you need legal guidance after one has been enacted, contact our corporate law firm today.