August 2, 2007

People enter into business ventures every day—whether to form a new company or join an existing one. The process requires prospective partners to spend a great deal of time negotiating the terms of the admission, which often includes a buy-sell agreement.

Many people approach business ventures the same way they would a marriage. They look for a partner they can trust—someone who will be a teammate, confidant and cheerleader. Just like some marriages, though, not all business ventures last forever. In fact, the typical marriage vows raise issues that business partners frequently encounter:

  • for better (a partner wants a bigger piece of the pie for all the business he generates),

  • for worse (a partner hopes to transfer his interests in a failing company to get out of the business),

  • for richer (a partner would like to sell his portion of the business to take profits off the table),

  • for poorer (a partner wants to bring in outside investors to bail out a troubled company),

  • in sickness (a partner is permanently disabled and can no longer contribute to the business venture),

  • and in health (a partner wants to retire while he is still young and healthy),

  • until death do us part (when one partner dies, the other may be forced to accept the deceased partner's inexperienced spouse and/or children as partners).

While breaking up is always tough from an emotional standpoint, it does not have to be difficult from a legal one. To protect themselves throughout the relationship, business partners should consider three primary issues when entering into a buy-sell agreement: restrictions on transferability, repurchase events and valuation.

Restrictions on Transferability

Unlike their public counterparts, private companies are allowed to dictate who can be an owner. Because most buy-sell agreements restrict the ability to transfer ownership interests in the company, shareholders should carefully consider any exceptions they want to include, such as permitted transfers for estate planning purposes.

As an alternative to an absolute prohibition on transfers, many buy-sell agreements provide for a right of first refusal with respect to proposed transfers. For example, if a shareholder receives a bona fide third-party offer to purchase his or her shares, the other shareholders and/or the company would have a right of first refusal to purchase those shares on the same terms and conditions, including price.

Because majority shareholders often want to prevent a minority shareholder from blocking the sale of the entire company, many buy-sell agreements contain a "drag-along right." Under this provision, if shareholders representing a majority interest want to sell their shares, they can force the minority shareholders to support the liquidity event by selling their shares as well.

Conversely, minority shareholders may want the option to participate in a sale
if the majority shareholders decide to sell their interests in the company. To that end, many buy-sell agreements also contain a "tag-along right" that allows minority shareholders to sell a pro rata percentage of their shares and avoid being left behind with an illiquid investment.

The "Shotgun Buy-Sell Right" or "Texas Shootout," another type of buy-sell provision, provides flexibility when one shareholder wants to buy out another. Certain triggering events (e.g., a deadlock on a major decision) will allow a shareholder to initiate the buy-out of another shareholder. While the initiating shareholder sets the buy-out price, the other shareholder has the option to sell his or her shares to the initiating shareholder or purchase the shares of the initiating shareholder—all at the set buy-out price. One benefit of this provision is that there is generally no need to undertake a formal valuation since the initiating shareholder has an incentive to price the shares fairly. On the other hand, it theoretically favors a shareholder with deep pockets or a partner who is better equipped to operate the company.

Repurchase Events

Many companies want their shares to be held only by people who are actively involved in the operation of the business. When a person ceases active involvement for whatever reason, his or her interests may be subject to repurchase. Common triggering events include death, permanent disability, termination of employment, retirement, involuntary transfer of the shares (such as bankruptcy) and divorce (where the shares are transferred to the shareholder's former spouse). The common theme among these repurchase events is that the shareholder either no longer is actively involved in the business or no longer holds the shares personally.

The parties to a buy-sell agreement should consider whether the repurchase right may be exercised by the company, the other shareholders, or both. In addition, they need to determine whether the repurchase right will be mandatory or optional.

Valuation

A buy-sell agreement also should stipulate how the parties intend to value the shares in the event they are repurchased. The following is a description of some common valuation methods:

  • Determination by the Parties: Although the parties can include a value in the initial agreement, the price is typically updated each year to account for changes in the value of the business. A drawback to this method is that the parties may have to spend a great deal of time negotiating the value up front and on an annual basis.

  • Book Value: A company's book value is determined by taking its assets and subtracting its liabilities. One problem with this methodology is that book value does not account for a company's earning potential. In addition, it only reflects the original cost of the company's assets, less depreciation.

  • Multiple of Earnings: This methodology attempts to value the company in a manner similar to the way potential buyers would. Although it is a much better reflection of ongoing value than book value, the approach may not be appropriate for certain types of companies, such as a start-up with high initial costs that result in low earnings.

  • Appraisal: Under this approach, an independent appraiser determines the fair market value of the interests being repurchased. The advantage of this methodology is that the shareholders do not need to negotiate a value up front, but rather allow a third party to determine it as needed. The buy-sell agreement should specify how the appraiser will be selected, who will pay for the appraisal and whether any discounts can be applied to the interests being repurchased (such as a discount for lack of marketability).

It Pays to Plan Ahead

Most people enter into a business venture expecting it to last forever. Like many marriages, however, these relationships often take unexpected turns. A thorough, well-drafted buy-sell agreement will allow a business to conduct its affairs as planned, while providing for an effective mechanism to address unintended events.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.